How to obtain a reasonable yield
Paul Nugent, Wakelin Property Advisory
I’m quite regularly on the receiving end of a new investor’s lament that the 3-to-3.5% rental yields of the typical investment grade property in our major capitals is a bit low, and I’m then usually probed for the secret stash of great assets with better yields.
Yes, in nominal terms rental yields are at generational lows. But of course we also live in a time of very low inflation and low interest rates. Let me illustrate the cost in real terms with some back-of-the-envelope workings. It’s possible for many borrowers to secure an interest-only investment mortgage at 4.4% (for simplicity we’ll assume they borrow 100% of the property’s value). Let’s use the worst-case yield of 3% and plan for 20% of rent to be consumed by holding costs such as management fees and maintenance. The income shortfall represents around 2% of the property’s value per year. The gap shrinks by approximately 40% for most tax payers – due to negative gearing – so after tax represents an annual commitment of around 1.2% of the property value. To illustrate, for a $600,000 property, that’s around $600 a month that the out-of-pocket investor needs to find in order to hold this asset.
Putting aside the obvious conclusion that these numbers are eminently manageable for today’s typical property investor, the example gives a clue to how chasing yield can disappoint. Should you find a way to squeeze some extra yield (and we’ll talk about a way to do this below), the tax man is effectively going to claw back 40% of it because you have fewer losses to set against other income.
More importantly, there is an unescapable trade-off between yield and capital growth. Properties with higher yields always deliver lower capital growth. And due to the combination of gearing, the magic of compounding and the set-up of our tax system in which property investment is undertaken, strong capital growth always generates wealth far in excess of what a strong yield can achieve.
Saying that, it is possible to improve rental yield within narrow, prudent parameters. Specifically, the investor must still focus on an inherently quality asset with features that are in demand from buyers and tenants – so a well-located property in a high land value area with period architecture.
The genuine opportunity to increase yield prudently comes from identifying an under-capitalised property; one that would benefit from comparatively inexpensive cosmetic renovations and lifestyle upgrades which, whilst not adding substantially to the property’s capital value, deliver a significant increase in rent.
Let’s return to our $600,000 property above that yields 3% gross or $345 a week. It’s a little tired, having been untouched renovation-wise in 25 years. The owner spends $30,000 on new carpets, paint, window blinds, a dishwasher, a new stove, new benchtops and cabinetry in the kitchen, plus some improvements in the bathroom. As a result the property can now be rented out for $445 a week – a jump of $100 (which isn’t unusual).
Once we add the $30,000 renovation cost to the capital base we can see that the gross rental yield rises from 3% to 3.7%. Another way to look at this is that the gross yield on the $30,000 is an impressive 17%.
However, this trick can only really be undertaken once per property. Moreover, in our savvy property investment world, prices of ‘tired’ properties are often bid up to a point where this strategy isn’t worth pursuing. Further, the tax man will grab a significant chunk of this uplift. So by all means take the opportunity if it comes, but otherwise learn to love low yields.
Paul Nugent is a director of Wakelin Property Advisory, an independent firm specialising in acquiring residential property for investors. wakelin.com.au