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Reproduced with permission.
I am often asked is it better to buy a property that has a high rental return or potential for capital growth. If you look at the calculations below, I think you’ll be able to make up your mind relatively quickly.
Let’s assume that you have $400,000 to invest and you have two options:
Option 1 – Large house in a regional area
Buy a brand new property in a regional area that has a rental return of 7% pa ($28,000 pa) and a projected capital growth rate of 4% pa.
If you chose to buy the new home in a regional area, the rent pays for most of the mortgage repayments and you only need some extra money to pay for other expenses such as council rates, insurance, etc
Option 2 – Inner city unit
Buy an older style unit in an up and coming suburb that has a rental return of 4% pa ($16,000 pa) and a projected capital growth rate of 7% pa.
If you buy the unit, you have to dig deep into your pockets as the $16,000 pa doesn’t even cover the interest payments, let alone the principal component and other rental expenses. Oh yes, we also have body corporate fees but as the unit is an older one with no lifts, swimming pools and is part of a small group of eight units, the body corporate fees are very low.
All I have done with the figures is simply swap the growth rates and rental return numbers around but you will see that this makes a HUGE difference in your long term wealth.
Let’s fast forward 10 years.
Based on a capital growth rate of 4% pa and a rental return of 7%, after 10 years the regional property is worth $592,000 and the rent is $41,000 pa. However, based on a capital growth rate of 7% pa and a rental return of 4% pa, the unit is worth $787,000 and earning $31,000 pa in rent.
After 10 years, the rent from the regional property is still greater than the rent from the unit but the unit is worth more.
Let’s fast forward 20 years.
After 20 years, the property in the regional area is worth $876,000 and the unit is worth $1,548,000.
So far as the rent is concerned, the regional property returns $61,000 pa but the unit is earning $62,000.
After 20 years, not only is the inner city property worth much more but it is also earning a higher rent. If you bought the inner city property in the up and coming suburb rather than the house in the regional area, you would be $672,000 richer.
So, what do you think is better, capital growth or rental return?
Happy House Hunting!
Written by Peter Koulizos, university lecturer, author and buyers advocate.