When discussing property investment there are two somewhat conflicting philosophies of property investment. Some suggest you should invest in property for high rental return (the income earned over a year represented as a percentage of the value of the property) while others feel you should invest for capital growth (the increase in value of the property.) 

We would all like to buy properties that have both great capital growth and a high rental yield. But if you buy good property, that's just not the way it works.

Throughout New Zealand there are locations for the purchase of property investments (usually the lower value property areas) where you  can achieve higher rental returns but get poor long term capital growth. And there are also locations (usually the higher cost poperties) where  strong capital growth usually goes with a lower rental yield .

From the above definition alone one can see why this inverse relationship exists.

As the value of a property increases, then it follows that its rental return decreases. This is of course unless the rent increases by the same proportion, which does not normally happen. Rents eventually go up but these increases lag capital increases by a number of years. 

So the situation during any extended period of high capital growth as has happened in the recent New Zealand  property boom is that rental returns fall. This is just the way the property market works.

And now in the slower phases of the property cycle as we are experiencing in New Zealand, when interest rates are rising and affordability of properties is decreasing, more potential home owners are turning to renting properties. This is the stage of the property cycle that rental growth starts to catch up.

Many investors would prefer a higher yield. They feel they need the higher rental returns to pay their mortgage. They also believe they cannot buy many properties because they can't afford to service additional loans.  

Strong capital growth is the key to a successful property investment. Even though the first year or two of holding an investment property can be challenging, remember that capital growth builds your equity much faster than loan re-payments and rental income will. 

It is suggested that property investors should seek a balance between growth and income and view their investment as medium to long-term and be prepared to ride out the cycles.  The rental income needs to be high enough to help with your holding costs such as loan repayments, insurance and rates.  But it should not be the main reason for investing, unless you are retired and are just looking for income to maintain your lifestyle. 

If you have any doubt about the importance of capital growth, the calculations in the table below may change your mind.

Imagine you bought a property worth $400,000 in a poor growth area delivering 5% capital growth and 10% gross rental return; in 20 years your property will be worth just over half a million dollars.

On the other hand, if you had purchased a property for $400,000 in a high capital growth area showing 10% per annum capital growth and only 5% rental return the property this property will be worth $2,691,000 at the end of the same period.

That is a massive difference in the final value of your investment property.

In the meantime the rentals on your property would have grown substantially in line with its capital growth and they would catch up to the rentals you would achieve on the first (high return) property.

The real bonus for the investor who bought the high growth property is that he will be able to access the extra equity in this property and borrow against it to buy further properties.

It is very hard to do this with properties that have high rental return but poor capital growth. It is very difficult to save that deposit to buy your next property.