Chances are you have scanned dozens of articles online about real estate investing and found the same highly debatable question raised in each - Is it better to invest in a property for capital growth or rental returns? Instead of giving you a ton of confusing formulas, I’d like to take you on a journey of two investors - one seeking capital gains and the other rental returns and what a real world outcome would be so you can decide which strategy is ultimately the best.
Before we begin on our journey, it’s important to make sure we all understand the two most common but also misunderstood real estate terms - capital growth and rental return. Simply put, capital growth is the increase in value over time and you should typically aim for an annual increase of 7% to 10% in capital growth with a rental return between 2% to 5%. These properties are generally more expensive to buy than higher rental return properties and are located in capital cities and/or elite areas along the coastline with strong buyer potential.
On the other hand, rental return is the annual net income that your property pays you divided by your property value. Here you should typically search for large houses out in the suburbs or in regional areas that will provide you a higher rental return for the money you are investing aiming between 6% to 10% but generally receive a lower capital growth which is usually between 4% to 6%.
I’d like you to meet our first investor - Joe. Joe is a 51-year-old seasoned investor, who’s real estate motto is “there’s only one growth strategy - work hard,” and with his many years of experience believes in a long-term investment strategy that will provide strong capital growth. Our second investor is a Y-Gen, grab life by the horns novice investor named Drew. Drew joins many other investors who are of the mind that the best investment strategy is to purchase properties that provide immediate results or rental returns and keep money in their pockets with little upfront costs.
Joe recently purchased a unit for $500,000 in an inner city area with a projected capital growth of 8% and rental return of 5%. Young Drew also purchased a property for $500,000 but chose a large house in the suburbs with a projected capital growth of 5% and rental return of 8%.
Fast forward 10 years and the math reveals that Joe’s unit is now worth $265,000 more than Drew’s house but young Drew proves maybe he’s not such a novice investor after all by pulling in an increase in rental return of $12,000 over Joe.
Another 10 years later and our wise investor Joe shows his patience and property are earning him $7,000 more in rent and an astounding $1 million more in capital growth over Joe’s short term rental return investment.
Given this scenario, if investor Drew who was seeking greater rental returns would have purchased for capital growth he’d have an unbelievable extra $1 million in the property value. Can you afford to make that kind of mistake?