What’s the right strategy for this stage of the property cycle

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Michael Yardney

Now that we’re at the stage of the property cycle where capital growth is lower, and it’s likely to remain that way for some time, more investors are asking: “what’s the right investment strategy?”

Recently Gail Kelly CEO of Westpac warned that Australia is unlikely to ever again see the type of housing boom that sparked a massive rise in personal wealth in the past decade.

 

At around the same time Reserve Bank of Australia governor Glenn Stevens said  the RBA was not trying to “engineer a return to a housing price boom” by lowering interest rates?

So what is an investor meant to do? Is it time to consider cash flow positive properties?

 

How property investors make their money

Firstly it’s important to understand property investors make their money in 4 ways:

  1. Capital growth – the increase in value of their properties
  2. Rental returns – which provide cash flow
  3. Tax benefits – such as depreciation allowances and negative gearing
  4. Forced appreciation – this is where an investor “manufactures” capital growth through renovations or development.

 

Smart investors benefit from a combination of all of these.

 

Can I still get capital growth?
Recently AMP Capital www.ampcapital.com.au reported that since the 1920s, real estate has returned 11.1% p.a. after allowing for capital growth and rents. That’s a pretty impressive long term track record

While there is little doubt that average capital growth will be lower for the next few years, there will always be some pockets that outperform the averages. And within those areas there will be some properties that grow strongly in value while others perform poorly. That’s how averages work.

 

What about positive cash flow?
A positive cash flow property is one where the rental income received covers all of the property’s expenses (including interest) leaving money in your pocket each month.

In general properties with higher capital growth have lower rental returns. This means you can’t find cash flow positive properties in the higher growth, better locations of our capital cities. You must look to regional areas or mining towns where buyers require a higher rental yield (cash flow) to make up for the lack of capital growth.

Of course buyers with lower loan to value ratios, those who put more money in the deal may also experience positive gearing. The problem is they miss out on the benefit of leverage.

 

Which strategy is better – capital growth or positive cash flow?
There’s no simple answer. Clearly if both strategies exist there is a place for both of them.

I see more beginning investors go for cash flow positive properties.

On the other hand I tend to see more successful investors, those who have built a substantial asset base, grow their portfolio through leveraging off the capital growth of their investments.

Obviously property investment should be part of a wealth creation strategy, not just a purchase in isolation. So if you are considering property investment to build an asset base to one day replace the salary from your day job, then I would invest for capital growth every time.

The few dollars a week your positive cash flow properties might bring in immediately is not really going to make much difference to your lifestyle or your ability to acquire and service other, more desirable properties for your portfolio.

The problem is that you can’t save your way to wealth – especially on the measly after tax positive cash flow you can get in today’s property market.

And when interest rates increase – as they will again some day – a property that is cash flow positive today may be cash flow negative tomorrow.

 

Think about it…real wealth is not derived from income.
It is achieved through long-term capital appreciation and the ability to refinance to buy further properties.

If you seek a short term fix with cash flow positive properties, you’ll struggle to grow a future cash machine from your property investments. It’s as simple as that.

 

But here’s the trick…
You can’t turn a cash flow positive property into a high growth property, because of its geographical location.

But you can achieve both high returns (cash flow) and capital growth by renovating or developing high growth properties. This will bring you a higher rent and extra depreciation allowances, which convert high growth, relatively low cash flow properties into high growth, strong cash flow properties.

This means you can get the best of both worlds.

 

So how do you cope with negative cash flow?

Of course investing in negatively geared, high growth property means you have to cover the cash flow shortfall each month.

One way of doing this is to set up the correct loan structure. A line of credit could be used to supplement the rental to pay the interest on the investment loan and property expenses.  This buys an investor time.

The line of credit is often set up to cover the shortfall for 3 or more years until the property’s value grows sufficiently to refinance the loan out of the extra equity.

To use this investment strategy, correct asset selection is critical because to make it worthwhile you need the property’s value to increase significantly more than your outstanding loan balance increases.

This means you need to be investing in high quality assets so that you can maximise the chances of enjoying strong capital growth.

 

This strategy is not without risks…
The 4 main risks are:

  1. Poor capital growth – that’s why correct asset selection is so important.
  2. Interest rate increases – which can be addressed by fixing interest rates on some or all of your debt.
  3. Poor rental growth – which highlights the importance of owning properties that will be in continuous strong demand by a wide demographic of tenants.
  4. Lack of financial discipline – never use your financial buffers for uses other than covering your property related expenses.

 

In summary.

I can understand why beginning investors would be keen to buy a property with positive cash flow. They tend to be cheaper so it is easier to purchase and support this type of property. While they may give you short-term income, these properties will never allow you to accumulate the equity necessary to become truly wealthy.

And while the rent may seem relatively high initially, it is the ongoing capital growth of your property that will underpin its long-term rental income, which means that if you buy in low capital growth areas, your rents won’t rise over the years as much as rents in high growth areas.

This means the value of capital gains over the long term will blow comparable cashflow returns out of the water.

Remember as a property investor your focus should be on safely building your asset base so you can eventually develop the passive income from your assets that will allow you to enjoy the financial freedom you desire.

 

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