The Secret Ingredient For Capital Growth And How To Find It

Full disclosure here of my long held bias towards capital growth over yield. Now that the lending landscape has changed in Australia, I am even more convinced of the merits of this approach. It’s becoming increasingly evident that borrowers need to be much more selective with their asset choices.

Headlines screaming “property prices falling” are gaining loads of attention at the moment and there are many areas and property types that will suffer, but not all. When you buy for yield, you are typically sacrificing capital growth: it’s a well accepted principle that you can’t have both at once.

High yield equates to risk.

High yields are often found in lower socio-economic suburbs or single-employer areas where locals don’t buy the majority of the homes, investors do. If there are no locals who can afford (or want to buy) property, when the investor demand dries up there’s only one way for prices to go. It could be years before you see any sign of a recovery.

I’ve been concerned for some time that high yielding “investments” target the most vulnerable property investors: those who can least afford to take risks. If you want positive cash flow because you can’t afford to buy in a good growth area or because you want to quickly build a portfolio, then I suggest you do some extensive research before you commit.

It’s important to recognize that prices have, are and will continue to fall in risky areas. By chasing yield, many Australians have unwittingly put themselves in a terrible financial position. We’ve all heard stories of hapless property “investors” who’ve already had their retirements ruined following the end of the mining boom. In order to offset the loss of capital, you’ll need to get awfully big rents and even a yield as high as 10% simply won’t cut it.

That said, while I say that yield is not as important as capital growth, I want to stress that cash flow is extremely important. Investing in low risk property will require cash input for some years, so you’ll need a good income not only to get the loan approved but in order to maintain the investment.

Location, Location, Property

Property is a long game and I favour blue chip suburbs because these locations possess the foundations to deliver sustainable capital growth. There are many respected property experts in Australia who consider the evidence and have come to the same conclusions that I’ve arrived at through my own experience and research. The safest places to invest in this country are within a 10km radius of the CBD of either Sydney or Melbourne.

Yet suburb selection on its own is not enough, it’s important to drill down further. Every suburb has its nuances and less desirable areas. Not all property performs the same in an A-grade suburb. It's possible to have a lemon in a blue chip area and even a B-grade property can result in significant opportunity cost.

For example, I have a case study on a compromised terrace in Balmain that shows it LOST traction against the rest of the market to the tune of $180K over 12 years. The longer the owners hold it, the further away from the rest of the market they fall. Conversely, an over-performer would have outpaced the median growth rate for the suburb.

One reason we focus so heavily on capital growth is that over time your financial position will be greatly improved if you make the right choices now.

This illustrative median growth curve is typical of the inner ring suburbs of Sydney and Melbourne. Not all property grows at the same rate. 50% of property will grow at a rate that is less than the median and 50% will grow at a higher rate. You can see here that the difference between a low performing property and one that grows at a rate above the median for the area actually increases over time.

There is a way to magnify your returns in an A-grade location and it requires you to fine tune the property selection. This is achieved by understanding the characteristics that appeal to the largest proportion of local buyers in any given suburb.

Why is performance important?

Most people decide to invest in property because they want to accumulate wealth and ultimately experience financial freedom. Yet this dream won't eventuate if you hold a property that doesn't perform.

The consequences of a poor performer could include limiting your ability to buy or upgrade your family home and the opportunity cost of having your money tied up in a property that is not growing in value cannot be underestimated.

In our post APRA/Royal Commission world, borrowing capacity is now a scarce resource and we need to use it wisely if we really want to use property to fund our future.