How to accurately assess an investment property’s potential - November 2023
November 14, 2023 / Written by Rich Harvey
As a property investor you may have deliberated on what types of assets generate the best results for your wealth-building plans.
As you probably know, real estate returns are generated in two ways – via capital gains (i.e., increased value) and rental. Now, debate often rages among pundits on whether you should seek investments with capital gains potential or positive cashflow via higher relative rental returns.
What I’ve noticed in all the discussions about which is best is that while it’s a good idea to look at both aspects of investment, many people don’t fully understand what is meant by cashflow positive and why focusing on this solely can lead to bad choices.
Here’s a bit of information on the proper way to approach an investment’s cashflow numbers and how to make smart decisions when considering your options.
Gross versus net yields
Rental returns of various property assets are most often compared in terms of their yield. There are two types of yield that are most often discussed.
Firstly, there’s gross yield which is calculated by dividing the property’s annual rental income by its value or purchase price and then expressing that figure as a percentage. So, if a property is purchased for $500,000 and it generates $25,000 a year in rent, then it has a gross yield of five per cent.
The other is net yield, which is essentially the same calculation, however we use the net annual income. This is the rental generated less all annual holding and maintenance costs. Say the property earns rent of $25,000 per year, but the owner ends up spending $10,000 a year on keeping the property in good repair, paying rates, covering body corporate levies and servicing property management fees. That property’s net income is now $15,000 per annum, which means its net yield after costs is three per cent.
Why is it important to understand this distinction?
Well, because I have seen bad investments promoted as excellent cashflow assets based on gross yield.
A great example is bedsit student accommodation. You might see some of these properties in areas such as Ultimo in Sydney, or even in the CBDs of Brisbane and Melbourne.
A marketer might promote a student accommodation unit, quoting that for a $250,000 purchase price, you can collect $20,000 a year in rent, which is an impressive gross yield of eight per cent.
What they don’t disclose however is that to hold that unit, you must pay a very high body corporate levy. This is to cover building maintenance and repair, as well as additional services such as internet charges, 24-hour reception, common laundry area, shared kitchen facilities and so on. In addition, an above-industry average management fee will be charged because of the intensive use of these buildings. Suddenly that gross $20,000 income is whittled down to a net $7000 a year. Your net yield is now at 2.8 per cent.
This same sort of consideration can be applied to other high cashflow investment types. Think holiday homes or short-stay manged hotel-style units.
Understanding net yield is a crucial step in analysing investment potential, but there is another comparison that buyers must also weigh up.
Cashflow versus capital growth
If you study property assets for long enough, you’ll see the free market at work as, on balance, buyers seek to balance out cashflow and capital growth potential.
Generally, high cashflow assets tends to see less capital growth and vice versa. Essentially, the market prices assets to reflect a balance between cashflow and capital growth.
Here’s why this is important to remember as a property investor.
A good, secure cashflow is important. A consistent income from your asset helps ensure you can service your debts and keep the property in good repair over many years. Also, the ability to hold property long-term can result in better value gains i.e., capital growth.
While value growth is where you make your real wealth in real estate, buying a property with exceptional capital gains potential is no good if you can’t afford to hold it for a market cycle or two. That’s why an adequate net rental return is so crucial.
So, finding a balance between rental return and capital gain potential that suits your specific needs is what smart investors strive for, and that all comes down to asset selection.
You must find assets in great locations and with the right characteristics to deliver terrific value uptick while also delivering strong rental returns… and the best way to do that is by relying on advice from an expert. A buyers’ advocate who specialises in your location of interest is the right professional to make that happen. They can identify the fundamentals which ensure your property achieves premium rent, is rarely vacant and delivers strong capital gains potential.
The risk of investing without an advocate is too great, so don’t hesitate. Reach out and speak with one of our team. They’re well-placed to help you meet your long-term goals through savvy property investment.
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