Delving further into the fundamentals of making a property investment, we consider the importance of rental yields versus capital gains – which is more significant and what impact can each have on an investment strategy?
Rental yields are often considered a key signifier of a property’s potential. But they are not the only thing that investors should consider. Capital gains are also important, but the significance of each depends to some extent on an investor’s personal or financial circumstances. So how do you know whether to go for cash-flow positive properties with higher rental yields, or to hold out for the best capital gains?
What are capital gains?
Capital gain or capital growth is the profit that results from the sale of a capital asset where the sale price is higher than the purchase price. It cannot actually be realised until the asset is sold. Of course, the price of an asset can also go down, resulting in negative capital gains or capital loss.
How do you calculate capital gains?
Capital gain is the profit resulting from the sale of a capital asset as a percentage of the original purchase price. For example, if you paid USD200,000 for an apartment and you sell it five years later for USD225,000, you take the amount by which the price of the apartment has increased (225,000 – 200,000), which is USD25,000, and divide it by the original purchase price (25,000 / 200,000) to get 0.125 which when multiplied by 100 gives you the capital gain expressed as a percentage – in this case 12.5%.
Predicting what a property’s price might be in the future is of course, speculation, and capital growth figures are only accurate once a property has actually been sold.
What about capital gains tax?
Capital gains tax is tax levied on any profit accrued from the sale of an asset. It only applies when an investor sells their asset for a price that is higher than the initial purchase price. Not all countries implement a capital gains tax and most have different rates of taxation, but it is worth looking into what this figure is and who it applies to when assessing the pros and cons of rental yields versus capital gains.
Why should you consider rental yields?
Rental yields figures, particularly net rental yields figures, are a good indicator of how much cash flow investors can expect. High rental yields suggest that an investor will be able to cover the costs of any mortgages or management fees from the rent, and potentially have some left over. Higher rental yields can even make it easier to get loan or mortgage approval.
Rental yields can also be a pre-cursor for capital growth. When an area becomes attractive it is generally the renters who get there first. It’s easy for them to move and less capital is required to do so. An increase in the number of renters in an area means that rents goes up, but because renters are not purchasing the property in the area, property prices are not under the same pressure to increase and usually remain relatively steady.
However, growing popularity of an area is something that investors look for and even if the renters get there first, it is likely that owner-occupiers will follow, as the things that are attractive about an area – be it redevelopment and investment, enhanced transport links, employment opportunities or improved amenities – appeal to both renters and owner-occupiers. It is then that property prices are likely to start increasing.
Also, bear in mind that high rental yields are not always a pre-cursor to capital growth. Yields may be high, for example, not because rents are increasing, but instead because property prices are falling. It’s always worth looking into rental costs and property prices from years previously.
Why are capital gains figures important?
Like gross rental yields figures, capital gains figures can be helpful when investors are comparing different properties, or comparing a property with other investment assets, such as bonds, stocks and shares.
Capital gains figures suggest how much your property will increase in value in the coming years. Focusing on capital growth in the long term can offer greater financial gains but this can be at the expense of a shortfall during ownership. Investors need to consider whether they can cover this shortfall.
For good capital gains figures, look to areas where demand is high and there is a shortage of supply – factors that cause property values to rise. Generally properties with high capital gain are found in more attractive or sought-after locations such as commuter areas with strong demand from young professionals or places due to undergo major development.
Which is more important?
When it comes to investing in property, it’s important to get the balance between rental yields and capital gains right according to the investor’s circumstances. The investor needs to be able to fund their property investment and if they need their rental income to cover their mortgage repayments, then rental yields may need to be at a certain level. However, chasing returns at the expense of solid, sustainable long-term growth is also not wise. It’s always prudent to bear the bigger picture in mind.
It’s rare that you will find strong capital growth and high rental yields – negatively geared properties often offer higher capital gain, while high rental returns can mean that capital growth is lower, but there’s no right or wrong when choosing which to go for. Strong capital growth helps to generate long-term capital profit but this can be at the expense of rental returns that don’t cover expenses meaning that investors may suffer until a property is sold.
Higher rental yields can mean that a property pays for itself and in some instances cash reserves are also generated, but on selling, capital gain is less. Where cash flow is good, consider ways you could add value to the property yourself, through renovations and other improvements. Overall, property prices in the long-term generally increase, even if there are some shorter-term fluctuations in prices, so it’s also worth considering how long you intend to keep a property before selling it on. To maximise capital growth, consider keeping an investment property for five to ten years.
In a best-case scenario, high rental yields and strong capital growth are desirable, but these do not always go hand in hand, so consider your financial circumstances and which will be best for making your investment successful and in line with your financial strategy. But always look at both and find the right balance for you.