There are two types of investment return. The first is the income received from the investment and is usually taxed as income annually. The second is capital growth. Capital Growth is the rate at which the value of your investment is growing. Capital Growth is usually taxed as Capital Gain when the asset is sold and 50% of the gain is taxed at the Income Tax Rate. In both cases, it is assumed the investment is held in the investor’s name.
The Total % Investment Return is the addition of Income and Capital Growth. Thus, if you have an Income of 4% and a Capital Growth of 6%, the Total Investment Return will be 10%.
Risk and Return
Investment returns are based on supply and demand and the risk you may lose the investment.
A risk-free investment is generally accepted as the 90 Day Bank Bill Rate. This means there is virtually no risk that you will not receive the income and capital at the end of 90 days. Some definitions of a risk-free rate might be for a longer period, say a 10-year Government Bond. The problem with this definition is that over the 10-year period, inflation may rise and thus the income will have less value.
In you were investing in a portfolio of blue chip shares, you may consider this risk is less than if you were investing in a portfolio of start-up companies. Therefore, you would expect a higher return on the riskier startup companies.
Income on Investments
The income component is generally paid at regular intervals from monthly to annually. Some people relying on the income for living expenses are more likely to choose investments with a higher income component.
If you have an investment of $10,000 earning $400 a year, the investment return would be 4%. (Income / Amount * 100)% or 4%.
If you are investing in shares, fully franked shares will provide you with a higher income when the Imputation Credits are deducted from your taxable income.
Real Estate has the advantage of non-cash tax deductions, such Building Write-Off. However at the time of sale, this Building Write-Off is written back, that the Building Write-Off is a tax deferral rather than a tax deduction.
If you are investing in real estate, you are likely to have borrowed money for the investment. Any interest on the borrowed money can be deducted from the rental income.
One of my favourite sayings is that if you never sell a property, you never pay Capital Gains Tax.
Before you purchase real estate, you should consider your EXIT STRATEGY. You may intend to keep the property and pass it to your beneficiaries in your will. It will then be their decision to decide to hold the property or sell and pay the Capital Gains Tax.
If you know the rental income will not provide you with sufficient income in retirement, choosing a year when you anticipate your taxable income will be low may be an option to consider. Currently 50% capital gains are taxed as income in the year of sale. This can prove to be a significant amount of money particularly when inflation is high.
Capital Gains
Capital Gains are the rate at which the value of your investment rises on an annual basis. If you buy a property for $1,000,000 and you expect the property to rise in value by 10% during the year, the value of the property would be $1,100,000 at the end of the year, giving you a capital gain of $100,000. If you were to sell the property at the end of the year, you would be taxed on half ($50,000) as income. Of course, you would deduct buying and selling costs. But if you don’t sell the property, no tax is paid. The trigger for paying Capital Gains Tax, is the sale of the property.
A word of warning for those with property in their Self-Managed Superannuation. Currently the government is attempting to change the legislation so that unrealised capital gains in SMSF’s will be taxed annually. You should be receiving updates from your accountant or financial adviser. Make sure you carefully watch the current situation and act if you think appropriate.
Real Rate of Return
The higher the inflation rate, the greater will be the investment return. This is because the investor will require compensation for Inflation. If you have $100 in the bank, earning no interest and inflation is $100, the buying power of that $100 will be less.
It is generally accepted that a safe investment will return 4.5% to 5% plus inflation.
A Real Rate of Return is the investment return less the allocation for inflation. While a simple version would be Nominal Return Less Inflation, the following is the correct formula to calculate Real Return
Real Rate of Return = [(1 + Nominal Rate) / (1 + Inflation Rate)] – 1
The following table displays the Real Rate of Return where the Nominal Rate is the same, 10%, but the Inflation Rate increases from 2% to 3% and then 4%. Note how the Real Rate of Return decreases as Inflation increases.
Comparing the Investment Returns for Real Estate and Equities
For a detailed analysis of property and share prices, I would recommend you read the article from FinPeak Advisers, called Comparing Residential Property Vs Shares: A Long Term Perspective.
While the Investment Returns on property and shares will vary slightly, for long term strategies, using the average for the two sectors over the period you are estimating capital growth should be sufficient. The final mix of property and share is likely to depend on the investor’s preference and the tax strategies they wish to employ.
The following is a table of Average Historical Returns over different time frames:
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