Investment grade property: Yield vs capital growth

There are three main ways you can make money on property:

1. Rental yield
2. Capital growth
3. Growth on rental yield

Let’s have a chat about the first two.

Rental yield

A property’s rental yield is calculated by dividing a property’s annual rental earnings by its valuation. I often argue that the better way of calculating rental yield is to first subtract from annual rental earnings all of a property’s costs (think interest, insurance, management fees, strata fees, council charges etc). This will give you a much better picture of how much cash income the property will deliver.

Different dwelling types deliver different rental yields. Typically, apartments and townhouses deliver better rental yields than houses. This is despite the fact that apartments and townhouses are burdened with expensive strata fees and houses are not. The main reason for this is that house valuations are typically much higher than apartment and townhouse valuations in the same suburb. On the flipside, median rents don’t vary as much. Ceteris paribus (fancy economic term for “all other things being equal”), as the denominator in the rental yield equation rises, the yield falls.

Under normal circumstances you might argue that the higher the rental yield, the better. Conventionally this makes sense, until you start to consider taxes and capital growth prospects. Positive cash flow properties (properties with rental yields high enough to deliver annual profits to you after all costs) increase your taxable income. That’s prima facie absolutely a good thing. You’d much rather earn money and pay tax on it, than lose money and claim a tax deduction. But not if it comes at the cost of capital growth. And if apartments and townhouses are yielding more attractive rental earnings, you may pass up a house investment opportunity to chase this yield. We argued in Investment grade property: Dwelling types that house price growth tends to outperform apartment/townhouse price growth.

Let’s run some numbers with a 10 year investment horizon to see how this may play out in practice. We’ll assume an interest rate of 2% on an interest-only loan, a deposit of 20%, equal property costs of $5k per year and 100% occupancy. Please keep in mind this will be a very simplified model because we could be here all summer if we got bogged down in the nitty-gritty. There are definitely more factors which could be worked into the model like more realistic occupancy rates, rental growth, fluctuating interest rates, stamp duty costs, land taxes, depreciation and opportunity costs (ie what if you’d stashed your deposit somewhere other than in bricks and mortar).

	Houses	Apartments
Median price	$1,400,000	$825,000
Median rent (yr)	$28,600	$26,000
Rental yield	2.0%	3.1%
Deposit	$280,000	$165,000
Loan amount	$1,120,000	$660,000
Interest (yr)	$22,400	$13,200
Property costs (yr)	$5,000	$5,000
Median rent (af costs)	$1,200	$7,800
Rental yield (af costs)	0.09%	0.95%
Yield on deposit	0.43%	4.73%
Yield on deposit (af taxes)	0.29%	3.19%

Had you bought house in Sydney, then after 10 years you can expect to earn a measly $12,000 in rent after costs (but before taxes). Had you bought an apartment in Sydney, then after 10 years you can expect to earn $78,000 in rent after costs (but before taxes). I very simply calculated these figures by multiplying the median rents (af costs) by ten. The problem with rent is that all this rental income is now added to your taxable income. Factoring in a marginal tax rate of say, 32.5%, you’re looking at a cash in-hand profit of $8,100 for the median Sydney house vs a cash in-hand profit of $52,650 for the median Sydney apartment, over a 10 year investment horizon.

The reason you should always calculate your yield on deposit (final two rows) is because your deposit is your actual capital contribution. You put down 20% and borrow 80%, and in this interest-only example, you contribute no further capital. Your capital contribution is powerful and has opportunity costs. You therefore need to do this investment analysis to consider whether this is a worthy use of your money. Just looking at these figures with no consideration yet to capital growth, the yield on deposit for the median Sydney house of 0.43% (pre-tax) is embarrassing (although keep in mind that yields on deposits for many Sydney houses are actually negative – ie negatively geared). Still, take comfort in the fact that you’re yielding more utility than you ever would over a pair of birks. 4.73% (pre-tax) for the median Sydney apartment is okay.

Capital growth

Capital growth is very easy to observe. Is your property worth more today than it was a year ago? If so, voila – you have capital growth. The data tells us that house price growth tends to outpace apartment price growth. Annoyingly, tracking down reliable data on long-run property price growth seems to be a little tricky without a paid subscription to a service like CoreLogic. Most sources seem to agree that long-run Sydney median house price growth sits somewhere between 7 – 7.5%, so we’ll use 7.25%. As for the long-run Sydney median apartment price growth, I’m seeing figures ranging from around 5.5 – 6% – so let’s split the difference again and use 5.75%.

The beautiful thing about capital growth is that it doesn’t actually get taxed until it’s realised. Capital gains are unrealised the entire time you hold the property. You haven’t sold the property so there’s no “capital gains tax event” for the tax office to come knocking. This lets you take full advantage of the compounding effect of your property’s growth. Assuming a linear 7.25% growth rate (unrealistic assumption), your first year 7.25% return for the median Sydney house is $1.4m x 1.0725 but your second year 7.25% return is ~$1.5m x 1.0725. You lock the full value of that extra 100k into the property to experience compounding without having to carve-out any of your annual gains for the tax man/woman to crap all over your 10 year return. This perk does not apply to income, including rental income.

Applying the hypothetical growth rates above to this example translates to a 10th year house valuation of ~$2.63m vs a 10th year apartment valuation of ~$1.36m. Deducting the deposits and applying the 50% capital gains discount (check the eligibility criteria every time), with a marginal tax rate of 45% (most of your taxable income should be higher than this if you’re banking such a large one-off windfall), you’re looking at an after-tax capital gain of ~$736k (house) vs an after-tax capital gain of ~$286k (apartment).

	Houses	Apartments
Rent (10 yr af costs & taxes)	$8,100	$52,650
10 yr rental return on capital	3%	32%
Capital gain (10 yr af costs & taxes)	$736,250	$286,750
10 yr capital return on capital	263%	174%
Total gain (af taxes)	$744,350	$339,400
10 yr total ROI (af taxes)	266%	206%

Now you may argue that this is an unfair comparison because the purchase prices are different. This is a fair argument but remember there are pros and cons to this. A few points to raise here:

1. Opportunity cost: There are obviously opportunity costs with stashing more cash in a house deposit than in an apartment deposit and feel free to factor those into your decision-making.
2. Risk: We’re assuming linear positive price growth in this example, which isn’t realistic. The risk is much higher in the case of the house. A 10% drop in the property market translates to a $82.5k loss for the apartment, but a $140k loss for the house.
3. Borrowing capacity: The more debt you hold, the more restricted you are in your capacity to take out loans to finance other investment opportunities such as another investment property or to leverage a large stock market investment.
4. Rental yield: We demonstrated above that the rental yield is significantly worse for the house because house valuations tend to be much higher than those for apartments.
5. ROI: This is exactly why we also calculate and express return on investment as a percentage. The larger the deposit, the harder the money will have to work for you to yield a higher ROI (expressed as a %).

Again, keep in mind this is a very simplified model. Even if we can say the historical median house/apartment growth rates are accurate and we can say with any degree of certainty that they’ll continue on the same trajectory and we can be sure that your specific investment choice just so happens to be the “median” house or apartment, prices won’t grow in a linear fashion. You may be exceptionally unlucky and experience 10 years of sub-optimal house price growth (or even negative growth) only for the market to deliver higher-than-expected returns after your investment horizon has expired to later balance things out and revert to the mean.

Bottom line

There are means of achieving both high rental yield and high capital growth and none of the above is limited solely to different dwelling types. Location and expected population growth for example each play a large role as well. Most people tend to opt for capital growth over rental yield. We know that’s true because every man, woman and their dog on east coast of Australia seems to own a negatively geared property.

I for one like both. Obviously capital growth appears to be the more tax effective method of making money on property. But I still see value in high yields in the sense that they help you manage your cash flow during your investment horizon. In an ideal world you should be able to finance a property’s expenses purely out of its earnings without having to sacrifice your capital growth prospects. These investment opportunities exist – you just really have to do your DD and be very smart with your strategy.