Reply: 1.1
From: Sim' Hampel
Okay, now for a theoretical explanation after Rob's chest-beating explanation ;-)
It all comes down to supply and demand.
You actually have it the wrong way around. High capital growth properties usually do not produce enough income to cover interest payements and expenses (hence are negatively geared) because they are high capital growth properties !
In other words... the growth of the properties is driven by demand... people want to live there, or at least want to own that particular property. Therefore, the price goes up in response to that demand (this is basic economic theory of supply and demand).
For an investment property, you are relying on the tenant to pay as much of your costs as possible. During periods of high capital growth, rental growth won't keep up with the capital growth, so the gap between the income and the costs (ie. interest) increases - to the point where it costs you more to pay the interest on the loan than you get in income - hence it would be negatively geared if you bought it at that price. Prices/rent in Sydney have been in this situation for quite some time.
The main reason rents don't keep up with prices is that tenants are generally not as fussy as home buyers in which particular house they live in. If there is another unit or house nearby that is similar but cheaper in rent, they will most likely choose that.
There are also usually more places available for rent than there are tenants to rent them, as shown by the vacancy rate figures published in the media. During periods of high vacancy, where investors are competing with each other just to get a tenant into their house, rents tend to drop in real terms, sometimes significantly.
Exactly this is happening right now in parts of Sydney... continued growth in prices as well as falling rents serve to increase the gap between income and costs even further. Rental yields in some areas are now down well below 4%. Some people use a rough figure of needing yields of at least 2% above the current interest rates for an investment to be cashflow positive. So with yields at 4%, we would need interest rates to drop to 2% before these would become cashflow positive (personally I'm not holding my breath waiting for that to happen !). So as current interest rates are at around 6%, you will need properties with at least 8% yield to perhaps be cashflow positive. Just watch out when interest rates rise !
Now in country towns and the outermost suburbs of cities, there is less demand from people looking to buy property, which keeps prices subdued. Because there are also fewer investors buying in these areas looking for capital growth, there are usually fewer places available for rent. Thus demand tends to outstrip supply and rents stay relatively high. Stronger rental demand coupled with lower prices means that it is more likely that your income will cover your costs... hence investment property you buy will be cashflow positive.
Of course, you do not always get strong rental demand in these areas of low growth... which tends to indicate a severe lack of demand... perhaps a falling or cyclical population. It pays to look beyond just the capital growth and rental yield figures when investigating an area... also check out things like the vacancy rates !
So as you can see... in general, growth, rental yields and gearing are all closely linked.
Now, you can always buck the trend by getting creative with your purchases... both with good negotiation and with clever post-purchase improvements or alterations... which may mean that you are able to take a property in a growth area and make it cashflow positive.
It also helps to have a property boom coming soon too !
So what is best ? Capital Growth or Cashflow ?
As someone well known to all of us once told me... "I'll take great lashings of both please" !
Hope this helps.