This is always the first question I ask my client on the first discussion and most of their replies were – “Both”. Generally, these are two opposing performance indicators and only on unique circumstances a property will be able to generate both high rental yield and high capital gain. Let us dive in further to understand why we have to choose one to achieve the best result.
Understanding key terminology
- Capital gain – the increase in property’s value (10 years, long term)
- Rental yield – positive cash flow generated from property’s value (yearly, short term)
By identify certain attributes of a property, we will be able to characterize whether a property will perform better in capital gain or rental yield. In any real estate portfolio, a good mix of both types will spread the risk well to maneuver through market fluctuation. Ideally, before shortlisting properties to purchase, investors have to choose a preferred strategy, either for capital gain or rental yield, rather than the realizing the appropriate strategy after purchasing the property.
Strong capital gain properties
In order to have high potential in capital gain, the property must be purchased under market value in a good location with high possibility of future development. While sitting on slow paper growth, you might have to reduce rental rate sharply to secure tenants and suffer a few years of net negative cash flow. Properties with good capital gains will allow investor to accumulate long term wealth as the eventual gains will outweigh some years of negative cash flow.
In order to have high potential in capital gain, the property must be purchased under market value in a good location with high possibility of future development.
Strong rental yield properties
Typically, properties with high rental yield will have lower capital gain as the development in the location which attracted the tenants is already saturated for growth in the near future. Furthermore, being situated within walking distance to public transports and have good variety of amenities in the neighbourhood add-on to the purchase price as a premium to buyers, hence lesser room for capital gains. Nevertheless, properties with a good rental yield will allow investors to receive consistent net positive cash flow for other opportunities.
Which strategy has a greater risk?
Certainly both have its inherent risk in different market conditions.
During a market downturn, investors who are relying on rental income to fulfill their mortgage payment will feel the most pain. Being over leveraged with insufficient cash to tie over months of deficit, they put themselves at risk by selling the properties hastily and suffer losses in both capital gains and rental yield.
During a sluggish market, investors who have a potential capital gain property will be agonizing on the next good exit point to cash out. While reviewing his capital gain percentage which inches forward by a tiny bit every quarter, it reminds them on risk of losing to opportunity cost (when the cash can be better spent elsewhere).
Obviously, investors with 2 or more properties have more advantage over starters, who only have 1 property, as they could diversify their portfolio by having a better mix and survive in poor market condition. As for investors with 1 property now, fret not! You still have the chance to achieve a much better result than the seasoned investors, if you understand the fundamentals and start off the right footing.
Choosing the right strategy
For starters who have limited cash and income stream, the most effective strategy is to go for property with strong rental yield potential. These properties have consistent stream of tenants due to its proximity to industrial area, offices or international schools. Even in the worse market situation, by being flexible to reduced rent for a year or two, you will still have tenants coming in. Furthermore, with a decent amount of discipline, the net positive cash flow generated can be compounded and gradually build up your fund for the next real estate move.
For home owners searching for his first investment property, ask yourself if you need to rely on the rental income to pay off mortgage on time for at least 18 months?
- For those with low reliance on rental income, it is the best time to look for high potential capital gain properties. There will be more motivated sellers eagerly wanting to lighten their financial load as the economy dips further, start catching up with your trusted agent as they are probably the first outsider to receive information on underwater sale. Be vigilant for undervalued properties.
- For those who need rental income to pay off the mortgage, be mentally prepared to accept a rent cut to secure a deal from the reducing population of tenants in today’s slowdown of global economy.
In short, both capital gain and rental yield have its own pros and cons which have different effect in different market conditions. Depending on your financial situation and larger market / economic outlook, you have to select the one most suitable approach to better position yourself for growth in the upcoming market trend. Furthermore, by ensuring the right mix of the two will ensure optimal long term growth of your real estate portfolio.