Cash flow vs capital growth: Which is best?

Before you decide on your preferred option, you need to know about the fundamentals that underpin cash flow and growth property investments.

A cash flow strategy is a simple and tempting philosophy to follow. It involves investing in properties with high rental yield potential and a rental income that is greater than the total expenses of holding the asset. 

“Cash flow properties have a higher rental yield, so all of the expenses for the property, such as maintenance, mortgage interest and property management fees, are covered by the rental income received,” explains Derek Barlow, property director at CrowdfundUP, Australia's first property crowdfunding platform.

“Any additional income over and above these total costs can be utilised to pay down the loan on the property and increase equity. On the downside, though, the overall return upon sale of the property is generally lower.”

High income, low growth: Cash flow investments

Most cash flow investors are willing to accept lower growth rates, as they view the benefit of the investment as being its ability to generate an income.

For instance, if your goal is eventually to retire and live off your property income, then positive cash flow properties may be your focus. You can acquire investment properties that deliver a strong return, and once you reach your desired passive cash flow – whether it’s $500 or $5,000 per week – you can choose whether or not to keep working, and live off your property income.

This is the strategy advocated by property investment educator, mentor and buyer's agent Kevin Lee from Smart Property Adviser.

“My philosophy is: you can have an income in retirement from an unencumbered property portfolio if you start at least 20 years before retirement. When we’re old and retired, we live off income – but we can’t live off capital growth,” he explains. 

“Cash flow is also what helps you to build your portfolio. If you apply for a loan to buy a property, the first question the lender asks is: can you pay back the loan? Wherever your income is coming from, it all gets taken into account, and if you don’t have sufficient income in the servicing calculators, then you don’t get to question two or three.”

Serviceability is one of many reasons why Lee believes positive cash flow properties are the ideal investment choice, and capital growth investments are too risky for everyday Australians to consider.  

“I know a guy who bought a property in Peppers Resort in Airlie Beach, off the plan, for $700,000 a few years ago. It’s currently for sale for $350,000. There’s a stack of these stories on the Gold Coast, the Sunshine Coast, Airlie Beach, Perth – anywhere outside of the capital cities,” he says.

“When you invest for capital growth you are speculating and you’re forgetting that your number one job is to maintain mortgage debt reduction via a tenant’s income. If you have a tenant who pays their rent on time and looks after the property, and you actively pay down the mortgage with your cash flow, you can multiply that strategy and build a portfolio.”

Flip side of the coin: Capital growth investments

While there are plenty of advocates for a positive cash flow strategy, there are just as many experts who believe a capital growth strategy is the ideal method for profiting from property.

Cam McLellan, director of Open Corp, is one such expert. He believes that real wealth comes from doubling your asset holdings every seven to

10 years. 

“The properties needed to build a cash flow portfolio are usually regional or on the outskirts of major cities, and you’re lucky if regional properties double in value every 15 years,” he explains.

“If you invest $400,000 in a cash flow property portfolio and assume that it doubles every 15 years, your initial investment should double twice in value in 30 years up to $1.6m. While this may seem a lot in today’s money, it won’t buy much in 30 years. 

“If, on the other hand, you invest $400,000 in a growth property portfolio and assume it doubles every seven to 10 years, your initial investment should double three to four times in 30 years. If it doubles every 10 years, it’ll reach $3.2m. If it doubles every seven years, it’ll hit around $6.4m!”

McLellan firmly believes that growth assets offer the only genuine path to creating wealth when investing in real estate, as “you never achieve real wealth by trying to supplement your income”. 

“I don’t buy into the argument of which strategy is better; growth is the only way to build wealth,” he says. 

“But I also don’t want my properties to cost anything to hold, so the properties I select are growth-focused but have strong demand for rental. They are therefore cash flow positive a few years following purchase, as rents rise.”

The Holy Grail

Perhaps this is ‘the Holy Grail’ then: a strategy that seeks to enjoy the best of both worlds by securing both growth and positive returns in the long term.

This is the philosophy that buyer’s agent Peter Sarmas, director of Street Advocate, promotes.

“If you’re a professional investor, you can’t sustain your success without doing both,” he says. 

“If you chase growth only, you’ll run out of serviceability, because you’ll get to a point where the bank says, ‘I’m not going to lend you any more money because the cash flow isn’t there’. But you also need growth properties to build your long-term equity.”

Andrew Courtney, director and financial adviser at Alps Network, agrees that those who have the most long-term success in creating wealth “typically go for both cash flow positive properties, with a capital growth component attached to it”. 

“Investors who manage to find the sweet spot – where the property can have value added to it and therefore increases their yield, while also increasing the overall saleability of their property – will be in a much better position than one-trick-pony investors who are fixated on one strategy only,” Courtney says. 

“Investors need to be aware that although there are two camps in property investing, you don't need to belong to either one of them. Why not get the best of both worlds and build your portfolio systematically and sustainably?”

Is either strategy more successful than the other?

So far, we’ve heard from experts who strongly advocate for and against both strategies. 

It’s little wonder that Australian investors are therefore often confused about how to move forward with their own investing goals. Creating wealth through real estate can be a confusing situation to navigate, and ultimately, there is no definitive right or wrong answer, as the right investment for you will depend on your situation – and may likely change as your lifestyle evolves.

For instance, while you’re young and relatively unencumbered, a growth strategy may be ideal, if you have the income and lower responsibilities to support it.

But when you’re in your thirties, forties and fifties and have more responsibilities and lifestyle expenses, positive cash flow investments may be the better fit.

The most important part of the equation is to have clear intentions about what you want to achieve, by devising an investment strategy to guide you forward.

The tips and advice outlined on the following pages aim to help you do just that, so you can work out which type of property to invest in next. 

But if you’re not sure which direction to take, don’t gamble with your financial future. Reach out to an expert for professional guidance, suggests Sonali Rodrigo, financial planner at Tomorrow Financial Solutions.

“Talking to your friends at a BBQ and deciding you want to do what they’ve done probably won’t work, as there’s never a ‘one size fits all’ solution,” Rodrigo says.

“It’s always good to really make sure that what you’re doing fits your profile financially, and your risk profile. How tolerant are you towards taking risks and how upset would you be if your investment didn’t pan out in the short term? These are the types of things you need to consider, while really looking at your options from a holistic point of view.”

Capital growth vs cash flow – at a glance

Steve Jovcevski, property expert at financial comparison site Mozo.com.au, explains some

of the pros and cons of both cash flow and capital growth investment strategies

Cash flow strategy

Pros

- Using a cash flow strategy means investors are getting a weekly income and realising the value of their investment over the short term.

- Investors have more cash in their pocket to cover regular property expenses and unforeseen property expenses.

Cons

- In a residential property scenario where a property has a high rental yield and cash flow, it generally has very negligible or no capital growth.

- Since investors are earning a positive income, they can’t take advantage of a negative gearing tax benefit and instead have to pay tax on their rental profits.

Capital growth strategy

Pros

- Increased value of the property over the long term more than outweighs the cash flow benefits in the short term.

- Investors are more likely to make a loss with a capital growth strategy and can take advantage of a negative gearing tax benefit.

- LVRs are generally more generous, because banks are typically more comfortable lending for properties in desirable growth areas, often big cities.

Cons

- Cash flow is negative, meaning investors with a capital growth strategy need to dip into their own pockets to cover property-related expenses, such as mortgage repayments and council rates.

Cash flow and capital growth investments in action

Smart property investing decisions can set you up for a strong financial future. But with so many strategies and statistics to navigate, “real estate can get pretty confusing”, says Andrew Stone, director of Property Analytics and Buyer Advocacy.

To help give investors a ‘bigger picture’ view of how a cash flow and capital growth investment may perform over a 10-year period, Stone has crunched the numbers on some of the key metrics and relationships that define the real estate market, including median price and rental yield.

The relationship between growth and yield

This first graph places more than 4,800 suburbs across Australia into 10 equal-sized groups, according to indicative gross rental yield or the total rent over 12 months divided by the purchase price.

The suburbs on the far left of the graph generate a low yield of less than 3.1%; the middle-range suburbs return 4.2% to 4.5% and 4.5% to 4.7%; and suburbs with the best yields, on the far right, return more than 5.9%,” Stone explains.

“As the graph shows, the high rental yield properties generally cost less but also tend to grow less in value over time. The inverse is also true – to achieve strong value growth you generally need to spend more money on the purchase price and accept a lower rental yield.”

To illustrate the main difference between investing for positive cash flow and investing for capital growth, Stone has analysed the historical performance of two Australians suburbs: a typical Brisbane City unit and a house in the Melbourne suburb of Heidelberg West.

He has used these figures to project future performance for these two locations.

Positive cash flow investment: Brisbane City apartment

“Purchasing this type of property right now would cost you about $500,000. Assuming 80% debt finance at the same rates, and consistent rental yields over the course of 10 years, the property would grow in value by around $206,000,” Stone says.

Negatively geared growth investment: Heidelberg West house

“A negative cash flow investment in Heidelberg West would likely generate nearly twice the amount of increased equity – approximately $383,000 compared to $206,000 – of a cash flow property. These are rough figures, based on some broad generalisations, but the lesson is pretty clear: negative cash flow property investments can deliver greater long-term wealth,” Stone explains.

“In summary, positive cash flow investments can deliver strong passive income streams, but over the long term, investing for capital growth is a better way to accumulate wealth.”

Head to head: The experts weigh in

Cash flow fans

“We encourage our clients to invest for cash flow, not for capital growth or negative gearing. If you’re chasing capital growth, you’re effectively speculating. It’s an urban myth that property doubles in value in seven to 10 years; even in boom times this is not true.” 

– Kevin Lee, property investment educator, mentor and buyer's agent, Smart Property Adviser

“Cash flow is essential to ensure that your long-term plans are achieved. If you cannot fund your property expenses and meet the interest payments on any borrowings in the short term, it won’t matter how good the potential long-term growth is – you could have to sell in the short term. Basically, you need to look at the short term to safeguard future planning strategies.”

– Geoffrey Boyd, author of Understanding Cash Flows for Investment Properties

“The most important consideration for investors is your end goal. What do you want to achieve, and when? Cash flow can produce an immediate improvement in lifestyle and a financial safety net from day one, whereas seeking capital growth may mean you need to fund your assets for a period of time before enjoying the fruits of your labour.” 

– Steven Ryan, mortgage broker, Interstellar Finance

Capital growth fans

“A growth strategy is the only way to go, as a cash flow strategy has problems. Thirty years ago, a cash flow strategy worked, but now the initial capital required for deposits and costs is too large for most Australians, making a cash flow strategy near impossible. Steve McKnight was the godfather of cash flow strategy back in the day, but he sold his entire portfolio, and openly says a cash flow strategy does not work in Australia.” 

– Cam McLellan, director of Open Corp

“Focusing solely on cash flow as a strategy might fool you into thinking you are wealthy or comfortable, as you have assets sitting there that seem not to cost you anything. Yet you must understand that cash that is idle is really losing value – around 2% or 3% each year, or more during periods of high inflation. You must buy where the growth is, never solely for cash flow.”  

– Louise Lucas, CEO of the Property Education Company

Split down the middle

“You can’t build a portfolio without both types of investments ... There are lots of investors out there with a ton of equity, but they don’t have the serviceability – then you have investors with a lot of cash flow, but they don’t have the equity for the deposit. You have to respond to market conditions, and that requires a combination of both cash flow and growth properties.” 

– Todd Hunter, wHeregroup founder and director

“It is important to consider both cash flow and high capital growth properties, as it takes both sorts of properties to grow a substantial portfolio. If you buy all cash flow properties, you’ll soon run out of equity from growth to continue building your investment portfolio. In reverse, if you are just chasing capital growth properties, you will soon run out of cash flow to keep building your portfolio and pay for your negatively geared properties. Successfully investing in property is simple and it works; you don’t need to reinvent the wheel; you just need to do it right.”

– Sarah Rogers, principal financial advisor, Profolio

“If your intention is to purchase one property in isolation, it doesn’t really matter which strategy you adopt. However, to create meaningful wealth that can support you in retirement, you’ll need to accumulate a portfolio of properties. In the majority of cases, diversifying and having a mix of both types of properties will help you achieve sustainable wealth over the longer term.” 

– Pramu Rodrigo, managing director, Tomorrow Financial Solutions