What’s the right 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.

We're now at the beginning of a new property cycle, but it's likely we'll be lumbered with relatively high interest rates for a while and it will take another couple of years for inflation to fall into the 2-3% band of the RBA would like, and this has led some investors to ask if they should turn to cash flow positive properties.

You know…properties where the rental income covers all of the property’s expenses (including interest) leaving money in their pocket each month.

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.

Most of the new breed of so-called "property experts" "teach" cash flow - but then if you do what the majority of investors do, you'll get the same result all those other investors - 50% sell up in the first 5 years and 92% never get past their first or second property.

On the other hand, all the successful investors I've worked with over the years, those who have built a substantial asset base, have grown their portfolio through leveraging off the capital growth of their investments.

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.

Those investors looking for cash flow are thinking about the here and now, rather than the long-term and are buying properties that may solve a short-term problem but won’t give them the long-term results they hope for.

They won't ever build a big enough asset base to have a real "Cash Machine."

I understand that investors want cash flow to give them choices, but the fact is they first need to build a substantial asset base and they then can "buy" cashflow - this must be done in the right order.

You build a big asset base first then lower your loan-to-value ratios, maybe through buying commercial properties or maybe by buying income-producing assets like shares.

Sure when buying cash flow properties the rent may seem relatively high initially, but it's really 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 increase that much over the years.

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

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.

You will not be able to eventually replace your income with the type of cash flow you get from cheap properties (which generally start off with better cash flow) -meaning in the long run they are expensive because they don't get you to your goals – so they are not really cheap are they?

Of course, an individual property is not cash flow positive or negative - it all has to do with how you finance it.

If you have no mortgage all properties will be cash flow positive, and the higher your LVR the less cash flow surplus you'll receive, but it's important to remember that residential real estate is a high-growth, relatively low-yield investment.

The importance of 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 or secondary capital city locations 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 areas where prices are lower, the land value per square metre tends to be lower because there's plenty of available lands.

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.

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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, meaning 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 three stages over 20 to 30 years:

1. The 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 meantime?

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 to supplement the rental to pay the interest on the investment loan and property expenses.

This facility 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.

This strategy is not without risks…

The 4 main risks are:

• Poor capital growth – that’s why correct asset selection is so important.
• Interest rate increases – which can be addressed by fixing interest rates on some or all of your debt.
• Poor rental growth – which highlights the importance of owning properties that will be in continuous strong demand by a wide demographic of tenants.
• Lack of financial discipline – never use your financial buffers for uses other than covering your property-related expenses.

I’m sure you’ve heard about the importance of location.

In fact, you've probably heard me say that the location of your property will do around 80% of the heavy lifting of its capital growth.

I've written a detailed article on what makes an investment grade location here.

Then owning the right property in that location is just as important.

A-grade properties are not necessarily located in the most expensive suburbs and don’t all come with a multimillion-dollar price tag, but there will always be a depth of buyers regardless of market conditions.

In general, when looking for a property, it’s very rare to find the “ideal” property, so buyers usually need to make some compromises.

When they stumble across an A-grade property, they rarely need to make any or many compromises as it tends to “tick all the boxes”.

On the other hand, with a B-grade property, they have to compromise on a number of factors such as living on the wrong side of the street, or maybe not having a north-facing orientation; while many compromises are made when purchasing a C-great property like living on a busy through road or having an impractical floor plan.

So be careful … don’t get stuck with an underperforming property in the wrong segment of the housing market, because if history repeats itself, and it most likely will, you could end up with a dud property that you will regret owning and have difficulty selling if you need to.

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.