A Beginner's Guide to Positive Cash-Flow Investing

An intro from Jeremy Sheppard

This post is by Andrew Clough from Main Street Group in Brisbane. His company freely publishes a unique investment property report for a live property each week without kickback or commission. It guides readers through assessing a property as an investment. In today's article he does the important job of putting positive cash-flow into perspective.

A Beginner's Guide to Positive Cash-Flow Investing

Even if you've just started your research into property investment, you'll be aware of two basic strategies that are popular among Australian investors...

1. Negative Gearing
2. Positive Cashflow

You will also find that both strategies have an army of loyal (and vocal) followers who won't hesitate to argue its case, and leave you completely confused.

To which camp should I pledge my allegiance?

I personally keep a foot in each camp, and here's why...

Negative Gearing and Positive Cashflow are simply strategies that help you invest without breaking your wallet. There are many different strategies that will help you to make money through property investment. Main Street Group uses 8 different strategies for creating wealth through property investment, and negative gearing or positive cashflow are just two of them.

Note: The importance of selecting the right strategy is secondary to selecting the best property to invest in. Even the greatest strategy in the world is not going to help you if you select a dud property.

With that said, the purpose of this article is to help you understand the basics of identifying a positive cash flow property, so let's go...

What do we mean when we say Positive Cashflow?

The first thing we need to clear up is that Positive Cashflow Properties are not necessarily the same as Positively Geared Properties. There is not a huge difference between the two, nor should you waste your time getting caught up on the definitions, so let's keep it simple:

• Positive Gearing: If you owned a positively geared property this would mean that your rental income is covering any and all costs, including full mortgage repayments and all rental expenses (i.e. property management, rates, maintenance, insurance etc) directly, without you having to contribute any extra funds or "top up" your investment out of your own pocket.

There are a couple of things you should know about positive gearing to start:

• Truth 1: Properties that are positively geared from day 1 are difficult to find. If you insist on a rental yield of 10% or more you will most likely need to invest in a mining area, and these areas bring with them a lot of added risk for the average investor. Mining towns in particular are unstable because they're often wholly and solely reliant on the success of one industry.
  
  
• Truth 2: Equity is what makes most properties positively geared. When you think about it, every single investment property you buy could be positively geared from day one if you paid cash for it. But of course not everyone can afford to shell out a few hundred thousand dollars or more in cash, so we have to borrow from the bank. But most properties are positively geared if you were able to keep your loan to 50% of the property value or less - i.e. a Loan to Value Ratio (LVR) at 50% or under. This tends to occur if you have a large deposit, pay down your loan, or (my favourite) when your property value rises.

• Positive Cashflow: If you owned a positive cashflow property this would mean that your rental income is NOT enough to cover all of your costs (mortgage repayments and rental expenses) directly, which means that you would show a negative cash flow "on paper". However, this negative cash flow is then turned into positive cash flow once you add the tax credits you receive from the property after claiming interest expenses, rental expenses and depreciation.

So how do I 'Do The Math'?

Working out whether or not you have a cashflow positive property is fairly straight-forward. And here are some of the important variables you will need to consider:

Rental yield: The more rent you receive from the property the more income you have to cover the costs of owning the property. Therefore a high rental yield is vital if you are going to achieve a positive cash flow strategy for your property.

Interest rates: The lower the interest charges are on your investment loan the less the property is costing you to hold. Therefore the lower the interest rate the more likely you are to achieve a positive cash flow position.

Depreciation: The more you can claim for depreciation the higher your tax credit and therefore the better your cash flow position will be. Brand new or near new properties offer much higher levels of depreciation than older more established properties, so in general the newer the property the more likely you are to achieve a positive cash flow position.

Rental expenses: Rental expenses, such as property management fees, rates, insurance, body corporate fees etc, can have a huge impact on your cash flow. The lower the rental expenses associated with your property are, the less the property is costing you to hold, and the more likely you are to achieve a positive cash flow.

So, if you still have a little bit (or a lot!) of money left over at the end of the month after you've added and subtracted all of the income and expenses listed above, then you have a positive cash flow property! If you don't have any money left over and instead you need to "top up" your investment out of your own pocket at the end of the month, then you have a negatively geared property. Simple!

Positive Cash Flow in action

Let's have a look at a basic example:

Robbie has purchased an investment property in a regional town in Victoria for $280,000. The annual cost of holding the property is $28,248 which comprises of:

• Interest repayments on the loan: $13,502
  
  
• Rental Expenses: $6,588
  
  
  • Property management fees: $1,638
    
    
  • Letting Fees: $350
    
    
  • Rates: $2,000
    
    
  • Insurance: $600
    
    
  • Maintenance: $2,000
  
  
• Non-Cash Deductions
  
  
  • Depreciation: $7,500
    
    
  • Loan Costs: $658

Total yearly income: $18,200 (Robbie collects $18,200 per year rent from his tenant).

Net cost per year = $28,248 - $18,200 = $10,048

Robbie's investment property in regional Victoria, therefore, has negative cash flow "on paper" of $10,048 per year and this $10,048 per year can now be taken off Robbie's annual taxable income for tax purposes:

So if Robbie's taxable income was $50,000, this would now be reduced to $39,952($50,000 - $10,048 = $39,952). This means Robbie is only taxed on $39,952 instead of the usual $50,000, which of course reduces the amount of tax he has to pay (Robbie gets a tax credit).

A closer look at the taxes

• Previous Taxable Income: $50,000
  
  
• New Taxable Income: $39,952
  
  
• Previous Tax Payable (i.e. tax on $50,000 at the marginal rate of 34.5%): $8,547
  
  
• New Tax Payable (i.e. tax on $39,952 at the marginal rate of 34.5%): $4,930
  
  
• Tax Saving = $3,617 ($8,547 - $4,930)
  
  

Now Robbie can either wait until the end of the financial year to claim his tax credit (as he would have paid tax on the entire $50,000 throughout the year) or he can use a PAYG Tax Variation and ask the ATO to take out less tax each time he gets paid. This way, Robbie's tax return is effectively spread out over the financial year instead of being delivered in one lump sum at the end and, importantly this gives Robbie the cash-flow he needs throughout the year to cover the costs of holding his investment property. Ripper!

This investment property started out in negative cash flow territory "on paper", but then turned into positive cash flow once he added the tax credits he receives. Robbie's investment property is actually cash flow positive by $33 per week, or in other words, it not only costs him $0 to own, but puts $33 per week back into his pocket. Wowsers!

Let's see how his cashflow works out...

• Rental Income: $18,200
  
  
• Interest repayments on the loan: $13,502
  
  
• Rental Expenses:$ 6,588
  
  
• Pre-Tax Cashflow (Income - Cash Costs) = $18,200 - 13,502 - 6,588 = -$1,890
  
  
• Tax Credit: $3,617
  
  
• Annual Positive Cash Flow: -$1890 + $3,617 = $1,727
  
  
• Weekly Positive Cash Flow: $1,727 / 52 weeks = +$33 per week
  
  

If a property is going to pay me $33 per week, rather than costing me money every week, surely a Positive Cash Flow strategy is the only way to go, right?

A property portfolio that is providing positive cash-flow is of course the end-goal, because by the time you retire (or decide to quit your job and live off your property portfolio) you want a portfolio that is providing a healthy positive cash flow for you to live on.

But that doesn't mean it's always the right strategy from day 1. As well as being very difficult to find, the main disadvantage to a positive cash flow strategy is that you will often have to accept a trade-off between a positive cash flow and long term capital growth potential. This is because, in general, properties with lower purchase prices and operating costs as well as above-average rental yield are normally found in more 'sleepy' property markets (e.g. regional towns). And these more regional property markets simply do not attract the same economic and demographic forces that affect the supply and demand of rental properties, and therefore do not offer the same dramatic increases in capital growth we investors are looking for.

What about individual circumstances?

Personal circumstances also play a role. For example, the equation can swing in favour of negative gearing for higher income earners. They typically stand to gain extra benefit from tax refunds, and are more often able to afford the out of pocket costs of this strategy. In this case, it often makes sense to give up some short-term cash-flow to access a higher-growth opportunity.

So is a positive gearing or negative gearing going to make me rich?

To recap...

Positively geared = Rental income covers all costs to return a monthly cash profit.

Positive cashflow = Rental income doesn't cover all costs directly, but your investment still returns a monthly cash profit once you add tax refunds.

Negatively Geared = Rental income doesn't cover your costs, resulting in a monthly out-of-pocket cost.

Positive cash flow might be the strategy that enables you to purchase your first investment property or hold on to multiple properties over the long term, but the strategy itself is not what makes you rich.

What both strategies do is make an large investment far more achievable from a cash-flow perspective. They allow you to buy and hold an investment for a long period for low cost (or small profit) while it grows in value. But it's the holding of the investment, and the rate of capital growth over this period that will make you wealthy.

When a negative becomes a positive

Most debates miss the fact that that negatively geared property can become positive-cashflow or positively geared over time as the property value increases. As the property market rises, your rental returns increase while your major cost (loan repayment) stays the same, and this swings the cash-flow equation back in your favour. This illustrates why a negatively geared property with high capital growth can outperform a positively geared property (and indeed become positively geared itself) in the medium to long-term.

Profitable investing all comes down to selecting the right suburbs primed for fast capital growth, then buying affordably and holding while the market makes you wealthy.