To invest in growth or cash flow?... That is (no longer) the question

Margaret Lomas explains why the debate on whether to invest for growth or cash flow is becoming less relevant in the face of a fast-changing landscape and provides timely advice on how to approach this market.
 

With the global financial crisis seemingly well behind us, many people have begun to question just where this leaves property. For so many years now, property investors have placed themselves firmly in one of two camps in terms of how they view property investing. They either invest with a view to getting a great growth in the future, often accepting a very negative cash flow in the short term while they wait for this growth. Or, they buy property with a positive cash flow today, believing that the growth may be smaller (due to having bought regionally to access lower prices and higher yields). However, with the face of property investing being such a fast-changing landscape, is it as simple these days as choosing one or the other? 

I have personally been buying property for many years now, having bought the first one in 1999. Throughout this time, I have seen many changes occur and as such have seen the need to continually tweak my own strategies, and those I teach to others, in line with the general economic outlook at any one time.

Unfortunately, the many other self-styled property investment experts who exist have not done the same, choosing instead to stick relentlessly to strategies that quickly become outdated and which are not based on any known economic data or suitable consideration of all of the important factors. How many of them do you hear still steadfastly insisting that you must invest within 15km of a CBD, in the face of overwhelming evidence that in the past 10 years these areas have shown the most lacklustre growth rates?

Investors, too, are slow to respond, with many of them clinging to single strategies that may no longer be appropriate. You only have to visit the forums online to see that the diehard growth investors still strenuously defend this as a suitable choice, while cash flow investors hit back with valid arguments of their own.

The truth is that with the global economic landscape changing so fundamentally, the question of whether to buy for cash flow or growth today has become one that is somewhat moot – not only is it no longer appropriate, but investing has become far more complex, requiring a much more considered approach that takes into account a new set of parameters.

It’s purely economics

As it turns out, these days some positive cash flow properties grow well and some even outstrip the growth rates of those located in traditional iconic locations, such as CBD and coastal areas. Conversely, this means that many areas which are chosen for their almost guaranteed growth fail to achieve suitable growth after all, certainly not enough to justify the high cash input from investors over the years.

The reasons for this are not clear, but are most likely purely economics. Properties that usually show a positive cash flow are often situated in outer suburbs or regional areas and within the lower price ranges. Typically, these properties are also those in most demand and those which are, to some degree, recession-proof. When interest rates drop, more first homebuyers are able to enter the market and, as such, demand increases. When interest rates increase, people are able to afford less and, once again, more demand falls in these markets. When affordability is low, more people rent, increasing demand as yields rise to make lower-priced property attractive to investors.

Conversely, markets with higher prices, such as those in CBDs and coastal areas, are among the first to suffer from most economic events. Sharemarket crashes decimate the wealth of many, taking a lot of demand from the market as less people can afford to buy. Increasing interest rates take away the ability of many to buy higher-priced property. And the higher the value, the less the relative yield, locking out many investors with low personal cash flows from these markets and again decreasing actual demand and as such, growth rates.

All of these features combine to make the traditional opinions about what type of property grows best of all somewhat misguided. It also means that how we look at property, and how we invest in it, must become about so much more than a basic assumption that property in iconic locations will grow while low-priced property with better yields will not.

Interest rate factor

Interest rates have risen and will keep doing so for at least another 12 months. While we will indeed see some months where the Reserve Bank keeps rates stable, we have not yet reached the point with rates where the economy can grow without stripping affordability from the property market, and so further rate increases are inevitable.

For investors this will have an impact in a number of ways. Firstly it will initially put a dent in cash flow. Even those properties with large on-paper deductions may initially struggle to show a positive cash flow in the face of rising costs. However, if you have purchased in an area with high demand from both buyers and renters alike, the impact will be smaller for you as it is likely your yields were good at the outset. It is also likely that your yields will grow early in the ownership period, as strong demand always results in low vacancies, which in turn increases yields.

Those who have bought thinking that they are only after growth, and subsequently buy in those areas believed to have the best growth, will find themselves with a chunk of negative cash flow far too high to maintain, especially where they have considerable personal, non- tax deductible debt too. And the growth they are expecting may take years to materialise, or not materialise at all, as the interest rate rises begin to impact in the way that they should, stalling the economy and halting runaway property values at the top end.

Lower-priced property will be the first to return to positive cash flow, and in fact the growth will make this an even better choice and improve the net worth of property investors much more quickly than higher-priced property can in the current economic climate.

Higher-priced property will take much longer to see both growth and increasing yields and will remain, for some time to come, a choice with little upside. Not only will it strip you of personal funds, it will fail to achieve the growth required to make such a high degree of personal funds input pay off. It will also mean that, as interest rates do rise, those owning this sort of property will become more and more vulnerable and at risk of needing to sell quickly. And, if that situation does arise, a quick sale will be made difficult by a lack of demand.

Achieving the perfect balance

As I’ve pointed out in my book, 20 Must Ask Questions™, there are fundamental criteria for sound investing, and these 20 questions cover characteristics which are far more important than just cash flow and what people ‘feel’ will happen to an area. These include things such as how and when the population will grow, what people do in an area, the diversity of industry and the success of the commercial ventures in an area. They cover the council’s future plans and the long-term growth trends which can be determined from what is happening in an area today. These are all characteristics which ultimately mean that prices are either about to increase, or have increased recently and most probably rapidly. Usually prices increase first and rent returns follow more slowly and over a greater amount of time.

Growth is a crucial part of the plan; however, also being able to have, or work quickly towards, a positive cash flow is still the most viable way to build a sound and sustainable portfolio. Ideally, seeing this cash flow upon settlement is the best outcome, as then the chance to get back into the market again by buying more property will come sooner. If this is not possible, give consideration to properties with small negative cash flows where evidence exists of a change to this situation in the very near future. Aim for a portfolio which becomes, and remains, positive cash flow as quickly as possible.

It has always been my experience that well-bought property never goes backward in value, so staying out of the market may be a greater mistake than getting into one with a small commitment from you. Learn as much as you can about what truly drives property and be careful who you listen to. With so much attention on property, many of those opportunists who will try to take advantage of property investors will enter the market with all sorts of irresistible deals for you.

You can easily guard against this by becoming educated in your own right and by independently checking all facts that are provided to you. Take care but take action too. It’s been a while since such great opportunities existed for buying property, and you won’t want to miss out.

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