What’s the right investment strategy for this stage of the property cycle?
Thursday, August 8, 2013/
Great news for those interested in property investment and another blow for the property bears (yes, they’re still out there waiting for the sky to fall) – capital city dwelling values rose a further 1.6% in July, according to RPData.
However, despite the fact that residential home values have made a cumulative recovery of 6.5% since the market bottomed out in May last year, this property cycle is likely to be different to the past – one where capital growth is likely to be lower.
Interestingly, most commentators agree that we are unlikely to see the type of housing boom that sparked a massive rise in personal wealth last decade.
This has many investors asking: what’s the right investment strategy this time round?
Firstly, it’s important to understand property investors make their money in four ways:
1. Capital growth – the increase in value of their properties
2. Rental returns – which provide cashflow
3. Tax benefits – such as depreciation allowances and negative gearing
4. Forced appreciation – this is where an investor ‘manufactures’ capital growth through renovations or development.
Of course, strategic investors benefit from a combination of all of these.
Despite the lower predictions for this property cycle, you can still get capital growth.
RPData recently reported the following capital growth for our capital cities over the last 12 months:
- Perth 8.3%
- Sydney 6.5%
- Melbourne 4.3%
- Hobart 2%
- Canberra 1.4%
- Adelaide 1.1%
- Brisbane 0.8%
- Darwin -0.9%
But these figures don’t tell the full story.
In all states our property markets are very fragmented and there are some pockets that have significantly outperformed and many have underperformed the averages.
If you dig deeper you’ll find that in most states there is a group of suburbs that exhibited double digit capital growth last year. Within those areas there will be some properties that grow strongly in value while others perform poorly.
Where have the properties that outperform the average been?
In many cases these were areas going through gentrification; suburbs where a new demographic was moving in spending large amounts of money on renovating or extending their homes.
You’ll also find stronger capital growth in suburbs where growth in wages outpaces the average, meaning the locals can afford to pay more for their properties.
A positive cashflow property is where the rental income received 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.
This means you can’t find cashflow positive properties in the higher growth locations of our capital cities.
You must look to regional areas or mining towns where buyers require a higher rental yield (cashflow) to make up for the lack of capital growth.
Buyers with lower loan-to-value ratios, such as those who put more money in the deal, may also experience positive gearing.
The problem is that they miss out on the benefit of leverage.
Which strategy is better – capital growth or positive cashflow?
There’s no simple answer. Clearly if both strategies exist there is a place for both of them.
I see more beginner investor going for cashflow 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 cashflow 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.
Interesting, best-selling author Steve McKnight, renowned for writing a book on how he built a very substantial portfolio of positive cashflow properties, explains in his latest book, From 0 to Financial Freedom: How to Do it Today, that the strategy of buying cheap cashflow positive properties no longer works today.
The problem is that you can’t save your way to wealth – especially on the measly after tax positive cashflow you can get in today’s property market.
And when interest rates increase – as they will again some day – a property that is cashflow positive today may be cashflow 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 cashflow positive properties, you’ll struggle to grow a future cash machine from your property investments.
But here’s the trick, you can’t turn a cashflow positive property into a high growth property because of its geographical location.
But you can achieve both high returns (cashflow) 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 cashflow properties into high growth, strong cashflow properties.
This means you can get the best of both worlds.
Of course 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 or offset account could be used to supplement the rental and 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 three 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.
This strategy is not without risks and the four main ones are:
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 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.
I can understand why beginner investors would be keen to buy a property with positive cashflow. 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 is the ongoing capital growth of your property that will underpin its long-term rental income. This means that if you buy in low capital growth areas, your rents won’t rise as much as rents in high growth areas.
And over the long term the value of capital gains other investors will enjoy 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.