Positive cashflow properties are the ultimate goal of property investing. Most investors, if offered a guaranteed positive cashflow property would take it provided they could finance it.
The ultimate cashflow positive property of course is one you pay cash for or you already own outright. If you have borrowed no money to purchase the property then it is instantly cashflow positive and almost 100% so. (Less the expenses incurred in owning and renting it.)
If positive cashflow properties are the goal of investing in property in the first place, why do so many property investors end up with a portfolio full of negative cashflow properties and why do so many property investors find themselves starting their portfolios with negative cashflow property?
Ignoring the fact that in Australia the government gives investors tax breaks for having a negative cashflow property, there is more to know about positive and negative cashflow properties.
What makes an investment property negative cashflow in the first place?
When buying an investment property, the two things that make it negative cashflow are the expenses and the interest you are repaying on the debt you incurred to buy the property. So reducing the amount of debt held against the property is the most guaranteed way of seeing positive cashflow from the property. This is especially true for most Australian residential investment properties where the rent (yield) will be 3-5% pa and the growth in the value of the property will be 7-9% pa.
If you can purchase a property that is high yielding from the start (i.e. the net yield is higher than the interest rate), you can see positive cashflow immediately, even if you have a mortgage against the property. But high yielding properties tend to have a high yield for a reason and given there is no “free lunch” in the property investing field, you are unlikely to have high sustainable growth and a high sustainable yield at the same time.
A property may enjoy high yield and high growth at the same time for a short period of time, but once people start buying up the value, the yield will start to drop as a percentage of the value, hence you are unlikely to find high yield and high growth properties over the medium to long term.
So if you currently have a property portfolio comprised mostly of negative cashflow properties and are interested in how you could turn it almost cashflow positive, there are ways to do this.
One simple way is this. If you follow this example here, you can see how one $800k investment property compares to 2 x $400k properties.
Let’s say you have the capacity to buy up to $800k worth of investment properties, your wage is $100k pa, and you can borrow 100% plus stamp duty and costs at 7.5% interest rate, because you have equity from other properties. (I’ve set the rate high at 7.5% just to show how this example will work in even a tougher lending environment than now)
Let’s compare the following two possible options using Melbourne data as an example:
- You buy 2 x $400k properties, two brand new houses, $200k building and $200k land, in a transition suburb 17km from Melbourne CBD.
- Achievable gross rent currently is 4.6%, we may assume a potential growth for the next 5 year is at 9.4% per year (Melbourne’s average for the last few decades) due to its relatively lower price in comparison to Melbourne’s median house price of $550k and its distance from the CBD.
- So 5 years later, each of these properties will be around $627k.
- You buy 1 x $800k property, an old house of 25 years, $200k building and $600k land, in an established & traditionally high growth suburb, also 17km from Melbourne CBD.
- Achievable gross rent currently is 3.5%, we may assume a slightly lower growth at 6.5% for the next 8 year due to its relatively inflated land value after a 15 year great run.
- So 5 years later, this property will be around $1.1m. (Please note that a $1.1m home in the same neighbourhood at 7.5% interest rate, will attract a $83k mortgage repayment per annum, which is coming out of a family’s after tax net income.)
So let’s look at the following diagrams to compare the Cash Flow of the above two options.
Option 1 (2 x $400k):
$75/week or $4k/year out of pocket the first year. A total $19k out of pocket for the first 5 years. (see below table)
|Now||Year 1||Year 2||Year 3||Year 4||Year 5|
|Cost per week to hold||$75||$97||$82||$65||$45|
Option 2 (1 x $800k):
$489/week or $25k/year out of pocket the first year. A total $113k out of picket for the first 5 years. (see below table)
|Now||Year 1||Year 2||Year 3||Year 4||Year 5|
|Cost per week to hold||$489||$465||$436||$405||$375|
Let’s compare the total money made over a 5 year period by simply using: capital gain + cash flow.
- Option 1 (2 x $400k): Capital Gain ($627k x 2 -$400k x 2) + Cash Flow (-$19k x 2) = $416k.
- Option 2 (1 x $800k): Capital Gain ($1.1m – $800k) + Cash Flow (-$113k) = $187k.
On top of that, the stamp duty difference was: $43k – $7k x 2 = $29k.
So Option 1 is better off than Option 2 by: $416k + $29k – $187k = $258k. This doesn’t include the following two major factors in favor of Option 1:
- Easier finance: it is much easier to get 95% finance for a $400k property, and almost impossible or too expensive to do the same for a $800k property. In other words, option 1 needs less money from you!
- Lower risk: the risk for a $400k property to lose $100k in value is a lot less than an $800k property in the current market conditions. In other words, option 1 is lower risk for your money.
When you compare the two, you can see that a very negatively geared $800k property is costing you $489 a week to hold! While each $400k property only costs $75 a week to hold, which is much closer to a positively geared property.
For more information on the thinking behind this approach and for more information http://www.investorsdirect.com.au/blog/an-unconventional-way-to-view-the-property-market/