Many would- be investors are caught out when they purchase an investment property.
The reason being the yield is simply miscalculated in many cases, leaving the new investor having to find additional finances in order to cover the mortgage repayments.
The stated return in the agent’s advertisement seemed a plausible 6% pa. With interest rates at around 7%, the investment seems to stack up. But does it really? It all depends on what basis the yield is taken from. The gross yield, or the net yield?
The quoted gross return of 6% can be whittled down to as little as 3% when expenses are factored in. Whilst the investor takes 6% pa, after expenses they are only keeping 3%, leaving an unexpected gap in between income and repayments.
Capital Growth or Income?
Research shows that the majority of residential real estate investors buy an investment property with “potential capital growth” being the main investment criteria. Income is largely overlooked with the main focus being on annual capital growth.
It is close to speculation when an asset is purchased and the income stream in overlooked in favour of a focus (hope) on potential capital growth. But this is what many investors do, without realising it. Speculating on capital growth coupled with a property love affair is one of the reasons that many economists have concerns about the Australian real estate market.
Yield often comes in behind capital growth for investors. Importantly, the net yield is usually overlooked in favour of the often-quoted gross yield.
But if the net yield is strong, you will have a solid investment, one which is almost certainly going to give you what all investors are chasing, capital growth.
Over the long term, capital growth is influenced by a strong net yield, not the other way around.
Capital growth is an investor’s reward for owning the property over the longer term. The very best investments produce an income that covers all expenses, including mortgage repayments.
Real estate agents will almost always quote the gross yield as it pumps up the yield. As an investor, you need to focus on the net income that you will receive. The tenant is not going to pay those exorbitant strata fees and neither will the agent who sold you the property .
What Drives Down the Gross Yield?
When investing in a property, it is imperative that you are aware of the costs that will erode your return. Some of these costs are obvious and some are easily overlooked.
Costs that need to be factored in up front include vacancy (Allow for 2 vacant weeks p.a.), agent’s management and leasing fees, strata, water and council rates, property maintenance, land tax if applicable and landlord insurance. These are all expenses that you would not have if you did not own the property. Therefore, the income that you hold after these expenses have been paid is the real rate of return.
Taxation and negative gearing is another huge consideration for investors. Expenses can be offset against income, lessening the blow. However, the accountant Austin Donnelly summed it up the best when he said, “You are better off sharing a profit with the tax department than keeping a loss to yourself”.
When assessing the potential viability of a residential property investment, you should have clear objectives regarding returns.
Real Estate can provide a particularly significant capital gain over and above the rate of inflation. This coupled with a reasonable yield means residential property investment offers some tax benefits, an investment cash flow, generally good investment security and, at times, high real investment returns relative to those available from other investments.