Capital growth vs cash flow: Which is the right strategy?

When it comes to property investment, there are two strategies that often divide investors: invest for capital growth or invest for positive cash flow. Michael Yardney explains which strategy works best for the current stage of the cycle.
After the heady growth in value over the past couple of years, we're now at the stage of the property cycle where capital growth is lower. As such more investors are asking if they should turn to cash flow positive properties. You now…properties where the rental income covers all of the property’s expenses (including interest) leaving money in your pocket each month. In general properties with higher capital growth have lower rental returns. As such, you're unlikely to find a cash flow positive properties in the higher growth, better locations of our capital cities. You must look to regional areas or mining towns where buyers require a higher rental yield (cash flow) to make up for the lack of capital growth. If you're putting more money in the deal by way of higher deposit, then you may also get positive cash flow. But the problem is you're also missing out on the benefit of leverage.

Capital growth vs cash flow: which is better?

There’s no simple answer. Clearly, if both strategies exist there is a place for both.   I see more beginning investors go for cash flow positive properties. On the other hand, I tend to see more successful investors, those who have built a substantial asset base, grow their portfolio through leveraging off the capital growth of their investments. Obviously, property investment should be part of a wealth creation strategy, not just a purchase in isolation. So if you are considering property investment to build an asset base to one day replace the salary from your day job, then I would invest for capital growth every time. The few dollars a week your positive cash flow properties might bring in immediately is not really going to make much difference to your lifestyle or your ability to acquire and service other, more desirable properties for your portfolio. The problem is that you can’t save your way to wealth – especially on the measly after tax positive cash flow you can get in today’s property market. And when interest rates increase – as they will again some day – a property that is cash flow positive today may be cash flow negative tomorrow. And when interest rates increase – as they will again someday – a property that is cash flow positive today may well be cash flow negative tomorrow. Think about it…real wealth is not derived from income. It is achieved through long-term capital appreciation and the ability to refinance to buy further properties. If you seek a short term fix with cash flow positive properties, you’ll struggle to grow a future “Cash Machine” from your property investments. It’s as simple as that.

You can have it both ways

You can’t turn a cash flow positive property into a high growth property, because of its geographical location. But you can achieve both high returns (cash flow) and capital growth by renovating or developing high growth properties. This will bring you a higher rent and extra depreciation allowances, which convert high-growth, relatively low cash flow properties into high growth, strong cash flow properties. This means you can get the best of both worlds.

So how do you deal with negative cash flow?

Investing in negatively geared, high growth property means you have to cover the cash flow shortfall each month. One way of doing this is to set up the correct loan structure. A line of credit could be used to supplement the rental to pay the interest on the investment loan and property expenses.  This buys an investor time. The line of credit is often set up to cover the shortfall for 3 or more years until the property’s value grows sufficiently to refinance the loan out of the extra equity. To use this investment strategy, correct asset selection is critical because to make it worthwhile you need the property’s value to increase significantly more than your outstanding loan balance increases. This means you need to be investing in high-quality assets so that you can maximise the chances of enjoying strong capital growth.

Beware of the risks…

No strategy is without risk. There are four main risks you need to be aware of when considering this strategy:
  1. Poor capital growth – that’s why correct asset selection is so important.
  2. Interest rate increases – which can be addressed by fixing interest rates on some or all of your debt.
  3. Poor rental growth – which highlights the importance of owning properties that will be in continuous strong demand by a wide demographic of tenants.
  4. Lack of financial discipline – never use your financial buffers for uses other than covering your property related expenses.

The Bottom Line.

I can understand why beginning investors would be keen to buy a property with positive cash flow. They tend to be cheaper so it is easier to purchase and support this type of property. While they may give you short-term income, these properties will never allow you to accumulate the equity necessary to become truly wealthy. And while the rent may seem relatively high initially, it’s the ongoing capital growth of your property that will underpin its long-term rental income, which means that if you buy in low capital growth areas, your rents won’t rise over the years as much as rents in high growth areas. This means the value of capital gains over the long term will blow comparable cashflow returns out of the water. Remember as a property investor your focus should be on safely building your asset base so you can eventually develop the passive income from your assets that will allow you to enjoy the financial freedom you desire. Michael Yardney is a director of Metropole Property Strategists, which creates wealth for its clients through independent, unbiased property advice and advocacy. He is a best-selling author, one of Australia’s leading experts in wealth creation through property and writes the Property Update blog.

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