One of the main benefits of property investing is that there are two ways you can make money; a regular income known as rental yield or capital growth, where the value of the property you buy increases over time.
In reality, an investor will have a mixture of both yield and capital growth. Find out the differences to determine which strategy best suits your goals.
What You Will Learn
- Property investment yields profit from rental income and value appreciation.
- Rental yields are calculated using rental income and property price; net yield also considers annual expenses.
- Rental yield assures returns but higher yields pose greater risks and liquidity issues.
- Capital growth reflects long-term property value increase, largely dependent on location and market trends.
- Choosing between rental yield and capital growth depends on an investor’s specific goals and risk tolerance.
What is Rental Yield?
Rental yield is the return you are making or expect to make on a property you own or are interested in investing in.
Rental yield signifies the rate of return on investment. When investing in a property, many developers or estate agents will display their expected gross rental yield on properties that are on the market.
Property investors use rental yield to monitor how valuable their property investments and portfolios are.
How to Calculate Gross Rental Yield?
To calculate gross rental yield and determine how viable a property may be as an investment, you need to know the following:
- The purchase price of the property or a current market value.
- The annual rental income that you expect to receive.
Gross Rental Yield Calculation
(Annual rental income / property value or purchase price) X 100 = Gross rental yield %
Let’s say you expect to purchase a property for £250k and expect your annual rental income to be 18,000. The calculation would be:
(18,000 / 250,000) X 100 = 7.2 % gross rental yield
Therefore your gross rental yield would be 7.2%.
How to Calculate Net Rental Yield?
When calculating a net rental yield for a property, you will need to factor in any other costs you may have with the property, such as:
- Mortgage payments.
To calculate a net rental yield, you subtract any expected annual expenses from the yearly rental income and divide this by the cost of the property.
Net Rental Yield Calculation
((Annual rental income – Annual expenses) / property value or purchase price)) X 100 = % rental yield
Let’s say you expect to purchase a property for £250k and expect your annual rental income to be 18,000 but will spend 1,900 a year on expenses. The calculation would be:
18,000 – 1,900 = 16,100
(16,100 / 250,000) X 100 = 6.4 % net rental yield
Therefore your net rental yield would be 6.4%.
Understanding location is vital when looking for the best return when investing in property.
Property prices and average rents vary greatly depending on which town, city or region you want to invest in. It’s therefore vital to widen your search to optimise your rental yield.
Benefits of Investing for Yield
There are several benefits when choosing to invest for rental yield.
One advantage of investing for yield is the certainty you have when calculating your potential returns from rental income.
You can identify the monthly rent, look at your expenses and know the income the property will give you with reasonable accuracy. You can then use this to benchmark against other potential investments to maximise your return on investment.
When investing with a goal of capital growth, this isn’t possible. So, for example, many investors in London in the mid-2000s found themselves chasing capital growth and investing in higher-priced properties with large mortgages that they were subsidising as the rent wasn’t covering them.
When the financial crisis hit in 2007 and property values fell, investors could not keep subsidising the mortgages and sold with negative equity.
If the focus is on high-yielding properties, you can put yourself in a situation where the rent is offsetting the mortgage whilst also giving you positive cash flow.
Rent is Linked to Inflation
Another significant benefit of investing in rental yield is that rent is intrinsically linked to inflation. This is because rents are connected to wages, and wages are linked to inflation. This means if you are investing for yield, you have a recession-proof asset.
Downsides of Investing for Rental Yields
However, there are drawbacks when investing in rental yield, and you must understand them before investing.
Higher Yield = Higher Risk
Understanding there is a direct correlation between yield and risk is essential. As with any asset, the higher the return, the higher the risk.
For properties you have calculated to have a high yield, you need to step away and think logically about why this might be?
It’s more than likely that the price is low. If the price is low, but the area and the investment still have solid fundamentals, it can be a good time to invest.
However, if the price is low because the property is in a bad location, then you must consider what the potential drawbacks and costs involved with the investment are:
- How quickly do you feel you will be able to find a tenant?
- Does the property need any repairs or renovation?
- What do you anticipate the maintenance costs will be?
- Do you believe the tenant will be renting the property consistently? – A high yield can soon evaporate if the property is void for some time.
Another potential drawback is market liquidity. For example, property is considered more illiquid when benchmarked against other assets such as equities.
However, if you have a low-priced, high-yielding property, the price will be low for a reason. Therefore, if you want or need to sell the property, how confident would you be if you needed to sell quickly and at the price you believe the property is worth?
These are all significant considerations that are often overlooked when investing for yield.
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What Is Capital Growth?
Capital growth, also known as capital appreciation, is the amount your property or portfolio investments increase or decrease in value over time.
The percentage of the original purchase by which the property has increased will represent the return on the investment for capital growth.
Property investors aiming for capital growth should have a long-term strategy in mind, whether five, ten or 20 years.
Compared to the high yield and high-risk strategy of rental yield, a capital growth strategy is essentially lower risk.
Capital growth opportunities are usually in areas close to city centres. You will have chosen the place to invest in as you believe there is high demand for property, and the tenant demographic will tend to be professionals and families.
Because of this high demand, they tend to be easier to sell should you wish to exit the investment.
Property prices fluctuate over time, but long term, they have trended upwards. However, in the short to mid-term, they also go down. This makes predicting capital growth on potential properties speculative. You can only accurately calculate capital growth after you have purchased the property.
What Factors Affect Capital Growth
In addition to general market supply, many factors can affect property prices in any location. Research the following to optimise your return for each properties location, as they all have a positive impact on housing growth:
- Affordability ratio.
- Transport links.
- Population growth.
- Business activity.
- Wage inflation.
Benefits of Investing for Capital Growth
There are several benefits to investing for capital growth:
- Less risk.
- Higher liquidity.
- Compound growth.
Growth is Compounded Over Time
One of the main benefits of capital growth investing is that growth is compounded over time, which acts as an accelerator for the profits of your property portfolio.
Let’s say you invest in a property valued at £200,000:
In one year, the capital value of the property increases by 3%. In year two, that property would be worth £206,000.
The following year you see the same growth of 3%. That increase is now worth £212,180.
Then a further 3% gross leaves you with £218,545 in four years.
The table below highlights the true investment potential of compound growth. Your assets will double in price if you have growth of:
|% Yearly Growth||Time to Double in Value|
Leveraging for Capital Growth Investment
Since 1982 the average growth of UK house prices has been 6.7% a year, which means the average property in the UK doubles in value every 10.2 years.
This is the main reason property investors make considerable wealth investing for capital growth in the UK property market.
This acceleration effect is further enhanced if investors use leverage through mortgage finance. Essentially leverage is using other people’s money or borrowing to make higher returns.
If you are using leverage, it can make a dramatic impact on your portfolio over the medium to long term.
Drawbacks of Investing for Capital Growth
However, there are drawbacks when investing for capital growth, and you must understand them before investing.
Location is Key
Like investing for rental yield, there are no guarantees of profit when investing for capital growth.
It is essential to understand the fundamental drivers behind why a particular location will increase in value before investing.
You can make an intelligent guess as to why a particular location will increase in value, but the critical variable is totally outside your control; therefore, you do not get the certainty you can get by crunching the numbers when investing for yield.
The second drawback is cash flow. As a result, properties in areas primed for capital growth will tend to be close to or within city centres.
This means they will command a higher price and reduce your cash flow compared to investing in a rental field.
You will be impacted more greatly if the value of your property falls if you have invested for capital growth.
In the UK, from 2007 to 2012, the average price of a property in the UK fell. So if you were in a position where you needed to sell at this point, you would have made a loss on your investment and potentially had negative equity.
Therefore it is vital to ensure that your cash flow is positive to combat property fluctuations so you are not forced to sell.
Over the longer term, however, property in the UK will rebound and increase in value over time because of supply and demand fundamentals.
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Rental Yield vs Capital Growth
Capital growth and rental yield are two essential metrics for property investors, representing different aspects of return on investment.
Capital growth refers to the increase in the property’s market value over time. It’s the difference between the purchase and current or future selling prices. Investors focusing on capital growth aim to buy properties in areas with strong potential for appreciation, intending to sell at a higher price later on.
Rental yield is the annual rental income a property generates relative to its purchase price, expressed as a percentage. It reflects the ongoing return on investment from renting out the property. Investors targeting high rental yields look for properties in areas with strong rental demand, ensuring a steady income stream.
The primary difference is that capital growth focuses on long-term appreciation, while rental yield emphasises immediate income.
As a result, property investors must weigh their financial goals and risk tolerance to determine which strategy best suits their needs.
Often, a balanced approach that considers both factors can benefit a well-rounded investment portfolio.
Should You Invest for Yield or Capital Growth?
Whether your investment aim should be in rental yields or capital growth depends on what you want to achieve from the investment – find out what type of property investor you are.
Understanding your specific goals before investing is one of the most important parts of investing in property.
Every investor has a different reason to invest. A high-yielding strategy may suit some, but a strategy that achieves capital growth over the medium to long-term will suit others.
However, it would be best to consider both strategies before investing in a property. Understanding what capital growth and rental yields you can achieve will help you when planning to sell the property in the future
To understand your personal goals and the reason for your investment, you should ask yourself these questions:
- Do I need the income right now?
- How long am I looking to hold the investment?
- Am I able to be hands-on?
- What is my risk appetite?
Answering these before investing will dictate the right strategy for you.
There is also no reason to treat yield and growth as mutually exclusive. The aim is to achieve a total return, giving you a balanced portfolio with a high sustainable yield. This would cover your costs, won’t rely on you subsiding a mortgage, and in areas with fundamentals for future capital appreciation.
You can analyse the market to ensure you are not overpaying and invest in a property that allows you to take advantage of compound growth.
Property investment can yield profits through rental income or capital growth, making it a dynamic sector for investors.
Rental yield offers a regular, predictable income and tends to be linked to inflation, making it a relatively recession-proof asset. However, higher yields may indicate higher risk and rental properties can be less liquid than other assets.
On the other hand, capital growth offers an appreciation in property value over time, often benefiting from compound growth and higher liquidity. It’s less risky than high-yield investments but is subject to market fluctuations and heavily reliant on location.
Whether to invest for rental yield or capital growth depends on your goals, risk appetite, and how hands-on you wish to be.
Both strategies have their merits, and a balanced approach that considers yield and growth can lead to a well-rounded portfolio.
Ultimately, understanding the mechanisms of rental yield and capital growth can inform better decisions and maximise returns.