Why invest in prime Sydney Harbour property with a 4% rental yield, when other Australian properties may show as high as 8%-9% rental?

Over recent years some investors have been chasing cash-flow positive properties in Australia, or at least properties with a high rental return.

There have even been several books published about buying properties that achieve a high rental cash flow.  But one key point is often overlooked.

The long well documented history of Australian real estate teaches us that when investing in residential property in Australia there are many things to research, but three factors need to be considered in relation to the actual
return: -

ONE: Capital Growth

TWO: Cash Flow (i.e. rental)

THREE: Risk

 
Well located, prime properties in Australia traditionally have a lower rental return than property that is located in fringe or outer locations.
 
That is quite well known.

 
But, what many inexperienced investors in Australia fail to realise is that properties that show exceptional rental return either have high risk, or low capital growth.

 
Simply put, property investment in Australia that  has a high rental return, you will forego much of the potential capital growth.

 
Why should I buy for capital growth, rather than for rental income?

 
Capital growth is extremely important to the overall return of the investment.

 
What we do know for a fact is that over the past 50 years Sydney apartments on average have generated around 13% -14% per annum total  return  (Source: Real Estate Institute of Australia)

 
Prime properties have been higher than this, but for the sake of the illustration, let us take the average Sydney apartment appreciation.

 
Since we know that for prime properties 9% of this was capital growth, and 4% was rental, calculations can be easily determined.

 
Some people argue that if the return is to be 13%, why shouldn't I take 9% rental return, and 4% capital growth?  In their view that will mean the rent covers mortgages (all bank loans) and they are still getting a good 4% capital growth, as well as positive cash flow. Surely this would be a better investment?

 
Let’s simply check the figures over a 10 year investment period.
Assume the property was purchased in Sydney at say A$800,000, with a 70% mortgage ($560,000) and interest rates averaged 7% for the whole period.

 
Scenario one:  9% capital growth, 4% percent rental

Value of apartment after 10 years: $1,894,000.

Add rental after mortgage payments and all expenses: $32,000.

Return $1,926,000.

 
Scenario 2:  9% rental and 4% capital growth

Value of apartment after 10 years: $1,184,000.

Add surplus rental after mortgage payments and expenses $327,000.

Return $1,511,000.

Difference $415,000.

 
There is over $400,000 dollars difference in just 10 years!

 
In reality, it is likely the difference will be even greater, as these figures assume the average capital growth, and prime properties could achieve 11 or 12 % capital growth per annum.

 
For the past 50 years prime properties have averaged this capital growth, regularly over all long term property cycles.

 
The extra percent investors chase in rental return can be very costly long term as can be clearly seen from the above example.

 
1.  Australian Property has a combination of Risk, Rent, and Capital Growth. As history has taught us, you can get two of the three, but not all three.

 
 High rental return properties have always shown much less capital growth.

 
2. The best combination is low risk, high capital growth, and forgo the high rental return. The difference in the total return can be huge.