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gary bell

Yield vs Capital Growth

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Hi All,

 

I intend to gain financial freedom through property investment. For me, the better my decision making is now, the quicker I will grow that snowball.

 

There are lots of variables and different ways to invest but I have a fundamental question for TPH:

 

  • What do you feel is more important - yield or the potential for capital growth?

 

From the majority of things I have read/heard, yield would appear to be the favourite. However, this is something that I am wrestling with a little and would welcome some healthy debate.

 

Thanks,

 

Gary

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All depends on your attitude to risk.  Higher yielding properties tend to have higher levels of risk and less chance of capital growth.  Lower yielding properties tend to have less capital risk, but with the potential of higher future rental growth.  I'm going for the balanced approach of c. 5.5-6% yield.  

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Hi Gary,

 

For me, buying purely for capital growth is not a long term investment strategy - it's a speculative investment. The definition of speculation on Investopedia (http://www.investopedia.com/terms/s/speculation.asp) is telling in it's use of the word 'risk' a lot and the mention of gambling!

 

So for me, a speculative investment is high risk because no matter how good your spreadsheet is, it can't predict the future.

 

If buying for high yield however, it should be possible (as long as you are doing your sums right and buying in an area with strong fundamentals (jobs, transport, etc)) to work out pretty accurately how much money a property will make you, based on the current interest rate you would pay on a mortgage. This, for me, is very low risk.

 

The biggest risk to your income is interest rates going up, and actually I don't see this as a big risk either - because it's relatively predictable. We all know it's going to happen so it can be built into your calculations when analysing the property. Buying for high yield reduces the impact of interest rates increasing - as the income generated by the property should be significantly higher than the mortgage payments, so the higher the yield you are getting, the higher interest rates could increase before you start getting into trouble.

 

In an ideal world of course, you would want to buy a high yielding property in an area set for good capital growth! Then you get the best of both worlds. I don't think these 2 things are mutually exclusive at all, especially now areas outside of London (which might have stronger yields) are starting to increase in value.

 

 

The bottom line though is return on investment (ROI) With the ROI calculation, you can combine the income from capital growth and rental income to give you a total amount of profit from the property in relation to the money you have invested in that property.

 

I've attached a screenshot from a spreadsheet which shows the performance of 4 different properties with varying levels of yield and capital growth.

 

So buying for capital growth AND yield is obviously the best bet in terms of performance, and buying for capital growth has the potential to perform really well but the key variable affecting it's performance is completely outside of your control - i.e. house prices. So if you bought the low yielding property for high capital growth and interest rates go up and property prices don't (2 things which are both outside of your control) then you are going to be left with a property which might be losing you money each month!

 

 

For me, I would always want to buy for high yield primarily so I can sit back safe in the knowledge that the property should always make me money. If I can buy in an area which has a higher probability of a house price rise then I'll obviously take the capital growth too, but I would never base an investment strategy around it!

 

Sorry I got carried away with this reply!

 

Cheers

 

Andy

post-62-0-58910800-1390301195_thumb.jpg

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I think the decision depends on your goals and attitude you take to risk. Theoretically most of long-term growth will come from capital growth as you are utilising leverage. The benefits will change depending on your leverage levels too (I like that lengthy reply above and the spreadsheets). Dont forget you pay tax on income too. I think war-gaming it with a spreadsheet at different levels of leverage, different yields and different growth rates would illustrate the point and can be done for specific discrete investments (on my phone so no spreadsheets from me now).

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Gary,

 

Just thought I'd add some spreadsheets that will show your total capital (your equity plus the sum of your income) once tax and mortgages are deducted.  I knocked up some projections a while ago and just adapted it now.  It is after 15 years starting with a kitty of £25k with a £75k interest-only mortgage.  It does not take into account interest repayments so this would be the yield after these and other costs based on the portfolio value (so the actual income). It also presumes that you have neither withdrawn any equity to reinvest in more property (or to spend) or used the income for anything but income (so it is not compounded, just summed as a total you have spent on fast girls, booze or just squandered). It is though you bought a £100k property and rented it out then forgot about it.

 

There are 3 tables, the first without tax deducted, the second with 40% tax deducted and the third with 45% tax deducted.  They broadly show that tax dents your capital growth significantly!  They also show that property price growth once given time to compound is incredibly powerful.  In my view it demonstrates Andy's point above - growth is great and better with a good yield but hides the fact that if the yield is not enough you could lose everything back to the bank.  So yield reduces the risk and growth makes you wealthy.

 

Incidentally in 15 years that £25k would be £37,814 if it increased at an inflation rate of 3%. 

 

Andrew

 

No tax deducted           Growth         Yield 0 2.50% 5% 7.50% 10% 0                          25,000                             66,297                           122,993                 200,244                             304,750 2.50%                          62,500                           111,127                           176,940                 265,540                             384,181 5%                        100,000                           155,957                           230,886                 330,836                             463,612 7.50%                        137,500                           200,787                           284,832                 396,132                             543,043 10%                        175,000                           245,617                           338,779                 461,428                             622,475             With 40% tax           Growth         Yield 0 2.50% 5% 7.50% 10% 0                          25,000                             66,297                           122,993                 200,244                             304,750 2.50%                          47,500                             93,195                           155,361                 239,422                             352,409 5%                          70,000                           120,093                           187,729                 278,599                             400,067 7.50%                          92,500                           146,991                           220,097                 317,777                             447,726 10%                        115,000                           173,889                           252,465                 356,955                             495,385             With 45% tax           Growth         Yield 0 2.50% 5% 7.50% 10% 0                          25,000                             66,297                           122,993                 200,244                             304,750 2.50%                          45,625                             90,954                           152,664                 236,157                             348,437 5%                          66,250                           115,610                           182,334                 272,070                             392,124 7.50%                          86,875                           140,267                           212,005                 307,983                             435,811 10%                        107,500                           164,923                           241,675                 343,895                             479,498

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I have a view on this, which I have previously covered in some depth on my curated news feed.  Would it be too lazy to direct you to the article that I posted rather than retype it all again here (also Rob & Rob am I allowed to link externally?)?

 

http://www.scoop.it/t/residential-property-investment/p/4003004190/2013/06/10/cash-flow-v-capital-growth-which-strategy-is-best-open-wealth-creation

 

To cut to the chase...investing for income can outperform investing for capital where surplus cashflow is reinvested along the way :)

 

All the best

 

Richard

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Richard,

 

It entirely depends on the differences between growth and income and the tax you pay and what you reinvest it in.  It is the same for investing in shares where growth vs yield is also a common question.  As you say quite rightly in your article, regardless of how you do your projections there are always unknowns and assumptions (inflation, interest rates, rent inflation, growth rates etc).  So long as capital is reinvested either way you will maximise the growth from an investment.  It is probably worth considering each investment on its own merits and look at what your goals are from the investments you make.  Everyone has a slightly different set of circumstances - for example I could not have a portfolio that takes up all my time managing so letting agent fees will eat into my yields and I am looking to take money out of the business in around 15 years at the earliest so want overall growth to be the priority.  Roshan's approach is the one I am taking with both income and equity reinvested.

 

 

Andrew

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Some good discussion points raised here and I am sure that the spreadsheets can be primed either way I would imagine :)

 

However, capital growth is more risky to realise than rental income over the early years (note comment about speculation earlier by Andrew) and this brings me to my main point in Gary's case as a new investor...

 

It is commonly reported that a standard buy to let will not break even for about 5 years and unless you have a significant cash reserve or excess of income (say from a day job) to support the portfolio's cashflow needs in the early growth years there is a risk that the lack of cashflow could threaten the business even surviving that time period (plus the clock starts again with each new acquisition)....

 

So I would probably suggest that for a new investor such as Gary that they start with greater emphasis on yield (does not necessarily mean super yielding HMOs but 7%+ range properties say) and later on once stable they can diversify the portfolio to include some more capital growth opportunities if they so wish. Another issue with re-investing capital growth is whether or not it can actually be accessed or not (i.e. needs remortgaging and there may be a tax charge to pay in doing so)...and let's not forget that as with any business cash is king and a lack of cash is the equivalent of a lack of oxygen to a human :)

 

Having said all that - better to do something than nothing at all as is the case with the sleepwalking majority :)

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Thanks all for your contributions to the debate – there have been some really interesting points made.

 

Richard,

 

I really enjoy the material you ‘scoop’ on property investment and your interpretation of various data.  You too have made some good points but I have two observations/questions based on your responses:

 

  • In your article ‘Cash flow V Capital growth’, I understand that you make the case for yield on the basis that additional income could be used for reinvesting, thus ultimately growing a portfolio potentially quicker.  However, it would appear to me that this is still not a case of comparing ‘apples with apples’ as it does not consider that greater equity made on the high growth properties could also be released to reinvest, e.g. by way of remortgaging periodically.  Have I interpreted this correctly?

 

  • In your last response, you state that “another issue with re-investing capital growth is whether or not it can actually be accessed or not (i.e. needs remortgaging and there may be a tax charge to pay in doing so)”.  Assuming that equity can be released (e.g. by way of remortgaging), please can you elaborate upon what tax charge may be payable utilising this strategy.

 

A great debate all.  Thanks again for your thoughts!

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Hi Gary

 

Many thanks for the response and further questions.

 

I tried to go back to my original spreadsheet where I did the analysis behind this particular article but alas due to a hard drive crash a few months back and a very tardy approach to backing up my computer I managed to lose it - doh! I think I possibly did not allow for extracting any grown equity to re-invest with the capital growth model and so perhaps we were comparing the Granny Smith with the Cox rather ;)

 

WRT accessing any built up equity - the main two ways of releasing this are either to remortgage or to sell.  In a sale the capital gains tax would arise (subject to the annual allowance) as probably we all know.  But with a remortgage, less commonly known is if we remortgage beyond our original purchase price then we also create a tax charge as we are realising part of the gain; the accountants out there can advise on exactly how much could be payable i.e. is it CGT on new value or on new loan only?.  There is also a risk of over-leveraging with this approach and sooner or later it would be prudent to bring the average leverage on the portfolio down to an acceptable level (my inheritance plan is to leave a 50% LTV portfolio so that my beneficiaries can have a reasonable chance of gaining mortgages at that level). I have heard of at least one large portfolio investor be taken down by a high LTV approach.

 

Of course with both a sale or remortgage there are also additional costs involved which will eat into the proceeds - fees and tax.

 

Also, who is to say that we will actually achieve the high capital growth that we set out to and how easy is it to enter a high capital growth market anyway (think cost of properties in prime central London and required deposit). My point about accessing equity is also conditional upon us gaining new mortgage terms - depends on age, LTV, term and to some extent income to get the best deal going.

 

If I were to adopt this type of strategy - capital growth investing with equity released to reinvest and I could wait until retirement (effectively aged 55) - I might look into reinvesting via a SIPP where I would get an income tax credit to set off against a potential capital gains charge (to some extent this also applies to reinvested income)...but please don't take this to be financial advice as I am not an IFA.  One thing with a SIPP is that we can't invest in residential property, so we would have to look at commercial property but the definition is quite broad, plus leveraging is lower this way (typically 50%). I just thought this could be an interesting approach...

 

But as the owner of a plumbing and heating company once said to me when I was trying to convince him of the potential tax benefits of buying a business one way versus another - I will worry about making a profit in the first place and if there is tax to pay, there is tax to pay. He had a point and it is often said that we should not let the tax tail wag the property business dog (strange metaphor I know...).

 

Finally, when all is said and done - it's a horses for courses business and what suits some may not suit others - the main thing is to find what best suits you in terms of lifestyle, personal preferences, time commitment, access to funding, investment period, financial goals, attitude to risk, etc.

 

All the best

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Thanks Rob & Rob for your mention of this topic on The Property Podcast.

A really good debate which appears to have died now. Some really excellent points raised which have affirmed what I think will be my particular strategy moving forward.

I think all would agree that in an ideal world as an investor, we would like to invest in properties that offer both the best capital growth prospects and highest yields. However, this may of course be easier said than done as good capital growth prospects and high yields are not necessarily mutually exclusive but could prove difficult to achieve both.

Personally, I will be primarily focusing upon capital growth potential (rather than yield) when sourcing my next properties, as I see this as potentially the quickest way of growing my portfolio.

However, importantly I will ensure that the yield has plenty of margin so any investment remains cash-flow positive when such time arrives that interest rates rise to a more typical level.

Many thanks to all that contributed.

Gary

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I think all would agree that in an ideal world as an investor, we would like to invest in properties that offer both the best capital growth prospects and highest yields. However, this may of course be easier said than done as good capital growth prospects and high yields are not necessarily mutually exclusive but could prove difficult to achieve both.

 

 

Tune in to next Thursday's podcast for more on this exact point :)

 

You're quite right to make sure that whatever happens it cashflows well - as I said on the podcast, there's no point being on track for fabulous growth in year 5 if you have it repossessed in year 3!

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... But with a remortgage, less commonly known is if we remortgage beyond our original purchase price then we also create a tax charge as we are realising part of the gain; the accountants out there can advise on exactly how much could be payable i.e. is it CGT on new value or on new loan only?. .. 

 

I'd like to hear the clarification on that, I thought if you remortgage beyond purchase price the tax implication was limited to no tax relief on the portion of the interest beyond the purchase price.

 

I can see how taking out equity could be taxed as CGT, would it make a difference if the extracted capital went into a deposit on a new BTL, ie reinvested in the business. Or would the IR scupper that since BTL income is treated in an asymmetric way, ie Income tax on profit, no relief [on your PAYE] on losses?

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Mark Alexander (who was interviewed by Rob D for his new book) answered this in a different forum I just found (I haven't included the link or ref as unsure if that's OK or not?); seems that if an excess of funds released over the original purchase price is reinvested then that's OK but if used to fund lifestyle then a CGT liability would arise...and so the reinvesting capital argument gets stronger I am happy to concede:

 

This is a subject I do know a lot about and I'm happy to explain. 

The simple rule is that you can't claim tax relief on any borrowings exceeding the amount you paid for a property (known as the base cost) unless the excess amount is used for reinvestment into the business. The tax man "HMRC" will not accept that a new car, holiday etc. is a business investment. HMRC will accept that improvements to property or utilising additional capital to purchase investment property is reinvestment.

If landlords keep a balance sheet they should be very wary of having a negative capital account, i.e. drawing more out of the business than they have invested into it and made in terms of rental profits. This is a very clear flag to HMRC to investigate what percentage of mortgage interest relief is being offset against rental income.

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Hi Richard,

I was intrigued by your previous comments on this issue of tax so did my own research. It would seem that I read the same article by Mark, amongst other internet content in this regard.

I was also very surprised to learn that all costs borne by someone for raising finance, for the purpose of investment could also be offset against income received from those same investments. For example, I understand that I could remortgage my home to release equity, reinvest that money to purchase further investment properties, then subsequently offset the interest payments paid upon the new mortgage on my home against income from the same investment properties.

Anyway, this is probably veering away from the original topic and worthy of its own thread.

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I think Richard's point of tax is really interesting and given it is critical to the business strategy we are pursuing I thought we needed to know a bit more.  Given my posts above you may be unsurprised to learn that our strategy is concentrating on growth with a minimum yield at the outset that will cover the mortgage interest and other costs even when interest rates are far higher than now (so not insignificant thus at times like this providing income too).  No doubt our strategy is similar to many people on the forum expanding a business to use as a pension in 15-20 years time. Our strategy is to purchase properties at a discount if possible and remortgage and reinvest the equity.  I have no intention of selling properties unless the fundamentals change or I am forced to by unforeseen circumstances.  So while the tax angle on withdrawn equity may be veering off the original topic I think it is critical to pin down the facts as it could make all the difference to whether people here invest primarily for cash-flow or growth or even invest elsewhere to property (is saying that blasphemy on the hub?).

 

Being a really interesting chap I recently read a book I can commend to you by Iain Wallis who I think I first heard of on a certain geek's podcast.  The book is called 'Legally avoid property taxes' and he deals with the first half of this particular tax issue in Chapter 4.  It looks like if you withdraw in equity less than the original value of the property it is tax free - you can get some fast cars and women and gamble it away.  Or reinvest it.  If the value goes up significantly and you withdraw more than the original value of the property and you invest it in the running costs, education or to buy more property then you can offset these costs against tax. So that is the first part.  It seems if me, you or Gary are growing your snowball and reinvesting both the income and growth then the growth is tax free.  Our strategy seems secure.

 

If you spend that same significant increase on those same (but now somewhat older) fast cars and women though then the difference between what you withdraw and the original value is not going to be offset. 

 

The book is good as a guide but no substitute for a proper accountant though and I still have questions.  Perhaps an accountant (Iain are you on the Property Hub?) might be able to help here or Rob abd Rob could address these in the podcast?

 

I am not entirely sure from the book whether this money is taxed as capital gains or income.  I presume given it is derived from the capital it is capital gains?

 

Nor am I sure how it works if you withdraw money for reinvestment one year and income a few years later, that takes you above the original value.  Presumably you only pay tax in the non-invested value?

 

Say we have to sell those properties later, how is the capital gains now apportioned?

 

Does the original property get treated in a different way to the properties bought using the equity from an original property (ie debt derived from debt)?  That is to say if you use debt secured on property A for the deposit on Property B do you essentially increase the base capital available to you?

 

Do the HMRC look at a portfolio as a whole given that is the 'business' or do they calculate based on individual properties?

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Great questions Andrew, but I'm afraid I can add no more. I will definitely pick up that book so I can try to better understand this and wider tax issues.

If anyone can help with these questions, I would be really grateful for the advice. To echo what Andrew said, this could have significant implications for a lot of investors on this forum and my strategy will certainly be influenced by tax legislation in this regard.

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This should be a separate thread because it's brilliant.

 

I have a few ideas/suggestions but I'm going to speak with some tax advisers for 100% clarification (if there is such a thing with tax). 

 

I've put a call in and when I hear back I will comment here.

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Start buying as soon as you can and keep hold of it.... time will take care of most things. I've been REALLY low risk, low LTV and after 15 years or so of having it as a hobby, it's crept up on me as a nice earner. I now have to make some decisions about what to do with the capital I've built up and I suddenly hate the concept of CGT !!

 

Re invest what ever (or most) of what you earn. Don't be tempted to just spend this new income stream you get. It might seem nice, but you will kick yourself in 15 years for not reinvesting.

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Rob,

 

Given you are checking with your accountant I have another question:

 

Imagine this scenario.  You buy a property with £25k deposit and £75k LTV mortgage.  It triples to £300k.  You withdraw £200k of the equity and reinvest £150k into your business.  The £50k balance sits in your account while you look for the next deal, but it is your intention to invest it. The end of the tax year comes and goes.  How do you declare this money and could you be taxed on it because it hasn't been invested?  This is important because if it is taxed it would encourage remortgaging at the start of the tax year rather than other times in the year.  It may also encourage you to put all the money into a deposit so there is nothing left at the end of the tax year, thus reducing the effect of leverage on growth.

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Hi All,

I too am interested in hearing the results of Rob's conversations with the tax advisors. My thoughts on the subject (for what they're worth!):

 

Regarding the point about paying CGT on additional capital released through a remortgage:

 

I thought that you didn't pay CGT until you sold a property? If that's right then you don't pay any tax at all on money released through a remortgage, no matter what you spend that money on. You might however run into trouble if you do come to sell the property, at which point in time CGT would be payable on the total gain, which would include any money released over time through a remortgage. This article explains things well (although I can't vouch for the accuracy of any of it!) http://www.taxcafe.co.uk/resources/thetendertrap.html

 

Regarding being able to offset the additional interest payments on the larger mortgage against tax:

 

This whole concept is new to me so I look forward to finding out the proper answer on this. For me though, a logical way to think about this would be to say that the interest on any any money spent on non property related things would not be offsettable and the interest on all other money, whether it has been spent on property related things or has not been spent at all yet, would be offsettable. So as soon as you spend it on a personal item, you can no longer offset the interest on it. I guess you would need to keep accurate records and reciepts showing where the money was spent in case the IR decide to investigate. This is really just a guess as to how it might work...

 

Cheers

 

Andy

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