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Should you invest for rental return or capital growth?

Australians now more than ever, are thinking about investing in property, especially as the booming economy is returning more cash to their back pockets. When it comes to property investment the raging debate seems to be regarding whether you should invest for a higher rental yield or for capital growth.

In simple terms, rental return is the ratio of rental income to capital value and it is expressed in terms of the rent achieved for a property, as a percentage of the price paid for it. On the other hand, capital growth is the increase in the market value of a property. Units generally provide higher rental yields than houses, while houses offer better capital growth as the market for houses is predominantly bigger.

Generally speaking, investors in regional centres can attain a higher rental return but get lesser long term capital growth. However in the major capital cities strong capital growth usually goes hand in hand with a lower rental yield.

With rental rises lagging years behind market increases, strong capital growth will be the key to a successful investment. Rental income needs to be high enough to help with the costs of loan repayments, but it should not be the main reason for investing.

Take for instance Oscar and Sally. Oscar bought a property worth $400,000 in a poor growth area delivering 5% capital growth and 10% gross rental return. Sally alternatively purchased a property worth the same amount in a high capital area showing 10% capital growth and 5% rental return. In 20 years Oscar’s property will be worth just over half a million dollars, whereas Sally’s home will be worth $2,690,000.

The first year or two of holding an investment property can be challenging but keep in mind that capital growth has a far more extensive impact on the final value of your property than rental yields.