By Martin Bell
Recently a number of new investors have asked me for “positively geared” property and as such I thought it may be time again to talk about “Positive Gearing, Positive Cashflow and Risk”.
Positively Geared Property
Positively geared means the rental income will cover all of the outgoing costs (interest, council rates, body corporate and so on) BEFORE tax is considered.
However, a negatively geared property may still have positive cashflow. So what is positive cash flow?
Positive Cashflow Property
Property with positive cashflow would mean the rental income and your tax credits will cover all of the outgoing costs (interest, council rates, body corporate and so on). Utilising the tax credits does not mean waiting till the end of the year to get your tax back. A Tax Variation Form allows you to get your tax back fortnightly/monthly as you are paid (PAYG). Tax credits include depreciation which can be a significant “non cash” deduction; non cash meaning a loss the tax office allows you even though it did not cost you anything – I love the ATO!
So it is cashflow, not gearing, that is the real issue; what actually goes in and out of your wallet?Firstly, be very careful if people advertise “positively geared”, or even “positive cashflow” property. They will often be making some very dubious assumptions. Some people say that a property is positive but they are assuming you put in 20% deposit; meaning it is positive based on you only borrowing 80%. I look at positive or negative based on borrowing 100% PLUS all my costs involved in the purchase (using no cash of my own) – a big difference!
Generally to achieve positive cashflow property people will either buy older or cheaper properties; typically in regional areas where rental yields are higher. This is a higher risk than I am personally comfortable with – here’s why. Regional areas with smaller populations are generally more volatile. Small changes in the town can have a dramatic effect on your investment.
I spoke with a client last week who bought a new property in a Queensland country town for $350,000 chasing positive cashflow because he was told he would get $450-500pw in rent from mine workers. This sounds like a good bet, right?
It settled in mid 2009 and of course things had changed with the mine. The projects had been delayed and a number of people had moved out of town, etc. After being vacant for 5 months, he managed at tenant at $350 pw. A local, one of several renting superior accommodation at budget prices because all the investors who bought there are desperate. This is not a happy story.
In a separate story years ago, friends of mine who bought a house in Murray Bridge SA; again looking for positive cashflow. All went well for them (for a while, anyway) until the local abattoirs closed and many locals left town looking for work.
When hundreds lose jobs in regional centres many have to leave town to find work and the local rentals suffer. No tenant, no rent and no capital growth; add to that the plentiful supply of land and the fact that people have the option of building new homes. This removes a force that would otherwise cause existing house values to rise.
Remember long term capital growth is based on supply and demand. Supply means limited available land in the area , limited supply of housing. Demand means strong population growth- big numbers of people.
The Hans smallgoods factory on the Darling Downs closed recently with 200 jobs lost. If that was in the middle of Brisbane, or the Gold Coast would many of those 200 have to leave town to get work? I don’t believe so. Big populations mean big markets for tenants and less volatility in my opinion.
OK to summarise. In the past 10 years I have made over $1mil in capital growth over my 13 properties and that is now pretty much what Marion and I live on. Rents (and tax benefits) are important to me as they help me hold the property but where I have made the real money is capital growth.
As a “rule of thumb” I believe you may find a property with good capital growth and a fair rent return, OR fair capital growth and good rent return but NOT a great rent return and great growth. Let me ask you would you rather have a $400k property with 10% rent return and 5% growth OR 5% rent return and 10% growth? With 5% growth, after 20 years the property would be worth $1,061,319, with 10% growth it would be worth around $2,691,000; a difference of over $1.6m – and on just one property! There is no way you can make that up in rents.
Consider also how you build a portfolio! You are not likely to be able to retire on one or two properties. Everyone I know who has built a portfolio of any size has only been able to do it by using the equity growth in the first properties to fund the deposit and costs for later ones. Little capital growth equals little chance of buying more property. You won’t get rich on rents in my opinion (and experience).
Let me use a simple but very applicable analogy. Let’s say I planted a single fruit tree (purchase an investment property). I will get no fruit immediately. I have to water and care for it (weekly holding costs) but after a few years then it fruits. Do I then rip up the tree and sell it? No, I harvest the fruit knowing that year after year it will give me more. Now the fruit from just one tree will not make me enough money will it? So should I sell that first small harvest of fruit OR should I use it as seed to plant more trees until I have a whole orchard and the fruit supplied is then sufficient for me to sell and live comfortably on? I just have to tend and maintain the orchard. This may sound corny but it’s exactly my strategy.
I bought my first property and when it increased in value I used the equity as deposits (seed) for more property and so on. Once the portfolio increased to a point I could then use the increasing equity for “life style” (NB: the money is NOT taxable income because we own the properties in our own names). This strategy means we never have to sell the properties to realise the profits nor will we ever have to pay capital gains tax.
Of course properties that you buy with negative cashflow will change with time as rents increase to deliver a positive cashflow. The first property I purchased in 1999 attracted rent of $160 a week and left me with negative cashflow. It now rents for $330 a week; not only paying for itself but it now contributes strongly to covering the negative shortfall on my more recent purchases (not to mention it contributed to the equity required to buy these subsequent ones too).
Will positive cashflow/geared property work for some people ? It may do but it is more risk than I am personally comfortable with.
After 10 years of doing this I am willing to “stick my neck out” and say truly positively geared property; i.e. mainstream residential property (not retirement villages, student accommodation etc… and if you want to know why not that’s another “risk” story) is very, very rare in areas that have potential for good long term growth. PS: When I say “very, very rare” read “non existent” – in my opinion.
True positive cashflow is achievable in some instances but factoring a long term average of 7.5% for interest rates and you contributing no cash in for the initial purchase (incl. costs) means such an outcome will depend on both your taxable income and the finance strategy you use.
Don’t Despair
Many people using the mrd “Advanced Financing Strategies” are able to hold negative cashflow property without any input from their weekly budget.
While we will not offer you financial advice, we are happy to share our strategies, what we do, with you in an online meeting we call a “Personalised Retirement Options Plan” (PROP) at no cost or obligation to you. Strategies that are working for us and may very well work for you too.
A PROP is not aimed at those planning to retire soon. If you have not already worked a plan it may be too late for you. Our complimentary, no obligation offer is for those who still have time to avoid ending up broke. Are you working, do you have equity in an existing property and / or a cash deposit? Are you serious about ‘taking charge’ of your tomorrow by doing something today? If so, let us see how we may be able to help you with a plan that really works. I started at the age of 50 and it worked for me!
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Happy Investing,
Martin Bell
mrd Customer Care Program… because investing is personal
Reader Comments
Yoy state in your story the following -
NB: the money is NOT taxable income because we own the properties in our own names). This strategy means we never have to sell the properties to realise the profits nor will we ever have to pay capital gains tax.
I was under the impression when you sold an investment property if you made a capital gain over time you had to pay 50% of that gain in tax? unless you wrote off a loss on another investment.
Can oyu explain your statement, how you don’t have to pay capital gain tax.
Thanks
Hi Lyn
As it says “This strategy means we never have to sell the properties “.
I don’t sell and therefore I don’t pay capital gains tax. I currently draw on equity as needed to live on. There are several ways of using the equity in a property without resorting to selling it and paying CGT. Money I draw for personal use is not taxable income, I have not sold so I don’t pay CGT but yes I do pay interest.
Can you tell me how the capital gains is eventually worked out when out children inherit the properties? Do I need to keep records of all the drawing on the equity that we have drawn to live on and lifestyle or is all this debt lumped together and taken off the property before the capital gains is worked out when they sell?
Hi Robyn
If it was a pre-CGT asset for the person you inherited it from (that is, they acquired it before 20 September 1985), you need to know the asset’s market value at the date they died, and any relevant costs incurred by the executor or trustee. This is the amount the asset is taken to have cost you. If the executor or trustee has a valuation of the asset, ask for a copy of the valuation report. If not, you will need to get your own valuation.
If it was not a pre-CGT asset for the person who died, you may need details of all relevant costs they incurred as well as those incurred by the executor or trustee. The executor or trustee should be able to give you those details.
Personal debt is just that and not investment debt even though it may be secured against investment property.
See http://www.ato.gov.au/corporate/content.asp?doc=/content/00208572.htm&page=5
However when my children inherit our properties I hope I will have educated them well enough that they don’t sell the appreciating assets but hold them and use the equity as I am doing. I draw on the equity without selling or paying CGT.
A transfer of assets on death is not a “chargeable event” for CGT purposes. That means no tax is paid on your assets when you die.
It’s hard to say now what lending practices will apply in 30,20 or 10 years time but I would hope my children will have no need to sell and therefore will not pay CGT.
Hi, you mention that you own all your properties in ‘your names’, what about asset protection? Is there are particular reason you have not chosen a trust or other type of structure to hold your assets? Thanks Pel
Hi Pel
Trusts can be a complex question and I am no expert on that subject I have however done my research for my own strategy and decided that for me personally the downsides outweigh the ups.
I currently draw equity from my properties for my own use and that is not taxable – however with a conventional trust (and there are many types of trust) it would be taxed as income.
Many banks are reluctant to lend for property held in the name of a trust and that can be a real issue.
I have spoken to several clients who are set up in trusts and they comment that – “everything we do seems to become more expensive because of the trust”.
Certainly if I was in a “high risk” profession- say as an obstetrician, where the chances of litigation are pretty high , then I may think otherwise.
Anyway, as I said I am not an expert so for an accountants opinion see -http://investmentmentor.com.au/from-the-desk/purchasing-property-in-a-trust-or-not/