After collecting the rent and paying out all of the property expenses, some properties will have a shortfall, others will meet their own costs while others still will make a profit, where the income exceeds the expenses. The first falls into the category of negative cash flow while the other is considered positive cash flow.
Negative cash flow property
If you own a property that makes a loss, even after any tax deductions are claimed, your property has a negative cash flow. You may wonder why you would buy a property for which you have to reach into your own pocket every week or month. The simple answer is that people tend to accept a negative cash flow because they think that once they are ready to sell, they will reap more in capital gain than they have paid each week to hold the property. While this may indeed be the case, it also may not, and the investor could instead be seriously out of pocket and facing significant investment losses.
In addition, every property with a continually negative cash flow that an investor buys impacts directly on their lifestyle today. You must consider how much disposable income you have and are willing to commit to this strategy, as this will instantly determine how many properties you can buy.
You must also be aware that any negative movements in the economy, such as rising interest rates, will make your negative cash flow more negative. You might be able to afford the $100 or so per week that you have calculated will be your negative cash flow today, but if rates rise and it becomes, say, $150 a week, could you still afford it?
If you also have a personal mortgage that rises at the same time, a rate rise may really hurt you financially. This, combined with inflation and the low wage growth which has been evident in recent years, means you might even be forced to sell before the anticipated growth has occurred. You could then be left with no capacity to recoup what you have lost.
Positive cash flow property
On the other hand, but arguably equally risky, is the situation where you find property with exceptional rental returns. In this scenario, you may actually receive more rent than you need to cover your expenses – and this provides you with a positive cash flow. You will pay tax on this positive cash flow, because your net profits will be considered income.
Properties with these extremely high returns often exist in areas where there is a reason for the rents to be so high – for example, there may be a single industry in the town, like mining, which means there are a lot of renters who are there for the employment. Areas such as these carry high risk of volatile values. In Australia during the mining boom, for example, there were many examples of people paying high prices for property with unbelievable returns, only to have the values fall alarmingly as the demand for commodities lessened.
For investors who are not willing to take either of these risks, the properties to look for are those situated in ordinary residential areas in both cities and regional towns. They tend to have annual rental yields of around 5% to 6% of the purchase price. It is at this level of rent return that the better cash flow outcomes can be achieved. Properties closer to central business districts can have yields as low as 2% to 3%, and this can make achieving an even or positive cash flow very hard indeed.
It’s important to point out here that, over time, your negative cash flow property may become positive cash flow. If rents rise in the area, the percentage yield you are achieving rises, as it is measured against whatever you paid for the property, not what it is worth in the coming years. If you buy a negative cash flow property and rents quickly rise, then you may not have to bear that negative cash flow for too long.
However, if they don’t rise, or if they were relatively low to begin with, you may sit on that negative cash flow for a long time, effectively compounding your losses and placing more reliance on exceptional capital growth to pay you back down the line.
This is an edited extract from 20 Must Ask Questions for Every Property Investor (Major Street Publishing $29.95), exclusive to Canstar, and republished with permission.
Cover image source: Jaturonoofer/Shutterstock.com
About Margaret Lomas
Margaret Lomas is a qualified financial and investment property adviser, and the Founder and Director of Destiny Financial Solutions. She is the author of nine property investment books including 20 Must Ask Questions for Every Property Investor, How to Achieve Property Success and Investing in the Right Property Now!, published by Major Street Publishing.
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