Decreasing Rents vs Increasing Rents

By Michael Mackinven | Property

Jul 18
Decreasing rents versus increasing rents

DECREASING RENTS VERSUS INCREASING RENTS

The three pillars of any sound property investment are CASHFLOW, CAPITAL GAINS and TAX ADVANTAGES.

In this blog I want to explain how rising and falling rents directly affect capital growth and the true return on your investment.

For simplicity, I will use an example of a property located in a city, like Auckland, where rents are rising due to a mix of high demand relative to supply and inflationary pressures.

I also will use another example of a property located in a city somewhere in the world with decreasing rents due to a mix of low demand relative to supply and deflationary pressures.

I want to demonstrate to you that if the property yield (Annual Rent divided by the Purchase Price) remains the same then the value of the property MUST go up or down. This change in property value is an unseen profit or loss that is only realised when the property is sold.

Property Example One – Decreasing Rents (3%/annum)

Purchase Price:                $500,000 @ 15% yield

Annual Rent:                   $75,000              ($500,000 × 0.15)

End of year one

Annual Rent:                   $72,750              ($75,000 × 0.97)

New Property Value:      $485,000           ($72,750/0.15)

Capital Loss:                    $15,000              ($485,000 – $500,000)

True Annual Return:       $57,750              ($72,750 – $15,000)

Return on Original Purchase Price: 11.6% ($57,750/$500,000)

End of year two

Annual Rent:                   $70,568              ($72,750 × 0.97)

New Property Value:      $470,453           ($70,568/0.15)

Capital Loss:                    $14,547              ($470,453 – $485,000)

True Annual Return:       $56,021              ($70,568 – $14,547)

Return on Original Purchase Price: 11.2% ($56,021/$500,000)

As you can see every year the true return decreases because of the hidden capital loss. If this property had a loan the return on investment would drop even more dramatically.

Property Example Two – Increasing Rents (3%/annum)

Purchase Price:                $500,000 @ 5% yield

Annual Rent:                   $25,000              ($500,000 × 0.05)

End of year one

Annual Rent:                   $25,750              ($25,000 × 1.03)

New Property Value:      $515,000           ($25,750/0.05)

Capital Gain:                   $15,000              ($515,000 – $500,000)

True Annual Return:       $40,750              ($25,750 + $15,000)

Return on Original Purchase Price: 8.2% ($40,750/$500,000)

End of year two

Annual Rent:                   $26,523              ($25,750 × 1.03)

New Property Value:      $530,460           ($26,523/0.05)

Capital Gain:                   $15,460              ($530,460 – $515,000)

True Annual Return:       $41,983              ($26,523 + $15,460)

Return on Original Purchase Price: 8.4% ($41,983/$500,000)

 

You can clearly see how the yields rapidly converge and after only several years the return on the lower yielding property with increasing rents actually outperforms the initially higher yielding property with decreasing rents.

It is actually possible for the return on investment of a property with decreasing rents (capital loss) to drop to zero. In other words, an investor would just get their original investment back.

This simplified example illustrates the effects of buying properties with increasing rents and decreasing rents. There are many other factors that investors must consider when choosing a suitable investment property.

I look forward to your comments and as always if you have any specific needs, requirements or questions please feel free to contact me: michael@wealthladder.co.nz

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About the Author

I have been a property investor for over 13 years and have created a multi-million dollar portfolio including residential and commercial. I could go on about this but I’m not here to impress you but to impress upon you that YOU TOO can create wealth through property whether that be $100K or $5 million. I’ve been through the boom – bust – boom so I know what it takes to stay in the market. I live locally in Otahuhu with my wife and new baby boy. I love to help and teach people about buying well and for long term. We can all make a quick buck but the real strategy is creating long term wealth.