To someone who is risk adverse, positive cash flow can be the most important factor influencing an investment decision. While having money coming in each week is reassuring, this doesn't necessarily lead to an investment strategy that will build wealth in the most efficient manner possible.

Renters and purchasers have different value systems, and this leads us to a concept often used in risk analysis called utility, an invention of the great mathematician Daniel Bernoulli, who first published his idea of utility in 1738. The price of a property is the "market value", but a renter and a buyer have different values for the property, as would an investor wanting capital gain versus an investor wanting capital appreciation. Utility isn't an assets price, it is an assets value to an interested party, back in 1738 Bernoulli was developing a theory of pricing, still used today, that defined a mean utility as the value of an asset.

Someone may wish to purchase a property for their own home due to pride of ownership concerns or convenience. An investor may be concerned about rent, or about capital growth. The amount of money you have to start with, your immediate cash needs, as well as your marginal tax rate will affect how you value rent versus capital gains.

A renter has a different concept of how to value a home, to them capital appreciation is irrelevant so they will not pay a premium for this as a capital growth investor would, nor do they have the same pride of ownership or status seeking feeling as someone who buys for their personal residence. This is a major reason why rental yields are not uniform across the whole residential real estate market.

The price may be pushed up in desirable locations by a desire to live in an exclusive estate, or expectation of capital growth, but rent will be determined by a different supply and demand equation, mainly the demand for property for its proximity to schools, employment and facilities. Renters as a whole tend to be sensitive to rents in a wide location, a luxury house may have utility for a renter not much above that for a more ordinary house, and won't attract a premium rent. Many renters just want a roof over their heads and won't pay too much for a fancy one, in particular since renters tend to be either those with a high degree of mobility (who won't have much time to grow attached to a home), or those unable to afford a home of their own.

In general, the market tends to pay a premium price for properties in desirable locations. If the supply of land is very limited compared to the demand, prices will rise substantially. What makes a person buy a house is not always the same thing that makes a person want to rent in that area though, and as a result prices may rise in an area more quickly than rent can be increased, demand from investors exceeds demand from renters, leading to high prices and poor rental yields.

People refer to such concepts as an "income property" and a "capital growth property", but ultimately both capital growth and rental levels are set by supply and demand, not necessarily in the same way. As a result property in more desirable areas from an owner's point of view may become very expensive, yet renters who lack pride of ownership or a speculative interest in future capital gain would not necessarily be willing to pay the same premium on their rent.

Rental yields in such areas do tend to be bad because while demand is certainly there from purchasers, not much is from renters. All things being equal you'll probably get good capital growth in property bought for its rarity value (only a certain number of houses can be built with a direct view of the river or city, and those who want one of these places must pay a premium price), but even if the dollar amounts of rent are good, the purchase price of such property is so high that as a percentage rental yields often aren't much good.

Before one gets too excited about capital appreciation in a "good" area though, do remember that prices for up-market property are far more volatile and may carry substantial price risk if you buy at the top of a boom. The old saw about "location, location and location" being the keys to real estate investment is something of a simplification, in fact location has a lot of effect on price, but price and price appreciation are not the same thing. To enjoy good capital gains you will have to avoid buying at the top of a boom, which is as good a reason as any to apply contrarian timing to your whole portfolio, confining real estate purchases to times when property has not done well recently.

This doesn't mean you won't get good capital growth from a property with a good yield, but if you want more than the slow upward drift caused by inflation there must be something to cause a real appreciation in capital value. If an area has long been inaccessible but suddenly gets connected to the city by a new freeway this may bring up property prices, or if an area is targeted for a renewal project, or even if the individual house is renovated there may be a capital gain, but certainly capital gains are not assured, even if I would find it hard to keep a straight face while arguing that property located in a more desirable area has any real appreciation guarantee on it either.

Speculative activity will usually be low in the mediocre areas with nothing special going for them, but capital appreciation concerns do not play heavily on the minds of renters, they will pay a price for rent that is pretty much just determined by whatever the market will bear. There will be two things that affect how much a renter will pay. The first is how much they can afford to pay, which is a function of the demographics of an area, and the second is supply of rental property, where a glut exists there may be vacancies or landlords desperate enough to deeply discount their rent to attract a tenant.

There is also the effect, mentioned in a previous article, that the capital gain of a unit will generally not be as good as the possible capital gain of a house, or a block of land, because capital gain tends to come from the land itself, whereas the building just depreciates.

Therefore the typical high yield income producing property will be a small unit in a less desirable location, whereas a capital growth property will probably be a house in a premium location. This doesn't mean you will get a capital gain from a house in a premium location, at least over the short term, but most likely the utility of the well located house will lead to a superior price compared to rent, while capital growth is not guaranteed, to a large extent bad rent yields probably is.

A cash producing investment in some poorly located little flat that will produce positive income before tax, but very poor capital gains is not particularly suitable for gearing. If you receive $150 a week in rental income and $140 of that goes on the mortgage, you are making an immediate profit and your tenant is paying for your flat, but ultimately your annual profit will be very small. It is probably better to buy such a property with little or no gearing and take the rent instead. If you are a person on a high marginal tax rate this would probably not be satisfactory, you don't need more money right now and are seeking capital gains instead, trading off income through negative gearing and tax deductions for this growth.

If you have geared into a high yield property, and your investment does not perform well in capital gains, then your only profit is a few dollars in rent and the small amount of money paid off as the principal of the loan, both of which will be taxed as income. Your total profit may be only a couple of hundred dollars a year, making it unlikely you will ever become wealthy out of such in investment.

It does not make sense to negatively gear into such a property, the "growth" component of the price increase will not make you much profit so you aren't leveraging any growth. If you are going to buy an "income" property, it is best to do so with only a very limited amount of gearing. There is little point in trying to get leverage on these things. On the other hand if you can find a place that returns 8% just on rent you can't go too far wrong by paying cash for it, this is a fairly reliable income stream that may be said to be also relatively well hedged against inflation, because you can (sometimes?) increase rent in line with inflation, something you can't always expect from a typical income investment such as a bond and cash portfolio.

If you are on a higher tax bracket and have ample income, you probably would have very little interest in buying an "income" property like a unit, you would be looking for above average growth, and this can usually be found in a well located property with a significant amount of the purchase price being for the land itself, as long as it is bought at the right time and not at the end of a period of particularly high gains. In this case as capital gains are more likely it would make sense to gear into this investment, and for a person who considers their marginal tax rate to be a "problem", the tax deductions available right now will effectively get you taxpayer subsidised mortgage payments.

I don't get too excited about the immediate tax benefits of negative gearing, after all it is the worst kind of tax break - you actually do make a loss, which can be written off against your tax. Other forms of tax benefit such as franking credits, effective salary sacrifice and tax-paid investments allow you to save tax without actually being out of pocket. Nevertheless, tax advantages do arise from negatively geared property, especially because your inputs (interest payments) are completely deductible but only half the capital gain is assessed, which can lead to situations where the tax return in the first few years is much larger than the tax bill that comes later, if you so much as broke even on the investment itself this can in fact give you a profit overall.

Profits can be significantly greater for a capital growth type of property. When such a property goes up in value by 5% a year this will be a $10,000 capital gain on a $200,000 property, concessionally taxed as a capital gain rather than income, minus the after-tax cost of servicing the mortgage. If you can afford the negative cash flow produced by such a property, your after-tax gains will most likely be significantly higher from such an acquisition than that returned by a typical income producing flat or flats that produce the same gain, but taxed at marginal tax rates. If you gear into an income property instead you will probably achieve little capital growth, only servicing the mortgage, which seems to me like a pointless exercise.

So unless you actually need the income for other purposes, there is probably little point in buying these other "income" type properties, and certainly little point in gearing into them, you should probably concentrate on buying houses instead. If you did need the income, why would you want to gear into it in the first place?

Notwithstanding the above, I often hear real estate guys talk about borrowing heavily to buy income properties, as if merely owning the place was enough. At real estate seminars they show off median house prices to demonstrate capital growth, then show you how easy it is to buy income properties, their high rents making them easy to own, combining the best of both to demonstrate a form of property that is rarely seen, the high growth high yield property. Maybe they think the goal here is to own a property - it isn't, the goal is to make a profit. (Actually, the goal of a real estate seminar is not to explain property wealth building as such, the goal is to sell people on the merits of property investment and thus being in new business for the firm, and that is the "good" seminars put on by reputable agents, don't get me started on the gurus).

The logic that drives the "nothing down" movement, that owning a property is a sufficiently desirable thing that it should be achieved no matter what, is what makes people borrow 100% for an income property. Unless you are really achieving substantial positive cash flow to start with there is little other point in entering into such a transaction. In times of double digit inflation such a house might appreciate, but at the same time the interest rate on the loan would usually be very high as well, probably wrecking the cash flow benefits it brings.