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Michael Pope Blog post by Michael Pope

The Impact of Yield

In an earlier article, we identified that there are many different investment assets available to use in a strategy designed to deliver long term wealth creation, and that different investment vehicles differ in a number of key characteristics.  In the previous newsletter, we talked about the capital growth of an asset and how it could affect the outcome of our investment strategy.

In this article, we will look at the impact of the income (or yield) provided by an investment asset on the selection and outcome of our investment strategy.  There are a number of reasons for wanting to own investment assets which provide an ongoing income stream – perhaps the most obvious is that one of the key aims of an investment strategy for most people is to provide a future income stream that can be used to replace the income from paid employment, but there are other considerations.

Yield from investment assets comes in a number of forms.

In the case of company shares, many companies pass on some or all of their profits to their shareholders in the form of dividends (and associated franking credits), typically once every six months.  In the case of a residential property, the owner would expect to receive rental payments from the tenant, typically once a month.  Yields are often quoted as a percentage, representing the annual income expressed as a percentage of the value of the asset.  So a $10 share which offers two $0.20 dividends per year would provide a yield of 4%, as would a residential property worth $390,000 which delivered a rental income of $300 per week.  These figures are generally calculated before taking into account the impact of costs or taxation.

Depending on the choice of investment assets, there may be ongoing costs of owning the asset.  In the case of a managed portfolio of shares, for example, there will typically be an annual fee charged for the management of the portfolio.  Owners of residential property will typically find that they are required to pay local government rates, land tax, owners corporation ( previously body corporate ) charges if applicable,  building and landlords’ insurance, and they may choose to pay for the services of a property manager to look after the day-to-day management of the property.

If the asset has been purchased with borrowed funds, usually a mortgage in the case of a residential property or a margin loan in the case of a share portfolio, then there will also be interest to be paid on the outstanding amount of the debt.

A share portfolio with a margin loan could be constructed in such a way that the yield from the portfolio could be expected to generally exceed the amount of interest and fees payable, meaning that no ongoing contribution would be required from the investor.  For example, if the amount of the loan was 50% of the value of the portfolio, and interest was being charged at a rate of 8%, then an average portfolio yield of 5% per year could be expected to cover both the interest costs and management fees.

In the case of a residential property, however, it is common to borrow a higher proportion of the value of the property, often 80 to 100% or more.  The yield from residential properties in major population centres in Australia is typically in the range of 3 to 6% depending on the property and the location, and so the income in these circumstances would be insufficient to cover the costs, resulting in what is termed negative cash flow, and the owner will need to pay the difference.

In the previous article, we discussed the idea that an asset can be expected to grow in value over time (referred to as capital growth), and it can also be expected that the rental income from an investment property will increase over time as the value of the property increases.  This increasing income stream means that at some point in the future, the income will be sufficient to cover the costs of ownership (including interest), at which point the cash flow will change from being negative to positive, and the property will start to return an income stream to the owner.  The same asset growth will mean that the amount of this income stream will continue to grow into the future.

One of the aims of a typical investment strategy will be to have the investment portfolio, whether shares, property or a combination, returning a positive cash flow sufficient to fund our desired lifestyle by the date we are aiming to retire ( or at least to have the choice to cease full time employment ).

Given that a change in the yield of an asset of just 1% can bring forward this time frame by as much as 4 years, the time frame in which the portfolio needs to become cash flow positive will be a key factor in deciding on the target yield to be sought.

This illustrates why yield, in combination with the growth rate achieved, is a critical factor in the success of a long term wealth creation strategy, and why Empower Wealth considers the choice of investment asset to be such an important decision in implementing an investment strategy.

Empower Wealth’s Personal Wealth Management Program includes a sophisticated Wealth Projection Simulator which allows you to see the effect of asset selection decisions by modelling the effect of different yields and compound growth rates, together with all the other factors which influence the long term financial outcome of an investment, to give you the numbers you need to make an informed decision about your financial future.

If you would be interested in seeing how these tools and techniques could be applied to your own personal financial situation, please come and see us for a free one hour consultation by registering at our website or just give us a call.

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