When discussing property investment there are two somewhat conflicting philosophies of property investment. Some suggest you should invest in property for high rental return 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.

In general in regional centres and many secondary locations investors can achieve a higher rental returns but get poor long term capital growth. However in the major capital cities of Australia strong capital growth usually goes with a lower rental yield (the income earned over a year represented as a percentage of the value of the property).

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 happens during property booms is that rental returns fall. This is just the way the property market works.

In the slower phases of the property cycle, when interest rates are rising and affordability of properties are 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.

I understand why 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.

I guess that is why many beginning investors make the mistake of viewing their property investments as income driven.

Yet I still believe that is strong capital growth that will be 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.

So I suggest you seek a balance between growth and income and view your 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?

Let's look at a real example of David who bought an investment property in a regional town in NSW a few years ago.

When he bought the property for $90,000 it returned $135 per week rental. David was thrilled with this; he has money in his pocket every week.

Over the last few years he had over $1,000 per year positive cash flow from his property.  But after tax, he didn't have much to put aside and he hasn't been able to save for another deposit for his second property. And as interest rates have increased recently, he has been getting less positive cash flow. He understands the benefits of investment property but just can't get sufficient money together for his next investment.

Each year David asked the local agents what his property was worth hoping it has gone up in value enough that he can borrow against the extra equity.

But unfortunately each year he gets much the same answer. "It's gone up 2% or 3%".

So over the last 5 years, his property has only gone up slightly in value. It had not increased in value enough for David to borrow further funds for a deposit on a second investment property.

Imagine if David had bought a property that cost him $20-$25 per week, which he could easily have afforded from his salary. If he purchased in a good area with strong capital growth, his property would have gone up on average 50-60% in value over the last 5 years.  If he had bought it in some of the stronger growth suburbs in Melbourne or Brisbane it might even have doubled in value.

David would easily have had sufficient equity to purchase another investment property as was the case for his friends who bought properties in suburban Melbourne and Brisbane. Instead he has gone through most of a property cycle, had a small amount of surplus rental income but minimal growth. He is still stuck with one investment property.

Let's look at it another way.

How much positive cash flow could David ever hope to achieve from one investment property? $20 or $25 per week? Let's be generous and say $30. This would give him positive cash flow on your property of say $1,500 each year or less than $1,000 after tax.

George Kafantaris is a Director of Metropole & been twice awarded as Australia's Leading Buyers Agent. Being an avid property investor with a background as an accountant gives George the depth of knowledge to provide readers with unique insights into property investing. Go to www.metropole.com.au