Focusing on rental income cost you $1m+ in lost wealth

growth versus income

An investment property’s total investment return will consist of rental income plus capital growth. I have written about the importance of maximising capital growth many times. However, often investors are tempted to focus attention on income (when selecting an investment property) too, as they seek to minimise the cash flow cost of holding the investment property.

I propose that this is a mistake with a high opportunity cost. The reason investors make this mistake could be due to (1) not fully appreciating the consequences of their decision, (2) need to adjust their target property attributes or (3) need to reduce their investment budget.

Focusing on income means you must spend more on the building value

The value of a property consists of two components being the land plus any improvements i.e., the dwelling. Generally, land appreciates in value whereas buildings depreciate over time due to wear and tear, which I have written about here.

The table below illustrates this point. If you aim to achieve an overall capital growth rate of 7% p.a. to 8% p.a., which is a reasonable expectation for an investment grade property, then the more you spend on the building value, the greater the rate of land value appreciation you will need to achieve an overall rate of growth of 7-8% p.a.  

Building versus versus land growth rate

In summary, investors should focus on land value whereas tenants focus on the quality the dwelling.

Opportunity cost of focusing on income

It us unrealistic to expect an investment property to return more than 10% p.a. in total over a long period of time. That is, the gross rental yield plus capital growth rate cannot exceed 10% p.a. Typically, properties that offer higher rental yields will almost always deliver lower growth. This makes sense given the building value drives income but not capital growth.

Therefore, an investor can manipulate the makeup of their return (i.e., how much income and growth they may receive) by targeting different types of property.

The chart below compares the wealth impact of various combinations of income and growth. At the extreme (left-hand side), an investor could theoretically invest in a property that offers a 9% gross rental yield and 1% growth rate. And vice-versa on the right-hand side.

The calculation represents the present value (today’s dollars) of both the income stream (including negative cash flow) and capital growth if you sold the property after owning it for 30 years, net of all taxes[1].

Split between income and growth makes a big difference

This chart clearly demonstrates that targeting a higher rental income comes at a substantial cost. The opportunity cost of targeting say a 4% gross rental yield, instead of settling for 2% and more growth is worth almost $1 million (in today’s dollars).

Investing in the right property with the right attributes is literally a million-dollar decision.

Spend money on the property after you have purchased it 

If you do want to focus on generating more income from your investment property, then I suggest you purchase the highest quality asset that your budget will allow. Then, in time, you can spend money on improving the dwelling to achieve a higher rental yield if you like.

The advantage of this approach is that you will be able to claim a depreciation tax deduction in respect to the capital improvements that you make, which will help you reduce the tax you pay and create even more cash flow. I have discussed/analysed this previously here.  

Reduce your budget or fund cash flow partially from equity

If you are concerned about the cash flow cost of investing in a land-heavy investment property, then you can take one of two actions.

Firstly, you could reduce your budget. For example, if you are targeting a house, maybe consider investing in an investment-grade villa unit instead. Successful property investing is all about investing in the highest quality asset you can afford. And a high-quality property must have a substantial land value component.

Secondly, instead of compromising on the investment property’s attributes, you could consider funding some of the cash flow holding costs from equity or savings, if your financial position allows, as I’ve explained here. My intention isn’t to invite you to borrow beyond your means but more correctly inviting you to appreciate how costly (from a wealth perspective) it can be to focus on income when selecting the best investment property to buy.

Many buyers’ agents are conditioned to optimise income

It is true that many investors are (mistakenly) focused on income. As a result, I find many buyers’ agents are conditioned to believing that maximising rent is an important attribute when selecting an investment property. Hopefully, my analysis above demonstrates that doing so comes with a high opportunity cost. Instead, I’d encourage buyers’ agents to educate their clients about the cost of focusing too heavily on income. They then should redefine their investment property brief that meets their client’s cash flow budget, whilst at the same time ensuring they select a property that has the necessary attributes that will generate the highest investment return.

Growth first, income second

Hopefully this blog demonstrates how important it is to understand investment fundamentals. These fundamentals are rooted in basic math and logic and aren’t difficult to explain. But unfortunately, many investors, buyers’ agents and financial advisors don’t understand this asset class (i.e., residential property) well enough to deliver evidence-based advice.

[1] Financial modelling assumptions include rental income growth of 4% p.a., interest rate of 6% p.a., property expenses equal to 30% of gross rental income, maintenance of 1.5% p.a. of the building value to maintain yield, Victorian land tax rates used, and assume investor borrows total cost of acquisition.