The Rental Yield Myth: Why Stressing About Yield Is Too Late

If a client is stressing about the yield so much, typically it's probably too late. If that's the case for your end goal, why do you stress about it so much at the start on the way to your end goal? Cash is not king in this case. Cash flow ain't king in this case. We might as well end the episode now.

I just realized. People think about yields and they only think about that number and they go, wow, 0. 5%, 1%, but they don't consider the cash flow side of things, which actually doesn't have a huge impact. Capital growth is king in property investing, especially in the early stages while you're trying to scale. People are talking about property and residential property as a means to retire, but...

Welcome to another episode of the Property Nerds podcast. I'm joined by co-host Adrian Lee and Jack Fouracre from Fouracre Financial. And today we're talking about a very, very important one, but it does feel like a bit of a back to basics, but it's not because we're going to make the basics really unpack into this world of complexity. Because if you do that, you can understand exactly how far people are from the basics when it looks at the scenario today that we're going to cover off. And what it is, is rental yield impact on borrowing capacity.

Nerd alert! Property Nerds, the home for data-driven property investors, where we uncover Australia's hot and cold markets, latest headlines and trends. Adrian, you hear it often. I want a higher yield because it's going to help me with cash flow, going to help me with borrowing capacity. Let's talk about this borrowing capacity on yield.

And firstly, why you hear that often? And is it a good thing to target? Let's talk about a high level. What are your thoughts? Yeah, yeah.

Look, I think when people think about what you said, hey, let's maximize rental yield so that we can get the max amount of cash flow, which will give us the max amount of income, increased borrowing capacity. It's a very logical flow of thinking. But then when you break it down, there's so many different trade-offs that, like you said, it's going from the basics to actually, there's a lot of nuance between it. And in theory, it makes sense because you get better cash flow, you have better income, borrowing capacity increases. But what are the trade-offs that you have to consider?

And when you think about the trade-offs, it comes down to how many markets actually have this yield? What are the opportunities that you're potentially missing out on if you are chasing this yield? Is it even worth it? Because your extra, I don't know, $20, $50 of rent and you taking an extra couple months of searching for the property, you might have lost the $10, $20, $30,000 as well. That's massive, yeah.

And that could have been the difference in your rent for the 30 years that you've earned it, right? So sometimes it makes sense when you say it and you think about it. Logically, it makes sense. Logically, it makes sense, yeah. But it's like logic ain't always logic when you break it down.

Yeah, yeah. And then there's all these nuances where you go, hmm, actually, maybe I should consider something with a little bit of a lower yield. Now, the one thing that, of course, we can break down is borrowing capacity. Everyone talks about borrowing capacity as that preservation thing that you need to preserve it as much as possible. Is that true, Jack?

Do you need yield really to be this X factor for you to even just get decent borrowing capacity? So often what I see is if a client is stressing about the yield so much and they really need a high yield for a particular purchase for their borrowing capacity, typically it's probably too late for them because they should have addressed the borrowing power issues earlier in the piece. Is that because it doesn't make a difference? Well, it doesn't really make that much of a difference for him. Like half a percent, one percent here or there, it doesn't translate to these massive numbers that people may think.

Let's try and do some quick math. Math. This is going to be simple. Math. Just because it's calculated, it's not.

This is the most savvy borrowing capacity tool out. The calc on the iPhone. But if we take a 750K purchase and we say we take a 4% yield, that is a rent amount of $30,000. But if we make that yield at 750K 4. 5, a big half percent jump, that's $33,750.

So it's $3,750. So Jack, how much do the banks shade off rent usually? Call it 90. 90. So we'll go 10% off.

So we'll go 90. And we're being generous because sometimes it can be lower than 90, right? Yeah, it's quite common to do it at 90. Well, like most lenders are at 80. The amount of lenders that are shading it to 90 is increasing by the week.

And then debt to income ratio. So this is a multiple of this income that gets added to your borrowing capacity. What should we use? Six? Five?

Yeah. Okay, six. Drum roll. A whopping $20,250 in borrowing capacity increase. That's the difference between a good negotiator and not.

Yeah, I mean like, but like, does your game change, Adrian? If a customer comes up and goes, you know what? I need that yield. So instead of 750, we can get to 770. Not really.

And I think that's where, you know, a lot of people might think logical assumption is, hey, I've got $20,000 more, which is, you know, don't get me wrong. It's a decent amount that you could increase in terms of purchase price. But, and maybe you increase, I don't know, properties coming along and there's that one that sits a little bit above that amount. Right. But if you've just excluded five or 10 different markets because of the yield versus that one property that you could have gotten.

True, because this is the flip side. So we talked about borrowing capacity. As we can see, it's not a major impact by having a half a percent higher yield. It was only what, $20,000 more in borrowing cap. But the big thing is, if you have 4% yields here, like top of your head, you have to name the cities, but how many cities in our current buying markets that we're looking at suit a 4% yield at 750?

So quite a few, probably 10, 10 or so. But then if you move that to four and a half from that same 750. Less than half, I reckon. You lose five markets. Now, if a typical timeframe, by the way, most Aussies are refreshing their pre-approval, what, like a couple of times, one or two times, if they don't have professional support.

Pre-approval refresh at three months becomes six months all of a sudden. If we're looking at six months as a normal way to do it, and then you go two to four months with a certain professional, and now all of a sudden with a two to four months with a professional, that number is about to be that four to six months simply because you went from 10 markets to five. That's a game changer. It's half a percent to feel good about 20K more borrowing, but then it actually cut half your cities because you weren't open to having 20K less borrowing. Or if we put borrowing aside, the actual rental income that was higher was $3,750.

So you divide that by 52 is $72 a week. And it's income. Income is taxed. So, I mean, in this case, gearing, but I mean, like that's 50 bucks a week, probably after tax. So for $50 a week, you're willing to add multiple months to your search, half the cities that you choose from, and all for the hope that you think it helps your borrowing capacity, but it only increases at circa 20K, and you now lose all this money on the upside of the gain too.

Because if you took two, three months longer to search in markets that we can predict forecast hotspot markets in or high growth markets, and they're doing 1% a month, that's a circa $7,500 per month that you're losing out in growth from the purpose of trying to chase $50 a week in cashflow. That's wild. Cash is not king in this case. Cash flow ain't king in this case. We might as well end the episode now.

I just realized, holy shit, just don't do that. Punchline, finish it here. Don't do that, please. Don't do that. Now, I had a client send us a property in Broken Hill or something.

It was like 250, it was like an 8% yield. I was like, hey, why? That rental income is not going to move the needle for you the way you think. And actually, capital growth is king in property investing, especially in the early stages while you're trying to scale. So yeah, it's not a- Well, you've touched on a really good point, which is people are talking about property and residential property as a means to retire.

But residential property is a means to build wealth. And if you're happy with an inefficient portfolio, three to four residential properties can still get you a six-figure passive income inefficiently, but it can get you that. And if you want to make it efficiently, it's unlikely residential property gets you the passive income to the highest dollar usage it could be when you end up debt-free and the value's here and the rent's here. And so you can use that money in any way you want, go in other vehicles, go to commercial, exit, down Sure, prices go up a little bit, yields compress a little bit, but that's usually that middle ground where you don't have to compromise on both things. You don't have to go to one singular market that is in that 500k price point and the 4.

5% yield. So there's the compromise between the both where you get the best of both worlds as well. I think there's a bit of a hangover from the COVID period because I've worked with a lot of buyers agents over the years and during COVID when we had 2% rates, the marketing play was like, and the sales funnel was fully based around cash flow. Positive cash flow. Positive cash flow, blah, blah, blah.

Because literally you buy a 500k property, a couple hundred bucks a week, positive. And they would use this in their sales technique. And then as the rates went up, I started to speak to these same buyers agents and they're talking about, oh, you know, we might have to change the way we're selling because the cash flow thing, it's not really, you can't buy positive cash flow at 80% now. So yeah, I think it's still a bit of a, maybe there's a misconception from all of that during COVID and clients just aren't aware that it's not a thing anymore. You know, it's a really good point you say that because the amount of people that, no, thank you.

That's actually a really good point. You got a really good point there because, you know, it's the same thing when it comes to people going, ah, I got an 800k budget. What can I get in Sydney? Wait, why? Oh, but I got a 600k budget.

Can we get anything in Sydney? One bedroom unit? One bedroom unit, studio. Homebush West. But I now, it clicks.

Why are they saying that? Well, they're coming to a professional, they're open to buy nationally, but they're still saying that. I get it now. It's because they only experienced Sydney from 2011 to 2017. And I've now had this conversation.

I just realized there's a common theme here too. Me being Indian, I have many Indian clients too, but we have clients from all over. And I noticed from the Southeast Asian clients and just the Asian clients that had migrated to Australia between 2010 to 2015, that client base bought their homes during that time. And so when they bought their homes during that time, they don't have any history of data before that. They don't have any understanding of Brisbane and Adelaide and outperforming Sydney and Melbourne between 2000 and 2010.

They don't have any data of Bundaberg being one of the top performers in the country between 2000 and 2006. They don't have all this data. And so for them, their only knowledge is, wow, I got a better life in another part of the world. I got a great job. I've been saving hard, working hard, and I saved and I bought my home for my family.

And it was a lot of blood, sweat, and tears. And then all of a sudden, whoa, our money's doubled? You're telling me I can invest now? This is the greatest gift ever. New country, great life, new jobs, safety, weather, health, and then you've doubled your money too?

And imagine them spreading that out to everyone, Sydney the best, Sydney the best. And then all of a sudden, everything is about how do I get another Sydney place, another investment in Sydney? And then just doesn't, there's no data. And I spoke to them about that. I'm like, they're like, you know what?

That's all we know. Sydney's the best in our eyes because of that. And so it's so true because that whole, if that was the moment, it carries on. It's like a lag effect in the mind. It's just sitting there.

It's like positive cashflow. Well, look, who knows? Maybe we do return to positive cashflow again with the way rates have come down. But for now, we've got to assume it's not. And what you are today is what you are today.

So then based on that, Adrian, this is the part where people's portfolio planning that you and the team do a lot of visualization on. There's a curve. And this curve of passive income is this line like this for a target because inflation makes the target higher. And so today's 100K in about 15 years might be, today's 125K in about 15 years might be a 195K target that you've got to aim for. And so that's inflation doing its dirty deed, right?

But then the cashflow, we have a line called zero and the cashflow is a blue color. And the cashflow starts negative, but then the curve catches up and it goes beyond zero and goes to positive and eventually catches your target. How has that conversation shifted and how do people look at that? And what are some of the impacts you notice that that has on a property buyer and investor's mind when they see that negative to begin with to even get going later on? I think previously a lot of people weren't as receptive to it because we were so used to that environment.

Low rates, yields were stronger, everything starting off with positive cashflow, whereas now we are in this environment where everything is going to be negative even if you have a 20% deposit and things like that, we're going to start off negative. But I think a lot of investors have understood that that's the environment we're in right now. And I think it's a good point that you brought up because it's shifting with the times. Previously, and as we kind of know, growth and cashflow aren't correlated. You can find places that, at least back then, high growth, high cashflow.

But if we're thinking about the reality or the environment right now, it's probably arguable that some of the best places do have slightly lower yields or not the best yields, which is why we're making that argument of, hey, you're limiting your options in terms of markets if we are chasing this yield. And what that means is if we are looking for the best growth, because that's what we're doing, we're trying to build wealth, we're trying to build the portfolio size, we do have to have that little bit of sacrifice in terms of negative cashflow at the start. But it does come around, as you've mentioned, it comes up to hit neutral, positive cashflow with time as you pay down debt, as rents increase, as rates potentially decrease as well, and then it gets you to that goal. So I think it's becoming a lot more normalized now. A lot of people understand that's a sacrifice that you have to make to build up and get the best results for your portfolio later on.

Absolutely. Temporary sacrifice, long-term gain. In short, $5,000 a year in additional rental income isn't as good as $70,000 extra of capital growth. That's it. And if you can get that growth because you had more cities to choose from, you had a faster purchasing time, you had more properties that you were open to, and your budget worked harder for you because you had a bigger budget to do multiple things, game changer.

So that's the yield part and how it's not really a big impactor on scaling a portfolio as it once used to be when it comes to residential property and building wealth. The bigger drivers are actually going to be three things. Number one is your mindset around how long you're willing to hold on to negative gearing properties before that chart, like we said, turns from negative to positive. Because once you can see the other side, you can be like, that's my goal to freedom. Number two is how much actually you are in terms of how good you are as a saver.

That's the thing, right? We know that today's market requires one to two K negative cash flow per month, depending on which property, but most are sitting around there and some higher, some lower, depending on your budget. But if you're at one to two K, if you're saving three to five K, mentally, that doesn't hurt you. But if you're saving two K a month and you go, I want to get into property investing and that takes all of it, and you're going to be deflated because one property took all of it in this time, you might not build a portfolio. So how you are as a saver also helps.

And then the third part, hardest one to move, but it's a key one to think is property is more on your strategy, your team around you and your income. So it's not going to be the yield. Your household income having a $20,000 bonus at six times debt to income ratio is 180 K. That bonus that you worked hard for, that business that you scaled, that promotion that you got, the job that you changed, the pay rise that you did, like these things make a bigger impact than four to 5% yield or four to four and a half percent yield. That's the game changer.

And so that's the key part here. And like when you're building out your portfolio, you don't want to be so stuck on yield. And that's the key for today. Now, Jack, I want to shift to another topic though, because yield is one thing, but when it comes to scaling a portfolio, we've noticed other entities too. And with yield, we've noticed that it's not as obviously big of a scaling part to the journey, but other entities we've seen popping up all the time, especially in recent times has been SMSF.

Now, I know we can go to a whole other topic on this and we will in future episodes, but there's something in particular that's come out now more from a timeliness matter that we're like, oh, this is very interesting.