How to manage your cash flow when negatively geared

Investing in negatively geared properties require you to be more diligent in managing your cash flow to ensure you cover the shortfall. Jeremy Sheppard shows you how

Recently, I wrote an article outlining some of the topics a property investor needs to consider when weighing up the benefits of pursuing pure cash-flow positive property against pursuing pure capital-growth property. It usually comes down to an investor's financial circumstances.

You can read this article in the June 2014 edition of Your Investment Property magazine. 

For those of you who are in the fortunate position of being able to afford the negatively-geared option, there are some gotchas! You will have to manage your portfolio a little more closely with respect to cash flow. Hopefully this article is of some help.

Managing uncertainties

The best approach to managing a negatively-geared portfolio is to know beforehand what you are getting into. There are some issues that can’t be  before you buy, you need to get a few things right.

1. Serviceability

A mortgage broker or lender will examine your finances to ensure you can afford a loan of a certain size. But they can never see the full picture as accurately as you can. You're responsible for ensuring there is a healthy safety margin. Accept their caution, don't push against it.

If you're already working a part-time job on weekends, this is no longer something you can take up in times of trouble. The lender won't know if your income earning capacity is already at full tilt or if you're just coasting. Be conservative

2 Future employment

Unless you don't mind living in a cardboard box under the freeway bridge, you can't have a negatively-geared portfolio and no job. If you lose your job, everything changes.

You need a good idea about your future job security. 

3 Estimate everything

I create a spreadsheet for every property I'm looking to buy. I include everything I can possibly think of:

• Deposit
• Mortgage insurance (if applicable)
• Legal fees
• Rent
• Vacancy
• Mortgage interest (and principle if applicable)
• Property management fees
• Insurance
• Strata (if applicable)
• Rates
• Repairs and maintenance
• Land tax
• Depreciation
• My marginal tax bracket

The idea of 'spreadsheeting' everything is two-fold:

1. To estimate cash-flow loss each week
2. To estimate return on investment (ROI) - including capital growth

4 Choose the right loan structure

Most people view the question of fixed versus variable interest rates as a play on their bottom line. That is, they’re trying to maximise return by picking the most efficient option. I think it’s wiser to view it as a play against risk. In other words, don’t choose one or the other based on saving interest payments. Instead, choose one or the other based on your risk circumstances.

Keep your eye on long-term fixed rates. If you see them rising, jump in and fix rates. If you see them rising, jump and fix before they go beyond what you can afford.

5 Get the right investment advice

Be sure to find a good accountant,one who is familiar with property investors and preferably has their own investment properties, too. And get a professional depreciation schedule.

Investing is all about risk and reward. A bog standard buy-and-hold investment will give you about a 20% return on your investment when considering average capital growth, normal interest rates and a 20% loan-to-value ratio. But the return on investment you get from some good advice will make that 20% look ordinary.

Imagine paying $700 for a depreciation schedule and in the first year alone, there's an extra $1,400 tax saving that you would never have claimed otherwise. That’s a 100% return on your investment!

What about advice from your accountant? It may cost you a thousand dollars but could save or earn you double that.

The same is true for all the services property investors employ, from research analysts and wholesale developers to solicitors and pest inspectors. In the right circumstance, the right advice will give you bigger ROIs than you’re ever likely to get from your property portfolio directly.

6 Realise that depreciation is not a freebie

Depreciation is a tax claim you can make before the expense is actually incurred. But sooner or later that expense will come around. You will eventually need to replace carpet, for example. You can’t just make the claim and then not plan for the future.

While you’re waiting for that big expense to come around, stash spare cash in the mortgage with the highest rate of interest. Ensure there is a redraw facility on that loan, however, so you can actually draw down that money when you need it.

7 Document everything

Once you’ve bought a property, you will receive invoices, rental statements, rates notices, insurance premium renewals, mortgage statements, etc. Keeping track of this is essential to see if your original cash flow estimate prior to purchase was correct.

I scan to PDF every piece of paper documentation I receive about a property. I store it all in a folder on disc for that property and financial year. I can then load it to the ‘Cloud’ for my bookkeeper to pick up and perform the data entry.

It’s not a bad idea to be your own bookkeeper to begin with to gain a good feel for what is going on in your portfolio on a week-to-week basis.

8 Maintain good property management

Ensure your property manager contacts you three months prior to a lease expiring. Review the market in terms of vacancies and rent. Review the property’s condition, too.

Make sure that, if the market will support it, you increase the rent at each opportunity. Similarly, if the market has dropped for whatever reason, you need to secure your tenant for another term as soon as possible. 

Keep your property in a good state when you can afford to. Don’t let problems fester – they can often lead to even bigger problems. You don’t want a property manager telling you the property can’t be re-let in its current state or the rent needs to drop to reflect the poorer state of the property. 

Let your property manager know that your finances are tight and thetenant must keep up to date with rent payments. If they don’t, you’ll have to evict them as quickly as possible and get someone else in.

You can also say that your insurer won’t pay a claim for lost rent if you offer any leniency to the tenant. If this is passed on to the tenant, it should keep the rent coming in regularly.

Reward faithful tenants. Get any problems rectified ASAP.

Make sure your property manager is keeping as close an eye on your property as you are

9 Shop around for the best mortgage

Making changes to the way in which you rent out your property could lead to significant savings. Make sure you have the best mortgage option. You may be paying too much interest if you haven’t been watching the mortgage market for a while.

But don’t let interest rates be the sole reason for a change. Speak with an experienced mortgage broker who understands your current circumstances and future goals, one familiar with property investors.

You can also shop around for a better insurance policy. But be careful not to under-insure.

10 Use your credit card carefully

Although you should have a cash-flow buffer in a redraw account, you might also like to have a credit card with an interest-free period. Rather than take money out of the mortgage and pay more interest, make the most of the interest-free period on the card.

Only use your credit card if you're sure you can pay back the full amount owing before the end of the interest-free period.

11 Give up unnecessary living expenses

If things get a little tough, what could you go without? Have a list of luxury items and a weekly value for each in terms of savings if you gave them up. If there is not much on the list, then you're either too inflexible or your cash flow is too tight already.

You might like to follow a more frugal lifestyle for the first month after purchase to build up an even bigger emergency buffer. Don't live like that all the time though - property investing is a long journey.

Know what you can cut out to live on the cheap for a while and how much it will save you

12 Take a rational approach when things start turning pear shaped

If it starts getting ugly, you know whether to sell or whether to tough it out. Don't just choose one option instinctively based on fear or over-confidence. Examine the market and your finances. Examine options in a business-like, unemotional manner.

If for whatever reason you're not making ends meet, either by poor miscalculation or something not going as planed, you need to cut your losses. Forecast when you'll run out of money. You need to allow yourself enough time to gracefully get rid of the worst cash-flow asset rather than having a distressed sale.

Examine the market your property is in. Look at the number of days properties typically spend on market before selling. You can see this data at the back of the August issue of Your Investment Property. It's also available on Boomapp.com.au. If the 'days on market' starts to lengthen, your cash flow buffer has to as well.

13 Draw on equity

You can borrow more money to pay your expenses. But this will only work if those expenses are one-off hurdles followed by a nice downhill stretch thereafter. You can't employ this technique for very long. You'll find your interest expense accelerates amazingly quickly.

Last words

I deliberately took the conservative approach with this article. But there is a valid reason for it. You can't want to be in a position where you have to sell your asset.

Distressed sales go cheaply and there are exit costs too that make the exercise very inefficient. There are also costs incurred when entering the market that need to be absorbed by having ownership for a long time. So the first option is usually to hold.

But life can get pretty depressing if you feel that all you're doing is feeding banks. Good planning, conservative estimates and a healthy margin for error will save you from this. And, of course, a positively-geared investment would help, too. 

Jeremy Sheppard is an active property investor, research analyst for Hotspotcentral.com.au, and creator of the DSRscore.com.au

This feature is from the August 2014 edition of Your Investment Property magazine. To read more, please click on the link to purchase the issue.