Updated: Jan 27
With super low interest rates, some novice investors are being enticed by the promise of strong cash flow. They see potential yields of seven or eight per cent, deduct the holding costs, and see the remaining balance as easy income. Unfortunately, no one ever created significant wealth on cash flow alone because it is capital growth that will change your financial future.
In property investing, different strategies can be deployed to produce different outcomes, but either one should be formulated to fit with an investor’s goals and personal circumstances.
Simplistically, investing for either capital growth or cash flow are two separate strategies, each with pros and cons. This means that investors must arm themselves with sufficient education before they go down either path.
As an example, over the past 20 years, I've invested in both blue-chip capital growth properties as well as cash flow ones and the outcomes are clear. The capital growth properties have delivered millions of dollars-worth of life-changing equity. While the cash flow properties have indeed produced positive cash flow but have not grown in value as much. Yet, they have both played a role – they are same, same but different.
Before deciding on the best strategy, investors must be clear on what they’re trying to achieve and have a tailored property investment strategy to help get them there.
Cash flow strategy
High yield, high cash flow, or positive cash flow property investing is something that is currently very popular with first time, younger, or inexperienced investors. This is of no surprise considering the seemingly endless amount of property spruikers, project marketers and inexperienced buyers agents/property investing agencies spent pushing this strategy on social media and across the marketplace.
Of course, income levels play a role in determining investment strategy, and no doubt many investors simply can't afford to buy and hold a handful of quality blue-chip growth assets.
But does this mean they should go and buy six $200,000 cheap properties offering high yields of eight per cent? Probably not.
Maybe a single quality blue chip property $1 million property with a three per cent yield would deliver better outcomes and better fit their risk profile over the long term?
Perhaps a balanced yield/growth approach, such as two $500,000 properties with 4.5 per cent yields, is more achievable and will help them move towards their goals faster?
One thing that investors buying in high yielding locations don’t seem to understand is that the yield can be a measure of risk. That is, this the higher the yield, the higher the risk.
So, let’s take a look at some of the risks that can be involved in chasing cash flow over capital growth.
1. If it seems too good to be true, it probably is
Many high cash flow properties are off-the-plan or brand-new dwellings.
Sometimes the planned “spreadsheet cash flow” of a property looks very different to what is actually delivered at the end of a given year. Quite frankly there can be far easier (and lower risk) ways to generate $20 or $30 a week!
2. Low capital growth
High cash flow properties are often located in lower socio areas with low buyer demand that are also often investor-heavy areas so have limited appeal to owner occupiers. With 70 per cent of the nation’s housing being owner occupiers, it’s these emotional homebuyers that drive upward pressure on property pricing
Properties located in suburbs with poor demographics and fundamentals are simply not conducive to experiencing capital growth. Let’s look at a real example, focusing on a couple of randomly picked suburbs in Brisbane (a popular city with investors). CoreLogic data shows that the Inner North suburb of Ashgrove has delivered 10-year median house price growth of 49.9 per cent. Conversely, in Logan Central, an investor heavy suburb located 26 kilometres south of the CBD, has delivered just 5.5 per cent median house price growth. That’s quite a variance isn’t it?
3. Low rental price growth
Over time, rents technically should rise. It is the combination of rising rents and reductions in debt, which lead to negatively geared properties eventually becoming cash flow positive. The truth is high yielding properties located in lower socio areas have little upward pressure on rents. The demographics and income levels simply do not drive enough demand to lift rents higher. Playing out our Brisbane example again, compare the 10-year rental growth in Ashgrove of 30 per cent versus Logan Central at 6.7 per cent. Rental increases are harder to push up in some areas than others because of the demographics of the people who live there.
4. Higher vacancy rates
High cash flow areas tend to have an influx of new supply, which puts pressure on rents as well as on vacancy rates. When there is more supply than demand, landlords can struggle to find a tenant. In turn, this means the property can be vacant for weeks or even months, which leaves a big hole in your personal finances as you still have to make the mortgage repayments. Again, a spreadsheet of what income is “possible” is much different to a proven history of rental performance of capital growth properties in superior locations.
5. Low quality tenants
In low socioeconomic areas it stands to reason that tenants are also on lower incomes. While many tenants on low incomes are model tenants, sometimes these areas can have a large proportion of problem tenants. This can lead to higher levels of rental arrears, property damage or turnover of tenants, all of which increases the costs for you as the landlord.
6. Higher maintenance costs
Chasing cash flow means it’s about owning a higher quantity of properties – it’s a
volume strategy rather than a quality asset one.
Of course, multiple properties mean multiple expenses, especially for repairs.
All investors have had experiences when a couple of their properties needed urgent repairs at the same time. However, when an investor owns a high number of cash flow properties then it stands to reason that there are also more costs involved in maintenance and repairs. Just think of the costs involved in repairing or replacing essentials such as hot water systems, air cons, dishwashers, and toilets? Those expenses soon soak up all that “extra” cash flow don’t they?
7. Harder to divest
Because cash flow properties are usually bought by investors that means that the sales market for them is usually restricted to investors as well. As I mentioned, owner occupiers make up 70 per cent of the market, which means that only 30 per cent of the market is investors. So, the buyer pool for these types of properties is already small and can shrink even further in times when investors are not overly active, such as during the pandemic. Of course, as a seller, you always want strong demand for your property because it helps to increase the price. Cash flow properties rarely have people fighting it out to be the new owner so vendors are often left to take what they can get.
Data Source: Core Logic Median House Price 10 years to 30/11/2020