How to Build Passive Income through Property Investment in New Zealand

Investing in property to build passive income in New Zealand can be a lucrative venture. However, it’s essential to strike the right balance between capital growth and yield. While yield is important for portfolio sustainability, maximizing capital growth should be the primary focus to achieve long-term wealth goals. In this article, we explore the drawbacks of solely chasing high yields and provide guidance on finding the ideal mix of capital growth and yield for your investment strategy.

Understanding Capital Growth and Yield

To begin, let’s define capital growth and yield.

Yield refers to the annual rental income generated by a property, expressed as a percentage of its value. For instance, if a property valued at $350,000 yields $35,000 in annual rent, the yield is 10%.

On the other hand, capital growth represents the percentage increase in a property’s value over time. Suppose the property’s value increases from $350,000 to $385,000 in the second year, indicating a $35,000 gain. In this case, the capital growth for the year is 10%.

Potential Financial Impact

The following table illustrates the stark contrast between an investment with 10% annual capital growth and one with 5% growth over a 20-year period. Property 1, experiencing 10% capital growth, accumulates a net gain of $1.791 million. In contrast, Property 2, with 5% growth, gains only $534,000.

The substantial difference in capital growth over two decades exceeds $1.256 million. Although investing in the 10% yield property may seem tempting initially, the net benefit of Property 1, the high capital growth property, amounts to $1.101 million (after deducting $155,000 in lost rent due to the lower yield).

Why High-Yield Properties Typically Lack Capital Growth

The challenge with pursuing high-yield properties is that, more often than not, they compromise on capital growth potential. While provincial or smaller towns may offer better yields, their capital growth prospects are usually inferior. Low demand in these areas translates to limited price pressure and slower price appreciation compared to urban centers.

Statistics demonstrate that investing in provinces leads to lower capital growth, and any gains are often eroded significantly during economic downturns. The period between 2003 and 2007 witnessed notable gains in regional property values. However, the subsequent recession in 2008 caused considerable value depreciation, which, as of January 2010, had not yet fully recovered. Conversely, certain growth suburbs in Auckland outperformed the national median during the boom, and despite experiencing price reductions in 2008, some have now regained or nearly reached their 2007 levels.

Purchasing High-Yield Properties in High-Growth Areas?

One might assume that the solution lies in finding high-yield properties in areas with exceptional capital growth. While this approach is indeed better and may be suitable for some investors, it doesn’t guarantee capital growth equal to or surpassing that of lower-yielding properties in the same area.

Consider an example comparing a 3-bedroom home on 800 square meters of land with a block of flats on the same-sized plot. The 3-bedroom home is likely to track the median house price change for the area, assuming an average capital growth rate of 10%. However, the block of flats, predominantly attracting yield-focused investors rather than emotional homebuyers, will base its value on the annual rent and the corresponding yield expectations.

Suppose the block of flats generates $31,660 in rent during the first year. If the prevailing yield for such properties in the area is 7%, investors would be willing to pay only $450,000 (rent of $31,660 divided by 7%) for

the property, irrespective of its aesthetics or appeal.

In the second year, assuming a 5% increase in rent due to inflation and rental demand, the rent rises to $33,243. However, since the average yield for blocks of flats in the area remains at 7%, the property’s value would only reach $472,500. Consequently, the block of flats experiences a 5% increase in value, amounting to $22,500.

This simplified example highlights that while the block of flats might see slightly higher growth due to factors such as underlying land value, it will always be limited compared to the 3-bedroom home’s potential, as it cannot cater to the broadest pool of demand—homebuyers driven by emotional connections.

In essence, properties with higher yield tend to exhibit lower capital growth, and vice versa. The higher the yield, the lower the expected capital growth, and the higher the capital growth, the lower the anticipated yield.

Determining the Ideal Capital Growth Rate

Investing solely in bare land might seem like an appealing option for capital growth. However, it requires significant financial resources to service the associated debt. Consequently, it becomes essential to find a high capital growth investment that aligns with your financial circumstances, striking a balance between capital growth and yield.

For some investors, this may involve a combination of bare land and 3-bedroom houses, while others may focus exclusively on 3-bedroom homes or explore home and income properties. Working alongside financial advisors, banks, and brokers, you can determine the appropriate yield for your situation. Remember to prioritize investing in optimal capital growth areas and property types.

For instance, if you can afford to sustain an investment with an annual post-tax loss of $2,000, seek high capital growth areas and identify properties within your budget. Aim to allocate more funds to land acquisition while minimizing spending on buildings. If a 3-bedroom home on 1,000 square meters is financially unattainable, consider properties with smaller land sizes within the same desirable location. The diagram below illustrates the capital growth/yield continuum that must be tailored to your individual circumstances.

Finding the right balance between capital growth and yield is a delicate process, ensuring you prioritize capital growth while maintaining affordability.

 

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