Hedland & Newman

Understanding investment options – the difference between negative, neutral and positive cash flow property

Before embarking on your property investment journey, it’s important to understand how different investment options deliver different capital growth and cash flow outcomes.

It’s not uncommon for investors to jump into an investment without considering whether the type of return it’s offering is the right one for their personal financial situation and wealth creation goals. I learnt this the hard way early in my investment journey and it took me years to get back on track!

According to ATO data, the majority of property investors investing in negatively geared property fall within the lower tax brackets. Given negative gearing is a tax minimisation strategy first and foremost, are these investors really on the right path?

What is negative cash flow property?

In a nutshell, negative cash flow property or ‘negative gearing’ is defined as when the interest and holding costs you are paying on your investment property are greater than the rental income you receive.

The appeal of negative gearing is that it allows you to deduct the losses you have made on the property from your annual personal income (under current tax legislation), thereby reducing your taxable income and the prescribed tax you’re required to pay on that income.

Frequently the subject of much debate, negative gearing was introduced to encourage investment in property with the idea that this would increase the supply of rental accommodation throughout the country. Whether it has been successful in doing so is debatable but the advantages of negative gearing from a tax minimisation perspective cannot be denied.

What many investors don’t fully understand though is that the tax savings rarely cover the cash flow losses, leaving you with less cash in your pocket each year. 

The underlying investment case for negative gearing is based on the premise that each year the property will have grown in value, which provides the return.  With a long term outlook, over time gradual rental increases will eventually see a negative property reach a stage of neutral and then positive gearing.  However, it’s important to remember that capital growth year on year is not guaranteed and your return is only fully realised when the property is sold.

Who benefits most from negative gearing? Investors who typically gain the most from negative gearing are high income earners – those in the higher tax brackets are those best placed to maximise the tax benefits. Further, higher earners can afford to have less cash in their pocket every year and are generally content with taking a long term approach to building assets through capital growth. Their long term goals may be to turn their negative properties positive for retirement cash flow, create a portfolio of family assets, or to liquidate and pocket the profit.

Who doesn’t? Lower income earners considering negative gearing should investigate the pros and cons carefully to determine what benefits negative gearing will really provide. After all, investing is about the return, and until you sell the property, the return is not realised. You will need to weigh up whether you’re better of having that extra cash in your pocket each year – rather than waiting for a capital return that may not bear the fruits you had hoped for.

What is neutral and positive cash flow property?

In contrast to negative cash flow property, neutral or positive property doesn’t leave you out of pocket.

A neutral cash flow property means the property is making neither a profit or a loss each year because the loss is balanced out by the rental income.  Hopefully the property is generating capital gains, and it will likely become a positive cash flow property if rents rise and/or interest rates fall.

A positive property is one that that generates you an annual profit because the rental income exceeds the property’s annual holding costs. Tax will be payable on the profit but can be miminised by maximising your eligible deductions such as depreciation.

Who benefits most from positive gearing?

Positively geared property can be advantageous for most investors. The extra income stream can replace or supplement your salary, allow you to retire early, improve your lifestyle etc. It can be particularly beneficial for those on lower incomes who are looking to replace their current salary, or that of their partner’s, so that they can give up work to focus on family or other interests. It’s also a good strategy for building a portfolio quickly – the profit from your positive property can be used to invest in another.

Finding property that is positively geared from day one can be challenging as it’s often limited to regional areas.

Many believe that by investing in positive property from the outset they are forgoing capital growth.  While it’s true that in many positive property markets, rental yields are high and capital growth is slow, this is not a definitive pattern. Plenty of investors achieve both by making well-researched and informed investment decisions and selecting strong performing positive locations around the country.

Can a negative property turn positive, and vice versa?

As touched on above, a property that was originally negatively geared can turn positive if it’s a long term investment. Over time, rents will rise, interest rates may drop or you may pay down some or all of the principal (thereby reducing or cutting your payments).

Eventually, the rental income will become equal to or greater than the costs of holding the property – turning it neutral or positive. This is often the long term strategy of negative gearers who see it as a retirement plan – an asset that will provide them with cash flow during retirement.

Unfortunately, the opposite is also true. A property that was originally positively geared can turn negative in the event of a rental market shift and/or interest rate rise. Both cases typically need to be quite extreme to put a property into the red – it’s more likely that your profit will decrease rather than disappear. This, of course, is not ideal either.

Investors – whether positively or negatively geared – are encouraged to plan for these situations to minimise the impact if they are faced with one.  With some simple preparation – i.e. ensuring you have emergency funds put away – you will be well positioned to ride out tough market conditions.

Should I invest in negative and positive property?

Portfolio diversification is very important for risk reduction. Many investors find that a balance of negative and positive properties gives them exposure to a range of markets and doesn’t leave them with a cash flow problem. Investing in well-located negative and high returning positive properties is an ideal overall strategy for achieving the best of both worlds – growth and passive income.

How do you build a portfolio you can retire on?

The ultimate goal for most property investors is to create a portfolio that will eventually provide them with enough cash to live off.

Indeed, residential property is becoming increasingly appealing as an asset class among SMSFs and among those who are waking up to the grim reality that their superannuation and pension are going to fall drastically short when they come to retirement age. For others among us, we simply want to live a life of financial freedom as quickly as possible!

I’m often asked by investors: “How many investment properties do I need to retire?”  That’s a question that can’t be easily answered. Rather than a question of properties, it’s a question of “how much positive cash flow should I be generating?” Or, “how much equity do I need?”

For example, you may have several properties in your portfolio but if they haven’t increased much in value and/or they aren’t putting profit in your pocket each week, then you’re no closer to retiring than you were when you started investing! In fact, you’re further away than ever as your portfolio is costing you money, rather than making you money.

Another investor, may have just two properties in their portfolio. However, they made some smart property selections and seen their portfolio and rental income significantly increase in value in a just a few years.

So, how much do you need to comfortably retire for, say, 20 years? My current basic method of calculation when working out how much we need is based on $100,000 per couple per year for 20 years. Which means we need $2 million to comfortably retire on a 20 year timeframe.

The second question I’m asked is “how do I achieve this through property investment?”. There are several strategies – each with their advantages and disadvantages. The one that will work best for you comes down, as always, to your personal risk comfort level.

Strategy 1: Positive cash flow

This strategy focuses on building a portfolio of cash flow positive properties until you are generating $100K per year in profit.

Pros: The 20 year timeframe doesn’t apply here, assuming cash flow is maintained. You have the option to continue to build your wealth using your income and equity, and you will have some excellent assets to pass onto your family. Importantly, this strategy won’t leave you out of pocket while you’re building your portfolio!

Cons: Maintaining your portfolio (as opposed to selling it off) means you will remain at risk of market fluctuations during your retirement phase. Unless you pay down at least some of your debt, you will also maintain high levels of debt. You also need to be willing to continue managing, at least to some degree, your portfolio of rental properties.

How to do it? Creating this level of positive cash flow is challenging but certainly not impossible. It is founded on solid research which will identify areas where there are positive cash flow properties and some capital growth. Locations are likely to be regional areas undergoing significant economic development, which do generally carry greater risk. Once invested, with your cash flow and sufficient market growth, you should be able to purchase again within 24 months. Repeat this formula until your annual cash profit from your rental income has reached $100,000. Make sure you have a sound risk management plan in place and you are regularly (every six months) reviewing your portfolio and the markets you’re active in so that you are well positioned to react quickly to any negative situations.

Strategy 2: Growth – and then liquidating

This is probably the lowest risk strategy. It focuses on capital growth alone – building a portfolio of growth properties until you’ve created at least $2 million equity. At which point, you sell them and live off the cash profit.

Pros: Low risk. You’re not at the mercy of the markets as you have liquidated your assets and transferred the cash profit to a savings account and/or other low risk investments.

Cons: Your cash won’t last forever. A strict timeframe will apply and you will need to budget carefully. You also won’t have any property assets to pass to family members.

How to do it? The main issue with this strategy is that you are negatively geared. You will be relying fully on capital growth for financial gain. Smart property selection is crucial so thorough research is required to ensure you’re buying property that is going to deliver sufficient capital growth. As with strategy 1, if you can locate areas that deliver in excess of 10% growth a year, then you should be in a position to add to your portfolio every 12 to 18 months. The number of properties you need to invest in before you find yourself with $2 million in net assets will vary greatly between investors and will depend entirely on market growth and whether you have been paying down any of the principal.

Strategy 3: Growth – and then paying down debt

This strategy is combination of 1 and 2. You build a portfolio of both cash flow and growth properties. Once you’ve created sufficient equity, you then use some of that equity to pay down debt, essentially turning your negatively geared properties into positively geared properties and creating/increasing your passive income.

Pros: This strategy allows you to create a passive income to live off while maintaining your growth assets.

Cons: You will still be at risk of market volatility and will need to manage, at least to some extent, your remaining rental properties.  You will also still have some debt.

How to do it? Focus on acquiring two or three high yielding properties first to provide cash flow security. Then, diversify into a couple of capital city properties to offer long term growth security. With this combined capital growth and positive income, look to reduce LVR across your portfolio to around 50% over a five to 10 year period. This will increase your cash flow, provide higher security and reduce risk during the retirement income phase.

Regardless of the strategy you choose, remember to seek the appropriate advice from your property investment strategist, financial advisor and accountant to ensure you’re making the right decision for your financial situation and goals. 

 

3 tips on how to maximise your ROI with current interest rates

With the RBA’s recent reduction of the cash rate to 2.5%, one of the lowest seen in modern times, the current marketplace presents property investors with a golden opportunity to both grow their portfolio and increase existing returns.

Here are three tips for every day property investors on how they can maximise the current interest rate climate.

Maximise your existing ROI
 
Take immediate advantage of the current low rate environment to reduce your payments on existing property.

Securing a lower rate will increase ROI on existing positive cash flow property and could also be the decisive factor that could turn your negative or neutral investments positive.

The easiest way to address this is to assess your options with your current lender. Negotiating a better rate with your existing loan provider is not only more convenient, but also means you avoid the various costs incurred with a new lender such as application, settlement and valuation fees.  Ideally your starting point should be with a finance broker who understands your strategy and desired investment goals.  Securing a well negotiated interest rate now has the potential to pay valuable dividends for years to come.

Select property based on market factors

The very basis of positive property investing and ROI achieved is based on the gross return of your property versus the net holding costs to service the investment.  Naturally, a lower interest rate environment offers ideal conditions for investors to maximise cashflow returns.

In many positive property locations around Australia, investment homes returning over 9% PA are putting tens of thousands of dollars in their owners pockets. – http://www.crawfordrealty.com.au/property-for-sale

Regardless of where you invest, it is still important to ensure you lock in the best rate possible.  Do your research and consider using a broker. 

An experienced broker will assess your financial situation, understand your investment goals and do the shopping for you by comparing the rates on offer from their panel of lenders – generally all major banks and lenders in the region.

This will ensure you put yourself in the best position possible to maximise your investment properties’ cash flow.

Time to buy

The current market is creating excellent investment conditions.

Lower interest rates are having a positive impact on affordability which is now better than it has been for a number of years. 
Low rates look likely to continue for some time and most economists are forecasting steady growth across national property markets in the coming years thanks to the actions of the RBA. 

Overall housing markets are showing a promise of better times and are offering good rates of return for the level of risk they are presenting.  In fact, they are presenting diminishing levels of risk for the investor as rentals increase and the potential for negative growth abates – John Edwards founder of Residex Pty Ltd.

Keep in mind low rates won’t last forever.

Investors should take action to maximise both their buying position and investment strategy to plan for the future before rates begin to rise again.