Key takeaways
Capital growth is the primary driver of wealth creation, not rental income. Compounding capital growth does the “heavy lifting” in building wealth over time.
Property investors often fund purchases with borrowed equity, leading to out-of-pocket holding costs. Over decades, holding costs can add up significantly, becoming the true investment in the asset.
Properties with high capital growth but low yields often outperform in terms of net sale proceeds over time. High-yield properties may offer better IRRs in some scenarios due to lower holding costs but typically generate less wealth overall. An optimal strategy avoids balancing income and growth but prioritizes growth-focused assets in high-demand, low-supply locations.
Prioritize capital growth by selecting properties in premium locations with significant land value. Minimize holding costs post-purchase through strategies like cosmetic upgrades, reducing interest expenses, and optimizing tax benefits.
Focus on properties with solid fundamentals to sustain growth over decades rather than chasing short-term gains. A property growing at 7.2% p.a. over 30 years could increase in value sixfold, underscoring the importance of sustained growth rates.
When it comes to property investment, many investors strive to strike a balance between the income and the capital growth a property generates, hoping to maximise both.
However, I have written a lot about the fact that the income from a property, after expenses, probably won’t help you achieve financial independence.
It’s the power of compounding capital growth that really drives wealth accumulation and does all the heavy lifting.
However, optimising the income and expense profile of the right asset is critical to maximise your overall return.
What is your investment?
When you invest in property, most investors typically borrow the entire cost of the property, including stamp duties, by using equity from their existing properties as collateral for their loan.
This means they don’t invest any of their own capital upfront.
Their actual investment occurs when they must cover the property’s holding costs because the income it generates isn’t enough to cover all expenses, including the interest on the loan.
For example, if a property has an average holding cost of $30,000 per year after tax, over 20 years, an investor could end up putting $600,000 into that asset just to maintain it.
What is your return?
Your investment return is the combination of any positive cash flow i.e., if the property ever covers all its expenses, and the potential net sale proceeds.
Net sale proceeds are calculated by subtracting tax (CGT), selling costs, and repaying the loan from the sales price.
What is an internal rate of return?
The internal rate of return (IRR) measures the relationship between your investment (the holding costs) and your return (net sale proceeds) by calculating your return as an annual percentage.
This is an important metric because it allows you to assess how your investment performs compared to other potential uses of your cash flow.
Essentially, it highlights the opportunity cost of not investing that cash elsewhere, making it an important measure for evaluating the effectiveness of your investment.
Relationship between income and capital returns
The table below compares several property investments, all generating a total return of 9% p.a., but with varying levels of income and growth.
I’ve calculated the IRR for each asset and the net sale proceeds you would receive if you sold the property after owning it for 30 years.
This figure is after accounting for taxes, all expenses, and loan repayments, expressed in today’s dollars i.e., adjusting for inflation.
You’ll notice that the lowest return occurs when the yield is between 3.5% and 4.0% p.a.
This highlights why aiming for a balance between income and yield is often an inferior strategy when selecting an asset to buy.
On the other hand, the second highest IRR comes from a property that sacrifices as much yield as possible in exchange for greater growth, specifically, a 1.5% yield and 7.5% growth.
The highest IRR is achieved by a property with a 6% yield and 3% growth.
However, here are some key points to consider about this scenario:
- The high IRR results from significantly lower holding costs, requiring less investment overall. In fact, this property’s net cash flow is projected to be positive after just 13 years of ownership.
- Because the rental yield is double the growth rate, the projected yield will increase over time. It starts at 6% p.a. and, by year 30, the gross rental yield is expected to reach 8.4% p.a. However, I find this projection unlikely.
- While the IRR appears impressive, this asset would only yield $520,000 in today’s dollars after 30 years, over five times less than a high-growth, low-yield property ($2.82m). To generate the same $2.82 million in net sale proceeds, an investor must own 5.4 of these high-yield properties. This could be quite challenging since the total cash flow holding costs would exceed $85,000 p.a., compared to just $34,000 p.a. for one low-yield, high-growth asset.
- When conducting this type of analysis, I recommend being cautious about assuming that a property investment will provide an average return of more than 9% p.a. over multiple decades. While it’s possible for this to happen, I wouldn’t want the success of my investment strategy to rely on that assumption.
Maximise your IRR by taking a two-step approach
To maximise your IRR, the first step is to purchase a property with strong potential for capital growth.
Once you buy a property, it’s challenging to change its capital growth prospects, so this should be your top priority when evaluating different property investments.
Generally, this means investing in a high-quality location where land supply is limited and demand is high, and buying as much land as your budget will allow. In short, spend most of your budget on the underlying land.
The second step is to take steps after the purchase to minimise the property’s holding costs. By reducing these costs, you lower your investment contribution, which helps maximise your IRR.
It also frees up cash flow for you to direct towards other investments.
You can minimise the property’s holding cost by making cosmetic improvements to the dwelling to enhance its rental income, reducing interest costs, and maximising tax benefits, among other strategies.
By following this two-step approach, your goal is to achieve a higher rental yield and reduce holding costs while maintaining the same growth rate without any compromises.
An example
In mid-2021, my wife and I bought a property in Indooroopilly, Brisbane, for $1.45 million.
At the time, it was in a very basic condition and had a long-term tenant, resulting in a very low rental income of just $400 per week, which equated to a yield of 1.44%.
Last year, when that tenant moved out, we took the opportunity to undertake some cosmetic renovations, costing $120,000. These upgrades boosted the rental income to $675 per week and increased the property’s value.
As a result of these improvements, I calculated that the internal rate of return (IRR) has risen from 10.6% to 11.5% p.a.
This is a practical example of how to apply this approach to maximise your investment returns.
It’s vital to understand what drives investment returns
It’s essential to never compromise on capital growth.
Maximising the average growth rate over your ownership period, which ideally should span several decades, is critical.
For instance, a 7.2% p.a. average growth rate over 30 years means the property could be worth six times its current value.
That’s how you build real wealth.
Avoid being lured into investing in properties that may appreciate significantly in the short term but lack the fundamentals to sustain that performance over many decades.
However, once you own the property, your focus should shift to minimising its holding costs.
This strategy will maximise your IRR and free up cash flow, which you can then invest in other opportunities.
