Cash flow is becoming a key issue for many investors particularly in the current environment where interest rates are rising. Bill Zheng explains how to find cash- flow positive properties and ways to increase the income you're getting from your investment .
One of the main reasons to invest is to have a passive income that is large enough to one day provide the life style of our choice. So cash flow is a major consideration for most property investors in Australia. In this article we will examine a few aspects of cash flow in relation to residential investment properties:
• Why do some properties have better cash flow than others?
• How do you find properties with good cash flow?
• How do you increase the cash flow of any properties?
• Should you consider good cash flow properties?
Why do some properties have better cash flow than others?
Most investment properties can generate rental income in Australia, the typical rental income is in the range of 3% to 10% of the property's value per annum.
It is unrealistic to expect any property to have both high yield and high growth over the long term, because investors in high growth areas will push the price higher and cause the rental yield to fall. This is the main reason why most property investors label properties either as a growth property or a cash flow property. Growth properties show on average 7-10% annual compound growth with possibly only 3-5% rent, while cash flow properties typically on average 7-10% rent growth with only 3-5% annual compound growth.
To be able to have positive cash flow from any investment property, you need to have high enough rent to cover your mortgage repayment and property expenses.
For example, if you borrow 80% at 8% interest, and your annual property expense (such as repair, council rates, etc) is 1% of the property value, then you need to have at least 7.4% rent (80% x 8% + 1%) to have a chance to have positive cash flow, assuming you don't have other tax benefits. If you lower the borrowing to 40%, you only need to have rental of 4.4% (40% x 8% + 1%) to become cash flow positive.
It is very obvious that you can have positive cash flow from just about any investment property if you can lower your gearing ratio, so cash flow is not just a feature of the investment property itself, it is also a feature of your finance strategy. Lowering your gearing ratio can lower your risk, but it can also lower your return on your money and make it harder for you to get into the market because a larger capital input is required.
Property values can go up and down in cycles, so can rental yield. According to Residex the average 10 year rental return in Australia has been 4%. If you go back ten more years the 20 year rental return is 7%. John Lindeman, Property Analyst at Residex believes "What we are going to see in the future is that rental yields will start to increase to the 20 year rental yield level of around 7%. Once rental returns approach 7% then it will become more affordable to purchase than to rent."
There is sign that this is already happening, according to Residex rent increased across the country last year, the standouts being Melbourne by 22%, Sydney 19% and Perth 17%.
We can use the simple supply and demand theory to explain why some properties have higher yield than others. For example, if supply is the same, when the demand for purchase is greater than the demand for rent such as in inner metropolitan areas, you will see property value goes up faster than rent, hence yield becomes lower over time. Whereas when the demand for purchase is less than the demand for rent such as in regional areas, you will see property value goes up slower than rent, hence yield becomes higher over time.
How do you find properties with good cash flow?
Some properties can have extraordinary rental yield, but these properties are found in regional areas where property values are low or the area is based on one industry where there is a high proportion of renters. Residex data shows that these high yield properties are also located in resource boom areas - infrastructure areas - like ports, smelters and mining towns.
It is dangerous to chase high yield only without understanding the potential downside. John Lindeman explains the hidden traps from some of these extraordinary yields: "It is a shortage of housing stock that creates the higher yields. The shortage is created because investors know these towns are boom and bust towns. For example, Moranbah in Queensland is a coal mining town where rents are astronomical, between $500 to $600 per week for a 3 bedroom house, but most investors are reluctant to invest there or start building more housing because the coal industry could suddenly suffer another downturn. The resource companies could start providing housing themselves for employees on fly in/fly out contracts and this would dampen demand overnight. As soon as the boom finishes, demand for rentals crashes."
One of the better ways to shorten your research time is to use the Residex Best Rent Report. This report helps investors identify high rental areas with reasonable risk management.
Here is how Residex's analysts come up with suburbs for the Best Rent Report:
• Identify all the suburbs in Australia that have at least 5% rental yield and 5% forecast annual capital growth for the next 5 years. There usually hundreds of suburbs in such a list.
• Look for areas where there are a high proportion of rental properties. Areas with less than 10% of rental properties are taken out.
• Make sure there are a reasonable amount of sales happening in the area. Areas without reasonable sales volume are taken out.
• Rank the areas from top to bottom with an emphasis on capital growth because the areas with the highest rental yield tend to be "resource" towns.
• Ring up local real estate agents, local councils, chambers of commerce etc that provide good local area knowledge and ask questions about the area; what industry, infrastructure, education, retail, employment, new developments etc are occurring. What, if anything is likely to adversely impact the housing market in the area. This anecdotal evidence is then analyzed to determine whether it is a good investment area to stay in the list.
• Reduce to 100 suburbs as the final list.
Keep in mind that many property investors in Australia use the Residex Best Rent report. It doesn't take a lot of investors to push up property prices if they all go to the same suburb, especially when the sales volume is usually low in a small town. It is possible to see the capital growth occur in the top ranking suburbs within a few months of the report going out as the bargains are quickly snapped up. So if you want to take advantage of the Residex Best Rent reports, you might have to be quick to act (Residex advise that the Best Rent Report is published quarterly).
How do you increase cash flow of any properties?
Investors looking for more cash flow can also do a number of things to improve the rental yield they receive on an investment property. If you are a more "active" investor and are prepared to work a little harder, you might consider some of the following:
• Improve the appeal of your property to tenants. This can be done through renovation, better landscape, air-conditioning and security, etc. The best way to find out what your tenants want is to ask them either directly or indirectly from the property manager. If you can give them what they want instead of spending lots of money guessing, you can produce maximum rent with minimum outlay of cash.
• Furnish your property. This needs to be treated carefully. Most tenants have their own furniture, furnishing your properties can greatly reduce the demand for your property. However, if you have done your research and pick the right target market, such as corporate visitors from overseas or interstate, you can definitely ask for higher rent than an unfurnished property, and the cost of furniture can be tax deductible as well.
• Ask for more rent. This can be easily overlooked by many property investors. Most property managers won't push too hard for higher rent to make their job difficult, you don't get if you don't ask. Obviously we need to be realistic at the same time, but it has been proven that people with higher expectation for things usually get better deals in life; this is true for your rent.
• Consider renting out your property by room. This can be a messy option and you might need to look after this yourself as most real estate agents won't entertain this idea. Tenants who are usually interested in rent a room instead of the whole property are students, some will pay more if you provide other services such as catering, etc. Check out the article on page xx for more about this topic.
• Optimize your finance. Most property investors only need a simple interest only mortgage for their buy and hold investment properties. Your repayments can be lower if you can keep your mortgage simple. You may also consider many little things like having your surplus cash sitting in an offset account instead of a saving account for little interest, taking advantage of the interest free period of a credit card, etc.
• Delay paying interest repayments and principle of your mortgage. While rent increases over time, delaying principle and interest repayments allows you to have better cash flow today. A simple way to delay paying principle is to have an interest only mortgage. You can delay paying interest repayment by using a Cash Flow Mortgage, which allows investors to pay only a portion of the interest charged every year, and allows the interest component that has not been paid to be accumulated into the future.
• Get help from the tax man. Many property investors underestimate how much the tax man can help with your cash flow. By using a good tax accountant who specializes in investment properties, you may be able to get a tax rebate on a monthly basis to help your cash flow. By using a good Quantity Surveyor, you may be able to get depreciation tax benefits from even an older property going back quite a few years if you haven't done a depreciation schedule for a while.
• Sacrifice equity for better Cash Flow. Many property investors are willing to sacrifice equity for better cash flow. An investor can get into a legal agreement (commonly called a "wrap" or "lease/option") with their tenants, to give away some future capital gain in exchange for higher rental now.
Should you consider good cash flow properties?
Let's review the pros and cons of investing in cash flow properties.
• The positive or neutral cash flow that they generate. You can't lose having money in your pocket.
• Typically lower entry prices (as well as lower stamp duty and land tax) because of their location - so for investors who don't have much equity or income it is easy to get started.
• You can use the surplus cash flow to pay down principal and allow you to draw on the equity to invest further into other properties.
• Because of the popularity of these types of properties it is not uncommon to occasionally achieve strong capital growth gains due to the demand for high yield properties.
• From a finance perspective the income generated from the asset means it is easier to get a full-doc loan with a lower interest rate.
• Because you are generating an income from the positive cash flow, you pay tax along the way. You get taxed on this extra income and money in the tax man's pocket is going to make it hard for you to create serious wealth.
• Because these properties are usually in regional or outer areas they can be quite sensitive to economic cycles. Therefore compared to properties located closer to the centre of our major cities these properties will generate lower capital growth over longer term.
• There are also potential higher costs associated with maintenance and more tenancy problems due to socio-economic factors.
• From a finance perspective it is harder to get low-doc or no-doc loans for some regional properties due to postcode restrictions imposed by lenders, mostly due to their smaller populations. The result is lower leverage which will reduce your return.
In our experience, property investors who are into cash flow properties may have one or many of the following reasons:
• They want to use the cash flow generated from these properties to balance the lack of cash flow from growth type properties;
• They feel more comfortable with the property prices of cash flow properties, many believe most growth type properties are over valued.
• They don't trust capital gain tomorrow, it may not be there in the future, at least you can count on the cash flow today.
• They are unwilling or unable to use finance resources to cover negative cash flow for a few years until their investment property turns cash flow positive;
• They want to enjoy the journey of property investing by seeing money coming in every month instead of waiting for a big payout one day.
• They believe income is the final determinant of capital gain. Without rental yield, there is no substance to the property value, so investing for yield is safer than growth.
• Some speculate that high enough yield can generate good demand for cash flow properties, hence higher property values.
Whether these reasons are correct or not is not important, what matters is whether you think its right for you. We don't believe there is one best way to invest, if there was, everyone would be doing it and that would make it an average way to make money very soon.
Although personally I like to have a balance of cash flow and growth for property investment, that is not to say that you can't bet on one side more than the other if that makes you happy. Being happy in doing your thing is a form of balance itself, happy people are more likely to succeed, I wouldn't trade that off with any other forms of balance.
This article was written by Bill Zheng (founder and CEO) and Tim Riley of Investors Direct™. Investors Direct is a property finance company that provides financial solutions exclusively for property investors and understands that your mortgage is an asset, not a liability. To subscribe to our FREE monthly e-newsletter on investment property finance visit www.investorsdirect.com.au
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