Capital growth VS CASH FLOW: What’s the best strategy for the current market?

You’re probably sick of hearing this debate about capital growth versus cash fl ow. Many investors have had their minds made up for a while on which is the best to pursue. I’d ask those minds to be open while I try to provide some fresh insight. Maybe this will stimulate some thinking to help you create new perspectives on the topic.

Is cash king?

There are two key benefits that high cash fl ow brings: greater ability to service debt, and income for retirement.

Serviceability

Without the cash fl ow to service a mortgage, an investor can’t even get in the game. There are rare exceptions, however, like no-doc loans or pure asset based mortgages. These are not offered by all lenders and not in all markets.

Straight asset lend mortgages are based on a very low loan to value ratio (LVR) such as 60% or less. These loan requirements ignore the borrower’s cash flow. This seems like a high risk to the lender. But because the LVR is so low, even in a ‘fi re sale’ the lender will get their money back and any unpaid interest too.

Apart from these rare cases, good cash flow is a starting requirement in order to

borrow money and buy an investment property. Most investors start off buying a negatively geared property and dip into surplus cash from their nine-to-fi ve job after other bills have been paid. If there is not much money left over at the end of each week, then the next property an investor buys, with the intention to hold, should be positively geared.

Positive gearing means that even before tax, the income should exceed all expenses. That means the rent is larger than the sum of:

Note that you actually pay more tax after buying positively geared investment properties. You lose some tax efficiency that a negatively geared property provides. The beauty of these high cash flow investments is they keep you in the game. After all, not many people go broke making a profit. Banks are happy to lend you more since your ability to service debt is not a risk to them. The more tax you are paying, the less risk you are to a bank – all other things being equal of course.

Retirement

A cash flow positive property portfolio is what most investors aim for in order to become financially independent. The idea is to get to a point where all the income exceeds all the expenses by an amount which, after tax, is enough to live on. Some investors believe they can keep acquiring property that is not positively geared but is cash flow positive after considering tax. This is where the depreciation claim reduces their taxable income so they are marginally better off after tax.

But each time you buy one of these properties you decrease your ability to service more debt since your taxable income has lowered. You can’t retire on a portfolio of these types of investment properties because you don’t have a nine-to-five once you’ve retired to claim the loss against.

Therefore, you can’t retire on a portfolio that is only cash flow positive after tax since you won’t have an income against which to claim the losses. Some rental growth or mortgage reduction is required first.

So at this point it seems that cash is king. However, you may also remember just how long it took you to save up for your first deposit. Saving for a deposit is a dog’s game. Imagine doing it again and again for each property you buy.

Cash flow only example

The benefits and disadvantages of a strategy become clearer if we take an extreme example. Let’s look at a case where there is excellent cash flow and no capital growth to see how we’d go.

Picture a $2m investment property portfolio that has a reasonable LVR of 80% and reasonable interest rates. Let’s also assume it is positively geared by 1% but has no capital growth. The positive gearing equates to an extra $20,000 added to the investor’s income each year. To get that 1% positive gearing with current interest rates, it will require a yield close to double that of the national average, and even higher when interest rates return to a more long-term average.

Now if the investor’s wage is $80,000 per year, then the extra income to go into a savings account or to pay down a mortgage is $20,000 each year. Although the marginal tax bracket for this extra money will be 37 cents in the dollar, we’ll assume a depreciation claim counters this so the full $20,000 is still available to pay down a mortgage with.

Keep in mind that depreciation is not a bonus, thanks to the ATO. Your investment property’s carpet is ageing. Let’s say it is brand new right now and needs to be replaced in 10 years. It may have cost you $4,000 to install now. And it may cost $5,000 to replace the carpet in the future. You can claim that $4,000 bit by bit over the next 10 years. But there is a bigger expense mounting for you to eventually pay in the future out of your own money.

A property worth $400,000 will require a deposit of $80,000 if the LVR for the loan is 80%. There is a compounding effect of reduced interest payments making it easier to save even more. But the next purchase also requires payment of stamp duty and legal fees. So it will take the investor about four years to save enough for a deposit, assuming no capital growth creates equity.

So, is growth king?

Without any capital growth to create equity to draw down on, it takes a long time to save up for the next property. Without equity to borrow against or savings, you can’t get in the game. There are some rare circumstances, however, like 105% LVR mortgages. These are far from commonplace though.

Lenders offering very high LVR products are looking for a borrower with extreme cash surplus, paying a large amount of tax. And the lender will probably examine the market closely in which the borrower intends to buy before giving the green light.

A 105% LVR allows an investor to pay for stamp duty and maybe even for lenders mortgage insurance as well. This means it is theoretically possible to buy an investment property without using any savings or equity so long as your cash flow is exceptional.

However, if for whatever reason the borrower is unable to pay interest, the lender is unlikely to get all their money back. Liquidating the property will usually attract the vultures looking for an easy meal. Unless there was significant capital growth before the borrower started defaulting and unless the property can be sold quickly, the lender will usually not get enough from the sale to pay out the mortgage plus lost interest, legal fees and the agent’s commission. You can see why very high LVR loans are quite rare. Apart from these rare cases, an investor is going to need equity or savings to get in the game.

Growth only example

Now let’s assume the case where we have all growth and no income to highlight the benefits and problems with a growth focused investment attitude. This might be an investment in land for example, with no buildings to rent out. A $2m portfolio that experiences 12% capital growth over the next year will create $240,000 in equity. That growth rate is about double the long term national average. Assuming the investor could service the extra debt with an 80% LVR, there is $192,000 in available equity that could be used to buy another investment property. This is enough to acquire two $400,000 properties.

But without cash flow the investor is paying a mortgage of 80% of $2m which at a long-term average 7% interest rate equates to $112,000 in interest payments per year. So this $240,000 gain is countered by a $112,000 loss to balance out at only a $128,000 gain. And this is assuming the investor has that much income against which they can claim such a monstrous loss.

What if you had that extra equity yet not enough cash flow to service the loan? You’re just as stuck as if you treat cash as king. And how does an investor retire on equity? Selling a property to release equity to live off is a pretty desperate measure. That cash may run out before you do. Nevertheless it is an option. Other options include reverse mortgages or annuities of some sort.

Using a straight asset lend mortgage or a no-doc loan, it is possible to draw on equity to fund the mortgage without having to sell a property. But this requires a very delicate balance between capital growth, prevailing lending policies and interest rates – all of which can be quite inconsistent. Positive cash flow is very important in retirement. It is a much safer option than living off equity which is a very tricky business.

Cash versus growth

It takes very high cash flow and several years of it to pay down a mortgage to have enough equity to buy again. But just one year of normal capital growth can achieve double the opportunity. But you need a lot of surplus income to service the ever increasing debt.

By now you’ve probably figured out that it makes sense to have both good cash flow and good growth. And you’ve probably realised that there may be times in an investor’s life when one aspect is more important than the other. There are many cash flow crazies that claim you can get both great yields and great growth. Is it possible?

High cash flow + high growth

Many one-trick-pony towns like mining towns are not the most desirable places to raise a family. But people in search of work, sometimes highly paid work, will venture there. They’re not in love with the place – they just need to be there for work. So they don’t make offers to buy. 

When there is an absence of buyers there is little pressure on property values to go up. When there are many renters vying for limited accommodation, rents go up. When rents go up but values are flat, yields go up. So often these towns have high yields.

Once yields get to a point to be attractive to cash flow needy investors, they wade into the market and pressure mounts on prices. Keep in mind that the growth in these kinds of markets is largely driven by the demand from renters outweighing the supply of rental accommodation which eventually causes prices to rise too.

In lower yielding markets it is not the renters but buyers forcing prices up. This eventually pushes rents higher too. The high yield environments push prices up whereas the high capital growth, low yield environments drag rents up. So, it is not unreasonable to expect to achieve both high yield and high capital growth in some markets across Australia. So why wouldn’t you pursue these locations? There are three likely rebuttals:

Some of these may be relevant to an investor’s circumstances.

High return = high risk

A high yield location where cash flow positive property can be owned even at an 80% LVR with normal interest rates is a market investors need to be cautious with. Quite often you’ll find only one industry or even only one enterprise operating in the region. Something happens to the fortunes of the town’s economy in such a way as to cause yields to rise significantly. This kind of poor economic diversity opens the investor to risk but offers excellent returns and growth.

I am not opposed to high risk locations so long as:

The way in which you mitigate risk is to know everything. Risk is ignorance. You counter it by knowing more than everyone else. For a mining town in particular, you need to know a lot:

If you know enough of these things, you may find investing in the company or the commodity directly much more profitable than investing in something as illiquid and indirectly related as real estate. When it comes to investing in these towns, you can’t say you prefer real estate to shares because it is a lower risk option. At this jagged edge of the market the risks are fairly even.

Best use of the dirt

You don’t need to invest in high risk, low diversity economies to have positive cash flow. You can improve a property via a renovation to increase the yield, for example. Of course, if you were to then borrow against the new value, you’d probably be in the same negatively geared position again.

Improving what is on the block of land can be a great way to rapidly increase the rent. Ideally, you want a skyscraper built on your block. But even a duplex or a granny flat is better than a single-storey three-bedroom house.

So you don’t need to look for special locations to achieve good cash fl ow; you can fi nd special properties in safer locations. However, this all comes down to spending a few dollars and converting the block to its best possible use. When you do this the rent and value go up. So long as you don’t borrow against this increased value, you may have a cash flow positive investment. But then there’s equity sitting their wasted. The lower LVR in this case is giving you the cash flow you need.

Keep your finger on the pulse

Once you’ve made the decision to invest in a high yield, poor diversity economy, you need to keep your finger on the pulse of that economy. If there is a slight shift in prospects, you need to make a confi dent and fast decision to either stick it out or cut and run. The research you started with needs to be maintained on a regular basis. Depending on the town, you may need to perform some thorough research every few months or even every month.

Subscribe to every local enterprise’s email newsletter. Set up Google to alert you of any news concerning that location or the major activities affecting it. Monitor the key statistics for any sudden shift. A very quick and yet comprehensive statistic is the DSR score (demand to supply ratio). This is freely available on boomapp.com.au and in the data section at the back of this magazine.

If the DSR score starts to drop suddenly or if it wanders into fi gures less than 20 (out of 48), this should trigger alarm bells to do some in-depth research, and quickly. Be careful starting any long renovation or development project in poor economic diversity towns. You don’t want to be caught with your pants down when bad news arrives about the economy. You need to know about bad news and get the property on the market and exchange contracts with the next sucker before they find out what you already know.

Balancing out abnormalities

Why would a tenant pay more in rent than they would pay if they were an owner? There are some legitimate answers to this question, such as not having a deposit saved. But you can see that in general it doesn’t really make much sense.

My point here is that a market in which it is cheaper to rent than own is an abnormal market, one that is out of balance. The forces of supply and demand will eventually balance out such markets. A market of positively geared property is a temporary market that is out of balance. It will rebalance.

If you’re looking for a positively geared property portfolio to retire on, you can’t rely on high yield locations as safe setand- forget investments. The only option for a long-term safe cash flow positive investment is to pursue capital growth which increases your rent and lowers your LVR.

Chasing high yielding locations is a strategy you should consider applying with a clear end in mind. It is not a truly long-term strategy. These market conditions don’t last forever.

There are some great city-based investment opportunities around the country for investors to capitalise on. With low interest rates, there is not so much need to go regional to try and find decent cash flow. So right now I would encourage the typical investor to play safe and invest in major cities as a general rule rather than regional markets.

Of course every investor has different circumstances. And there are diverse markets even within the same city. So I’ve provided in Table 1 some examples of markets which have better than average yields as well as good vacancy rates for investors who must treat cash flow as a top priority.

I have also chosen markets with sufficient stock available to more easily gauge typical rents and typical asking prices. This makes it easier to enter such markets. See Table 1 for my top 20 cash flow picks.

And for those interested in capital growth, I’ve provided a list of my top three picks for each state in Table 2. These differ from the top DSR scoring markets listed in the magazine’s data section and on boomapp.com.au because they involve some extra considerations like affordability, market cycle timing, neighbour price balancing, the unit to house value comparison, etc.

I’ve also excluded those markets in which there is too little stock available. This makes it difficult to enter the market. Finally, because the list was originally dominated by NSW, I have picked the top three in each state to provide some variety instead.

Weighing it up

One last point the capital growth nuts would want to have mentioned is that rents rise as property values rise. Both rent and property prices are determined by the forces of supply and demand. When demand outweighs supply, it usually pushes both rents and property values up.

So long as you don’t draw much from the increased equity that capital growth provides, then your property’s cash flow improves over time. And the greater the capital growth, the faster your cash flow improves. This is cash flow positive real estate via low LVR rather than via special locations.

I don’t believe that cash flow is always the best strategy, nor do I believe that capital growth is always the best option. There are phases in each investor’s life that suit different strategies. And there are also markets that defy the norms we usually associate with these two strategies. Every client that comes to me at Hotspotcentral.com.au is examined closely to find a market that best suits them for their current circumstances and goals. And any buyer’s agent who requests research services from me for their client will provide a unique brief for their client’s specific needs. Each investor is different and at a different stage in life. And it’s not just investors that are varied and dynamic – markets are unique and changing all the time too.

So for me, there is no one strategy that is better than the other. Everything needs to be treated on a case-by-case basis. Like with any business, there needs to be a balance struck between cash flow and growth. And given the dynamic nature of markets and our lives, we need to be flexible to consider different options and roll with the punches as they land.

My preference right now

My goal is to acquire a large portfolio, firstly to retire on and subsequently to pass on to my heirs when my days are over. It becomes very time-consuming keeping my finger on the pulse of every market in which I already own property as that number increases. I want to instead focus on the next acquisition. So these days, more and more, I prefer the ‘set and forget’ properties. In the past I have gone regional and chased high yields. But more recently I prefer allowing capital growth to lower the LVR to improve cash flow rather than choosing high yield, high risk markets. But that’s just me, and just me for just now.

Jeremy Sheppard is the creator of the DSR Score, which powers free research tool www.boomapp.com.au

This article was published in the June 2014 edition of Your Investment Property magazine. You can subscribe to the magazine here.