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Capital Growth in Property
Capital Growth an article By Stuart Wemyss
Author of The Property Puzzle and Smart Borrowers Handbook
The strategy outlined in this article is for investors who are primarily seeking above-average capital growth to increase the value of their investment property, over and above the cash flow generated by rental income.
For instance, if we consider that the average total income produced by an asset is say 15% a year, the capital growth strategy dictates that the investor would aim to achieve maybe a 10 to 11% increase in value and 4 to 5% rental yield.
Capital growth is primarily driven by the scarcity of an asset. Therefore, when selecting a property for capital growth, there should always be a consistently greater level of demand than supply. Unlike the current cash flow derived by a property which you can be sure of, the future growth of a property is an ‘unknown factor’. It is for this reason that correct asset selection is critical and enlisting professional help, such as the help of a good buyer’s agent, is money well spent (read: invested).
Investors using this strategy often make a loss on their cash flow (i.e. outgoing expenses related to holding the property are greater than income generated by the property). This loss can be offset against other taxable income, which reduces the investor’s overall taxable income and therefore tax payable (often referred to as negative gearing). Often, this attracts investors to this strategy.
However, we would caution investors on being enticed into an investment strategy by tax benefits alone.
As a general rule of thumb, properties that suit the capital growth strategy are found closer to major capital cities. This is because inner-city locations are often ‘built out’ so to speak, with a marked lack of developable land available and, therefore, limited housing supply. Additionally, many people like to live close to their workplace, entertainment and transport hubs and generally within easy access of major infrastructure found in inner-city areas.
How is a profit made from this strategy?
The premise behind investing for capital growth is that over time, as your investments increase in value, you can borrow against that growing equity to add to your portfolio. Obviously, this prospect is more difficult with positive cash-flow property, where your capital growth might be significantly less; therefore it can take longer to build sufficient equity to fund further acquisitions.
The trade-off is that your rental income possibly won’t cover your holding costs, leaving you out of pocket each month in the first eight to 10 years of ownership. However, there are ways to compensate for this, including using your growing equity as a cash-flow buffer if required. Because of this cashflow shortfall, the capital growth strategy best suits investors who have plenty of time to acquire high-growth assets and fund the cash-flow shortfall with working income.
At times, such as when this book was written, capital growth properties can become positive cash flow because of prevailing economic circumstances. In early 2009, for instance, we saw many investors enjoying record low interest rates of 4 to 5% and increasing rental yields of 5 to 6%. This, in turn, meant that even well located high-growth properties were achieving neutral or positive cash flow as interest rates matched or dipped below yields.
Following are financial projections outlining how the capital growth strategy works when it comes to crunching the numbers. The aim of these projections is to illustrate how you can deduce whether a capital growth strategy suits your investment goals.
There are many books written about how capital-growth strategies work, so if you need more information, there’s plenty out there.
Our financial analysis
How to develop financial projections
Developing financial projections involves forecasting all income and expenses. First, you need to forecast each investment property’s income and expenses, allowing you to arrive at a total for your projected property portfolio. You then have to work out how that affects your personal cash flow. Let’s work though a very simple example.
Assume you buy an investment property for $400,000 in year 1. The projected cost of this purchase would be:
Rental income @ 3.5% of property value $14,000
Less:
Interest on a loan for $431,265 @ 7% $30,189
Property management @ 8% of rental $1,120
Letting fee $303
Council rates $1,509
Insurance $776
Maintenance $612
Annual loss $20,509
The annual loss in year 2 will reduce, as we naturally assume the property value will increase while the rental yield will remain constant at 3.5%. A more valuable property should, in theory, command a higher rental return. The loss in year 2 would be projected to be $19,301 (I have included proportional increases in income expenses also).
Once this property investment portfolio’s cash flow has been determined, we need to check the investor’s affordability. This involves testing if the investor can still pay their bills after entering into this investment. Let’s look at the numbers.
Present After Property
Investor’s salary income $100,000 $100,000
Property loss (from above) - ($20,509)
Taxable income $100,000 $79,491
Tax payable on taxable income ($29,210) ($19,521)
After tax income $70,790 $59,970
Less:
Living expenses ($35,000) ($35,000)
Home loan repayments ($23,500) ($23,500)
$12,290 $1,470
The above cash-flow forecast suggests that the property acquisition is affordable, although it is quite tight (not a large surplus). In this situation, I would prefer to see the client holding some cash savings as a buffer, in case the property’s loss is more than budgeted.
To develop a financial plan, you need to prepare a long-term forecast in an integrated financial model, so you can assess different scenarios. That is, different property purchases for different amounts at different times. It will also need to account for things like land tax and the like at a portfolio level.
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