There are two ways you make money from property investment. One is from cashflow and the other is from equity. In a perfect world, you would try to maximise both, however you will generally have more of one than the other, depending on what you buy.
How equity works
There are three components to creating equity:
- Buying below value: If you can create some equity when you purchase the property, you are off to a good start. Being able to do this depends on having the network to find the property, your understanding of the market to recognise the opportunity and, thirdly, on your negotiating ability. In a down market this is obviously a lot easier to do than in a buoyant market.
- Adding value: If you do it well you can increase your equity in a property. This could be anything from a simple fresh coat of paint and new carpet right through to a major renovation. The key here is to know what adds value, manage your costs and don’t overcapitalise. Ideally, you want to add $2-3 dollars of value for each dollar you spend.
- Capital growth: This is when the property increases in value over time. Capital growth rates vary year-on-year and can be negative in some years and very high in others.
How cashflow works
The cashflow a property creates is based on how much rent you receive, minus your costs. You may get a tax rebate that will also add to your cashflow. Essentially, cashflow is the actual cash your property makes. To work out cashflow you must first understand what yield is.
Rental yield is your revenue and it is based on the amount of annual rent received in relation to how much the property is worth. There are two types of yield:
Gross yield = annual rent ÷ property value
$25,000 ÷ $400,000 = 6.25%
Net yield = (annual rent – annual expenses, except interest) ÷ property value
($25,000 – $5,000) ÷ $400,000 = 5%
Most people refer to gross yield, as it is an easier calculation to work out on the spot, because you may not have all the expenses handy. However, it is the net yield that will give you the best indication of how good the yield is and what your cashflow will be. This is because some properties have quite high expenses in relation to the value of the rent. The two key examples of this are apartments and lower value properties (i.e. those in smaller towns). This is because costs like rates, insurance, maintenance, body corporate costs take a higher percentage of the total rent.
Generally speaking, properties with strong capital growth have lower rental yields and those with high rental yields often have lower capital growth. When you are planning your investments, you will typically want to have a combination of these components to build a portfolio that increases in value while providing a decent cashflow. When purchasing a property, consider what equity the property will create and what cashflow it will create and then decide what combination is the best fit for your portfolio to achieve your personal goals. If you are on a low income, you may need to be solely focused on cashflow as that is your personal ‘weak’ spot. If you are on a high income, you can be more focused on properties that have a better growth potential as you should have surplus income to fund the lower yields.