Cash Flow is King!

Cash Flow

There’s an old expression that says ‘Cash is King’, but when it comes to property investing ‘Cash Flow is King’.

In my last post I mentioned how a positive Cash Flow can provide a passive income from a property portfolio. In this post I will explain why the consideration of Cash Flow is critical to your property investment journey.

First let’s have a look at the different aspects of cash flow:

Gearing

There is a lot of confusion out there between positive and negative Cash Flow and positive and negative gearing. For anyone new to these terms, let’s define what gearing is:

Gearing is simply the practice of borrowing money to purchase an income-producing asset.

Gearing can also be called Leverage and I discussed the use of this in property investment here.

If we know what gearing is, we can then define positive and negative gearing:

Positive gearing occurs when Rental Income is greater than Expenses (including interest costs) before tax.

Negative gearing occurs when Rental Income is less than Expenses (including interest costs) before tax,

Cash Flow

Then let’s look at the difference between positive and negative Cash Flow:

Positive Cash Flow occurs when Rental Income is greater than Expenses after tax, therefore you make a profit.

Negative Cash Flow occurs when Rental Income is less than Expenses after tax, therefore you make a loss.

You can now see that the difference between Cash Flow and gearing is whether the tax outcome has been considered.

Negative Gearing

Negative gearing is a hot topic at the moment, but you must understand that it is a financial outcome not an investment strategy. You should not be investing in property that makes a loss just to save on income tax. The primary reason to invest in property is to control an asset that grows in value over time, using the rental income to hold it.

Depending on your personal investment strategy and your risk profile, the properties you purchase may have a negative gearing outcome. If this is the case you need to be confident that the future growth of the property is greater than the cost of holding the property. Let’s use an example to demonstrate the cash flow of a typical investment property:

A $400,000 property receiving rent of $400 per week.

Cash Flow-$1,198
Rental Income($400pw rent)$20,800
Interest($320,000 @ 5%)-$16,000
Management Fee(8%)-$1,664
Council Rates($375 pq)-$1,500
Water Rates($300 pq)-$1,200
Insurance($100 pm)-$1,200
Maintenance($100 pm)-$1,200
Expenses(Total)-$22,764
Actual Loss-$1,964
Tax Refund(39%)$766

As you can see, the Rental Income is less than the total Expenses, with an annual loss of $1,964. Therefore this property is negatively geared. If your marginal rate of tax is 39% then you would receive a tax refund of $766, which would reduce the annual loss to $1,198. Therefore this property has a negative Cash Flow and is costing you $23 per week to hold. I have assumed that you have borrowed 80% of the purchase cost.

(Note: If you have used borrowed equity from another property to fund your deposit then your annual interest expense would be higher, and therefore you would have a higher negative Cash Flow.)

Positive Gearing

As per the definition above, if the Rental Income of the property was higher than the total Expenses then the property would be positively geared before tax. You would pay tax on the profit at your marginal rate of tax and this would result in a positive Cash Flow property.

On-paper Deductions

The example above shows a negatively geared property that also has a negative Cash Flow. This isn’t always the case though, a property that is negatively geared could also have a positive cash flow. How is this possible? It comes down to on-paper losses, which are deductions that you can claim where you incur a loss without the on-going expense. Just like any other physical asset, buildings and their fixtures lose value over time, also known as depreciation.

The tax office allows you to deduct the lost value of the building and fixtures each year against the income it produces. As you have already paid for the asset when you purchased it, the losses are ‘on-paper’ only without a corresponding expense each year. When you factor depreciation into your annual tax outcome it can soon make a negatively geared property a positive cash flow property!

Using the same property from the above example we can analyse what depreciation does to the Cash Flow. Assuming that this property depreciates by $9,000 in one year we can include this on-paper loss in the calculations:

Cash Flow$2,312
Rental Income($400pw rent)$20,800
Interest($320,000 @ 5%)-$16,000
Management Fee(8%)-$1,664
Council Rates($375 pq)-$1,500
Water Rates($300 pq)-$1,200
Insurance($100 pm)-$1,200
Maintenance($100 pm)-$1,200
Expenses(Total)-$22,764
Actual Loss-$1,964
Depreciation-$9,000
Total Loss-$10,964
Tax Refund(39%)$4,276

You can see that when the on-paper loss is included the tax refund is greater even though you haven’t incurred the actual cost of depreciation. The pre-tax loss of $1,964 has become a post-tax profit of $2,312. This negatively geared property is now a positive Cash Flow property and makes you $44 per week while you hold it!

(Note: the amount of depreciation you can claim each year does diminish as the value of the building and fixtures reduces. Over time your rents should increase which helps offset this.) I will cover depreciation in more detail in a later post as there is more to discuss on that topic.

Why Cash Flow is King

As you can see from the above examples, the consideration of Cash Flow is critical when building a successful property portfolio. A property that is highly negatively geared can potentially cost you a lot of money to hold and this is why so many investors get stuck at only 1 or 2 properties.

A savvy investor will plan for a balanced portfolio which includes high growth properties and high cash flow properties. If you also take advantage of depreciation you can improve your cash flow and a multiple property portfolio can be easier to hold.

As part of your property plan you must formulate a strategy as to what Cash Flow you need to build a sustainable portfolio. It is capital growth which creates your wealth but it is Cash Flow that keeps you in the market long enough to realise that growth.

 

1 Comment

  1. Thanks. This post is great in understanding how property can provide a positive cash flow, I didn’t know about on paper deductions and how important they are.

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