Rental Income v Capital Gain: Generating wealth from Property Development

March 24 2014

Rental Income v Capital Gain: Generating wealth from Property Development

We spoke to Property Development specialist Mark Lawrence to explore the differences, opportunity costs, and benefits of property development in the context of achieving rental yields versus a pure capital gain play in property development.

Below is an edited transcript of a great conversation between Mark and Kerrian Devlin from Ventura iD Property Development in Perth.

Kerrian: So Mark, rental income and capital gain – you generally don’t get both in the same investment, so maybe we could split that up into two different categories because neither is incorrect.

Some people buy a property just to get the rental yield, and others to gain capital growth. So if we split them into two categories and maybe start off with rental income.

You have some thoughts on that?

Mark: With the rental income, what you want to do is generate an interest and an excitement from a tenant. You want a scenario where when they walk into that property they feel comfortable at home and are prepared to pay for that.

The assumption is that you spend less on a rental property than you would on your own home. This is not necessarily true. If you are in an area where you are attracting an executive rental market, to under capitalise is actually a bad use of funds.

Things like stone kitchen bench tops, high ceilings, nicer bathroom fit-outs, nicer fixtures and fittings will attract a better tenant and potentially a higher rental yield. With those two things you minimise ongoing maintenance costs and you will also attract better quality tenants because of the better quality fit.

All this improves your yield.

Kerrian: And it also helps you in a competitive market where there are several properties that maybe competing for the same rental person. If your design is better than the others, even in a less competitive market, that person would probably be picking the better of the value properties to live in, so it reduces the down time in renting the property.

Man drawing a pie chart

Mark: Looking at the vacancy rates – say they are high and rent yield low. You really need to minimise the vacancy period and that creates a market edge and advantage over other properties near it.

Kerrian: Absolutely. So you look at the area, some places you generally don’t get a higher rental return per dollar you spend as say some of your suburban areas. If you were to spend two million dollars on a house, it doesn’t necessary equate to a 5% yield, whereas that is quite often achievable in some of the suburbs – $400,000 or $500,000

Mark: That’s right and that’s where you typically find the offset of rent yield or rent returns versus capital growth.
Capital growth is a function of land value, that’s why we have quantity surveying reports so when it comes tax time we get deductions for the depreciation on the value of the building over a period of time.

And so with a blue chip area, your upside is capital growth, you will sacrifice initially a bit on rent yield, but if you contrast that to an area that with a higher rental yield, the trend is that you do not appreciate the same capital growth. Still with shopping and employment opportunities, you can still balance the investment decision in whether you go into an area where it’s more directed into capital growth versus trying to create a balance of rent return.

Kerrian: Capital growth is taxed differently to personal income or profit form an investment, as you enjoy a 50% discount on the income make. This means that if you make a capital gain of $100 000, only $50 000 would be taxed at your marginal rate.

Retired people who may have a lot of assets, but not a great cash flow may take advantage of this scheme to increase their cash holdings.

Mark: That’s right, if high rental yields are a person’s strategy, where they are purchasing for this purpose income generation, then purchasing investments with high land ratio’s may not give the same rental returns as villas, town houses or units.

Kerrian: I know in my case, I accumulate as many properties as I can, and get as much rent from them as I can. The capital growth is irrelevant unless you actually want to re-finance and use them as security.

I would rather have 20 lower end suburban rentals that give me a higher yield which increases my potential for retirement, than to have the capital growth continually going up, because the only way I can realise that money is either to re-finance or sell.

If you structure yourself right, your income during the accumulation stage will be offset against costs and depreciation, leaving you with an income upon retirement.

Mark: It’s like a plant. If you take a rental property in its initial stages of the purchase, you’ll probably find in most instances if you got a balanced area where you got some prospects of capital growth, you as an investor will need to water the plant, you will need to nurture it, and at some point in time it will start to self-sustain. So in other words you come in after a short period of time, you plant a tree and 5 or 6 years after it starts to bare fruit.

So by nurturing the investment up front and investing into it, in time it will start bearing fruit so instead of you supporting it, it will start supporting you.

Kerrian: Correct. So at the end of the day, there is no right or wrong way.

Both strategies are sound. You can give examples of people that have been successful in accumulating many properties that don’t necessarily have great capital growth. Historically the West Australian market has worked doubled in value every ten years, so even if you purchased in an area you don’t believe has the best capital growth, historically the Perth market has doubled its market, so you won’t miss out necessarily in the long term, it’s more the short term strategy.

If your strategy is between 5 and 10 years then you need to be more selective on which one you think will work best for you.

Mark: That’s right. That’s why the Perth market is safe in a sense – it’s an ongoing market.

Historically, take the mining community where there is a very high rental return, an extremely high rent yield, but the prospect of the site closing in a number of years also creates a scenario where the capital growth could be very low. So it’s about balancing a scenario where you don’t have those ongoing costs or capital loss at the end.

Kerrian: You bring up a good point there because a lot of mining companies do have huge returns on the rental, but when that mine shuts, those properties are worth nothing because that town is basically only supported by the mining boom.

Mark: In a way you really need to just be looking at an area that is sustainable, it’s not exclusive one way or another, I’d probably be biased towards rent return and rental yield in the first instance, but doing that in the Perth market where there is always the prospect in capital growth and overall return in the long term.

Looking at starting your wealth creation journey with property development? Contact Ventura iD for a consultation with the team.

Follow Ventura iD on FB, Twitter

Recent Tweets

No questions found.