The main purpose of an investment is usually to make money. So how do you make the most amount of money when investing in property?
When you buy an investment property you get two types of return:
Cash flow: There’s the cash flow return, which is the net difference between the costs you pay to run your investment (mortgage repayments, property management/maintenance, insurance, council rates etc.), and the rental income.
Capital growth: This is the appreciation of your property’s value over time.
The ideal property investment delivers both — positive cash flow and high capital growth. However in reality it’s one or the other. The higher yielding/positive cash flow investments often appreciate in value slowly, and those with low rental yields lose you cash each year (that is, they’re ’negatively geared’) but then also have the greater likelihood for capital growth over time.
So this then begs the question — which is better, cash flow or capital growth?
Let’s examine this dilemma in detail.
Consider the following two investments:
(note for the purposes of this illustration we have assumed the full purchase price is borrowed, however it doesn’t have to be, and all other assumptions are listed in blue. You may adjust any of the assumptions as you wish)
Comparing our two investments
The positive cash flow investment in Scenario 1 only appreciates by 3.5% per annum, but it delivers a strong rental yield of 9.0% per annum as well. The strong yield at 9.0% is higher than the all up running costs of the investment at 5.5%, so the investor generates a healthy profit of $22,750 from the investment each year. This profit has to be taxed at the investor’s marginal rate of tax (37%), so the after tax profit is reduced to $14,333. The capital gain at 3.5% generates a further $22,750 return, and although this is only a “paper” return (there is no cash flow involved), it is fair to say that the overall return on the investment is the sum of the two returns, which equals $14,333 + $22,750 = $37,083.
In Scenario 2 we have a negatively geared situation where the rental income received at only 3.5% is insufficient to cover the running costs of the investment at 5.5%. So the investment actually loses $13,000 each year. In Australia the tax benefits of negative gearing allow the investor’s taxable income to be reduced by this $13,000, which at a marginal tax rate of 37% equates to a saving of $5,000 at tax time, and so the after tax loss is reduced from $13,000 to $8,190. The real benefit of the Scenario 2 though though is that the capital gain on the asset is a solid 9.0% per annum, which equates to $58,500. Again, combining the two returns and you can see that the total return on the Scenario 2 investment is -$8,190 + $58,500 = $50,310, or about $13,000 higher than the total return in Scenario 1.
The high growth option has the superior total return, and it’s due to the tax treatment of the profits
The high growth investment is clearly superior as it has the higher total return.
You can see this is due to the tax treatment of the investment. In Scenario 1 the tax is paid up front on the yearly profit, whereas in Scenario 2 the investor gets a tax refund and will only ever have a tax obligation if the property one day becomes positively geared, or if it is sold. It may never be sold, only refinanced, in which case the tax obligation never arises.
The high growth option is more suitable for high income earners (or those with equity in existing properties), because they have the means to sustain the cash losses
The high growth investment in Option 2 is only possible for investors who have the means to withstand the $13,000 cash loss each year. Not everyone can do this.
Let’s say buying your next investment costs you $130,000 cash (e.g. you borrow 80%, so 20% of the $650,000 purchase price is $130,000) and a further $32,500 cash is required to complete the purchase (e.g. 5.0% to cover stamp duty, legal/conveyancing, transfer etc.). So after laying out $152,000 to purchase a $650,000 property, do you have an additional $13,000 cash lying around each year to fund the cash losses on the investment? Typically it’s high income earners who can afford to do this, because they earn more than they spend, so they are more likely to have the extra cash.
But regardless of your income, if you have equity built up in other real estate assets, the high growth investment is available to you as well.
You can release the equity by borrowing against your existing assets. The borrowed funds can then be used as a “buffer” to cash flow your losses from the new investment properties. If and when the buffer gets depleted, hopefully there is enough equity available (including in the new investment property) to refinance and release more equity again. Better still, this strategy of continually refinancing high growth assets can be done not only as a buffer to cash flow your short term investment losses, but also to fund purchases of additional investment properties.
Be mindful of the risks
Higher costs/interest rates. Interest rates are the main running cost of the investment. Rising interest rates therefore increases your cash losses each which means they drain your cash flow faster. Factors like your income, leverage and buffer will determine how serious this issue is for you, if it means you can no longer sustain your investments you may be forced to sell, and that may be highly undesirable due to the tax and timing implications.
Low/negative growth (keep reading).
When the market rises everyone makes money, but will the next fifty years be as favourable as the last?
Over the last half century house prices in the main Australian capital cities have roughly doubled every 7-10years. The long-term growth average is therefore approximately 7-10% per annum.
E.g. a $100,000 property growing at 10% (compounded) per year for 7 years = $194,872 — roughly double.
Or a $100,000 property growing at 7% (compounded) per year for 10 years = $196,715 — roughly double again.
We can’t know for sure whether this trend will continue into the future, but if history is anything to go by then you could at least reason that you are taking a calculated risk. The same is not true when it comes to investing in businesses or shares. 80% of new businesses don’t even exist after 5 years!
Our population is increasing but our land is in short supply
Also keep in mind the simple fact that our population is increasing but our land is in short supply. No one can decide one day to simply build another suburb to mimic Bondi Beach, which is equally beautiful and equally close to Sydney CBD. But like those before them many newcomers to Sydney will absolutely want to live there. Increasing the supply of housing in Bondi isn’t easy either, there are council laws which restrict this. So the simple idea that our land is in short supply but our population is increasing suggests that house prices in the major capital cities should rise over the long term.
What is your break-even?
The worst thing that can happen in an investment is that you lose money.
But the break-even in Scenario 2 is only 1.26% (e.g. $8,190 cash loss / $650,000 property value = 1.26% break-even).
Is that a risk you could get comfortable with?
Other considerations related to growing your portfolio – the development of your portfolio and your investment objectives
The below table summarises the other key factors to consider when comparing the two investments.
There’s no limit to how many positively geared properties you can hold, but the tax treatment and lower growth in these assets means that your equity grows slower. Therefore (unless you have fortunes of cash lying around) buying multiple assets takes longer.
You can build a growth orientated portfolio faster, because your equity builds up faster. This equity can be used to fund additional property purchases.
If developing a passive income through property is your ultimate objective, then capital growth should be your main focus.
—
* thank you to Chris Gray from Your Empire for inspiring many of the ideas in this article.
