One of the most common questions I get asked is 'should I be focusing on capital growth or cash flow?'. This is such a broad question with pros and cons to both strategies, so let's dive deeper into this.
Ultimately I believe that capital growth is what creates true wealth in the long-term, however you must be able to sustain good cash flow in order to be able to service these investments. Naturally, high capital growth properties will have lower rental yields (negatively geared) so unless you're a high-income earner, we need to look at other strategies that will help you sustain this strategy.
Many first-time investors get stuck on their first investment property and can never move past this. This is due to the fact that they're contributing so much money out of their own pocket each month to cover repayments and related expenses, that they've now maxed out their borrowing power with the lenders. So how do we overcome this?
Building a successful property portfolio requires a lot of thought and a clear strategy to be put in-place. We need to consider many factors about the individual such as their income, age, goals, borrowing capacity, ongoing serviceability with the lenders, lifestyle and so on.
So let's take a look at the pros and cons of the capital growth strategy.
These investments are usually found in your high performing capital cities such as Sydney and Melbourne, where you'll need to have a considerably high borrowing capacity. Depending on the location and property type, we would usually be aiming for annual growth rates of approx. 7% - 10%.
If we look at a property purchased for $1M, over 10 years this would result in $967,000 - $1,593,000 equity gain. This is just from one property, so you can clearly see how this quickly adds up to create your wealth.
The downside to this strategy is cash flow. The average gross rental yield will usually range from 2.5% - 3.5%, which isn't enough to cover all related expenses. Let's look at the below scenario for a $1M purchase focusing on capital growth:
Purchase price: $1,000,000
Loan amount: $800,000 (deducting the 20% deposit)
Loan structure: Principal & interest at 3.50% (30 years term)
Monthly repayments: $3,593
Rental income: $2,513 (3.0% gross rental yield)
The above scenario shows that you'll need to contribute just over $1,000 a month out of your own pocket to cover the loan repayments on this investment property. Then consider other expenses such as property management fees, council rates, water rates and insurances which will add around $400 per month on top of this. You're now looking at $1,400 per month ($323 per week) out of your own pocket. And this doesn't even take into account any maintenance costs or vacancy days.
Can you afford this? You might be OK to service one of these properties but what about two or three of these? It's now easy to see why so many inexperienced investors get stuck here.
So let's take a look at the pros and cons of the cash flow strategy.
These investments are usually found in your sub-regional and regional locations, which will allow you to invest with a very small deposit (sometimes as little as $30,000). Depending on the location and property type, the gross rental yield will usually range from 5% - 8% providing really good returns.
The downside to this strategy is capital growth. The average annual growth rate will usually range from 2% - 5% in these markets.
If we look at a property purchased for $300,000, over 10 years this would result in $66,000 - $189,000 equity gain. If we multiply this x 3.4 (spending a total of $1M similar to the above capital growth scenario), then this will result in a total equity gain of $224,000 - $642,000 over 10 years. This means that you'll be generating approx. $743,000 - $951,000 less equity in 10 years than the capital growth strategy.
Let's look at the below scenario for a $300k purchase focusing on cash flow:
Purchase price: $300,000
Loan amount: $240,000 (deducted the 20% deposit)
Loan structure: Principal & interest at 3.50% (30 years term)
Monthly repayments: $1,078
Rental income: $1,646 (6.5% gross rental yield)
The above scenario shows that you'll be generating over $560 monthly cash flow after your loan repayments on this investment property. Then consider other expenses such as property management fees, council rates, water rates and insurances which will add around $300 per month on top of this. You're still looking at a surplus of $260 per month ($60 per week) cash flow.
You can now see how the cash flow investment property will actually be putting money back in your pocket. This will help you service more loans moving forward and allow you to build up your property portfolio.
So which strategy is actually better?
As mentioned at the beginning of this blog, I believe that capital growth will ultimately create your wealth however you need to focus on cash flow properties if you're not a high income earner, to be able to sustain any negative cash flow from a property.
You should have a detailed discussion with your buyer's agent to determine the best strategy moving forward. I then recommend sitting down with your mortgage broker to get a clear understanding of your borrowing position. Ask them if you were to purchase a capital growth investment with the above numbers, whether you would have any borrowing capacity left for your next purchase. If you're in a strong position, then you could consider a high capital growth asset.
I believe in order to build a successful property portfolio, you'll need to have a good mix of capital growth and cash flow properties. With some clients, I start with positive cash flow properties until they've built up enough surplus to service a high capital growth asset. And with other clients, we do the complete opposite. Every individual's circumstances are different and I always say that property investing isn't a 'one size fits all' scenario. A unique strategy needs to be formulated for each individual investor.
I hope all of this info is helpful and please don't hesitate to get in touch if you have any questions.
Disclosure: The information contained in this blog is my personal opinion only and is not to be taken as financial advice. Please speak with your accountant for advice based on your personal circumstances.
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