When buying investment property – capital growth first, rental return second: John McGrath

When buying investment property, capital growth prospects should be prioritised over rental returns, says property expert John McGrath in a recent blog post on Switzer, citing a recent Corelogic RP Data report showing rental growth was slower than capital growth over the past decade.

The report shows that across the combined capital cities, rents have increased by 50.7 percent (or 4.2 percent per annum) over the past decade compared to an increase in capital values of 72 percent (or 5.6 percent per annum), he says. 

Looking at different property types, house rents increased by 50.3 percent while apartment rents rose by 53.7 percent. Drilling down to the cities, the two capitals with the greatest rental increases were Sydney (no surprise) at 59.4 percent and Perth at 54.6 percent. 

"Rental returns are important because they help you with your loan repayments. That’s their primary purpose at the beginning of your tenure of an investment property," he says. 

In most cases, especially in the high value markets of Sydney and Melbourne, the odds are the rent on a newly acquired investment property will not cover repayments or other costs in their entirety so an investor will have negatively gearing. 

Regardless, the rent will still take care of a sizeable chunk of the outlays, thereby reducing the cost of holding the investment property while time does its thing to deliver capital gains. 

However, over time, if one chooses to pay the principal and interest on the investment loan; and rental returns gradually increase year to year, one will eventually get to a point where rental returns do in fact cover the whole mortgage.  And throughout all this, tax benefits such as depreciation, will also have a positive impact. After a bit more time, the rent will start to cover other expenses like strata fees and council rates too. This would take an investor into positive cash flow territory and that’s an excellent place to be – it’s the dream scenario for retirees. 

But that requires good long-term strategy, adds McGrath.

"Many people say interest-only loans are the way to go with investments because they keep your repayments to a minimum. This is entirely true and a good strategy to adopt if your cash flow is tight. But if you want to get to a point where the rent is covering everything, you’ll generally need to start paying some Principal at some point.

"It’s helpful to think about where you want to be in retirement and work backwards from there. But don’t do it alone – sit down with your accountant or financial advisor. You might want to keep your loan at interest-only to keep outlays as low as possible, wait for capital growth; then sell in 10 years for a profit. Another scenario might involve paying the principal and interest to reduce the loan down to positive cash flow as soon as possible, with the intention of creating a strong, debt-free, income-producing asset for life.  

"Your strategy will depend on your goals and the timeframe you have to achieve them. But if there’s one piece of advice I hope you take when buying an investment it’s this – capital growth first, rental return second. Always."