What’s the right investment strategy for this stage of the property cycle?

When it comes to property investment you’ll often hear two conflicting philosophies: invest for capital growth or invest for positive cash flow.

Now that we’re at the stage of the property cycle where capital growth will be lower for some years, more investors are asking if they should turn to cash flow positive properties—properties where the rental income covers all of the property’s expenses (including interest), leaving money in their pocket each month.

So which strategy is better?

There’s no simple answer.

Clearly if both strategies exist there is a place for both.  

I see more beginning investors invest in 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.

Of course I understand why new investors would be keen to buy a property with positive cash flow. They tend to be cheaper, so it’s easier to purchase and support this type of property.

While these properties may give you short-term income, the problem is they will never allow you to accumulate the equity necessary to become truly wealthy.

And while the rent earned by the property may seem relatively high initially, it’s 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 increase that much over the years.

Sure, cash flow is important, but the few dollars a week of positive cash flow you might receive is not really going to make much difference to your lifestyle, and the lack of capital growth will hamper your ability to get the deposit for your next property.

And when interest rates increase—as they will someday—a property that is cash flow positive today may be cash flow negative tomorrow.

In my mind, an investor’s focus should be on building their asset base so they can eventually develop passive income from their assets, giving them financial freedom.

What’s the importance of the land-to-asset ratio?

Since properties with higher capital growth have lower rental returns, you won’t find cash flow positive properties in the higher growth, better locations of our capital cities.

You must look to regional areas where buyers require a higher rental yield (cash flow) to make up for the lack of capital growth.

However, one of the main reasons properties increase in value is the scarcity value of the land they sit on, meaning you should buy properties with a high land-to-asset ratio (the land component should make up a substantial portion of the value of the property).

If you think about it, when you buy a cash flow-type property in regional areas where prices are lower, the land value per square metre tends to be lower because there’s plenty of available land.

This means the building accounts for much of the asset’s value, and in these locations the dwelling may lose value faster than the land can gain value, thus hampering long-term capital growth.

On the other hand, when you buy a high-growth property, it’s likely you have purchased in an area with a limited supply of land relative to buyer demand and your land-to-asset ratio is likely to be high. This means the land component makes up a higher proportion of the property’s overall value, giving the asset strong capital growth potential.

Now, don’t misunderstand me.

The ultimate aim of property investment is to obtain cash flow that will give you financial freedom, but things have to happen in the correct sequence.

Your investment journey is likely to comprise of three stages over 20 to 30 years:

1. Accumulation Stage: when you build your asset base (net worth) through capital growth of well-located properties. You can speed this up through “manufacturing” capital growth through renovations or development;
2. Transition Stage: once you have a sufficiently large asset base, you slowly lower your loan-to-value ratios so you can move on to the
3. Cash Flow Stage. Now you can live off your property portfolio.

How do you cope with negative cash flow in the mean time?

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 to buy you time.

For example, you might use a line of credit could to supplement the rental in order to pay the interest on the investment loan and property expenses.

This facility 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

The four main risks are:

1. Poor capital growth. That’s why correct asset selection is so important;
2. Interest rate increases. This can be addressed by fixing interest rates on some or all of your debt;
3. Poor rental growth. This highlights the importance of owning properties that will be in continuous strong demand by a wide demographic of tenants; and
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. But while they may give you short-term income, these properties will never allow you to accumulate the equity necessary to become truly wealthy.

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.