Rental yields can determine if investments deliver strong headaches or returns

Property investors often talk about ‘yielding’ properties. Cash flow positive terminology is splashed around in property forums.

Some successful investors have built significant wealth with a positive-yielding strategy, however, many people don’t completely understand it.

Achieving outperformance capital growth together with strong rental returns at the same time is a bit of a holy grail.

In most cases, and particularly with interest rates at current levels, investors must face the prospect of a cashflow-negative outcome at the beginning of their property acquisition journey if they are keen to achieve capital growth.

It’s the magnitude of the negative cashflow that matters.

Cash flow conundrum

A strong negative cashflow can cripple an investment plan for a couple of reasons.

Firstly, if it’s not planned well, it can erode savings and negatively impact important lifestyle (and non-discretionary) decisions.

For example, if the investment property is adversely impacting a household’s ability to spend on food, clothing, education, fuel or transport, the investment property won’t last long. Selling costs will further amplify any losses. If entertainment is also limited, (to the point of creating unhappiness), the investor may decide to sell as well.

A strong negative cashflow can also hamper an investor to continue investing. If loan servicing sits at the investor’s maximum capability, the only reprieve for further investing would be a substantial pay increase, or strong rental growth for the existing property(ies).

No amount of extra equity can change this, because servicing is all about the customer’s ability to pay the debt off, not their ability to source another deposit.

It makes sense to assume that an investor will target a stronger rental yielding property when they are cashflow sensitive. Some embrace this approach when they plan to acquire many properties for a long term ‘buy and hold’ approach.

But how often do they forecast the eventual outcome? And why is this so essential?

Something that buyers don’t often consider is the relationship between capital growth and rental growth. Gross rental yields move akin to a ship being steered; usually slowly. Melbourne’s rental pool has diminished over recent years, and even with the headlines about pressure on rents, the gross rental yield has only moved from 3 to 3.4 per cent over the past two years.

Most Melbourne investors will have noticed this increase in rents, but it hasn’t moved the needle substantially enough to ease the pressure on holding a property in this current interest rate climate.

So, if gross rental yields are reasonably static, this implies a high capital growth performer will likely experience similar rental growth over the long term.

Rent, capital growth relationship

The relationship between rental growth and capital growth is akin to a DNA strand. The rental growth and capital growth often oscillate in opposite directions, but over the long term, the ratio between rents and capital growth (gross rental yield) is reasonably consistent.

This suggests that an investor with higher capital growth assets will enjoy higher rents over time.

The challenge remains; servicing and cashflow.

How does an investor target the right property(ies) to provide themselves with a great post-retirement income?

Assuming a huge portfolio of low-priced properties will get an investor to their end goal faster is often a flawed model. Multiple properties can equate to multiple headaches and a large maintenance bill. This burden increases once interstate holdings are introduced too.

Rather, modelling a moderated array of growth and rental yielding properties, along with the required maintenance costs and tax surcharges, is good idea.

Like Goldilocks and her porridge, it’s important to tailor the plan to the individual investor to get it just right.