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Peanut butter & jam sandwiches

Margaret Lomas
Friday, December 07, 2018

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Have you ever wondered how new food combinations like peanut butter and jam sandwiches came about? I imagine they came from people breaking traditional thinking, trying something new and forging an untested path – often in the face of criticism and humiliation.

Sometimes, two things which were previously thought to be incompatible can be brought together with great success.

For many years, ‘experts’ claimed that you had to be either a growth investor or a cash flow investor. They declared that growth and cash flow were mutually exclusive, incompatible – like peanut butter and jam on sandwiches together!

If you already invest in property, you will know, as I do, that “ideal properties” with affordable cash flows and good capital growth are out there. I own many of them. You can find them too.

Finding the ideal investment property for you

If you have read any of my work, you already know and understand my 20 Must Ask Questions®.  Following these questions will ensure you select the right investment property for your needs. Now I would like to introduce the concept of “cash flow affordability” and how it impacts investors.

Before explaining cash flow affordability, let’s briefly revisit the concepts of capital growth and cash flow.

Capital growth

Assuming your objective is to generate the highest capital gain possible, you may think that investing in capital cities and coastal locations is the key.  We now know that this is not correct, as recent studies have shown that there are many areas outside of capital cities that have delivered some amazing growth.  

Since capital growth is directly linked to supply and demand, it is reasonable to expect that those areas with a population growth faster than the national average will experience greater levels of demand, possibly higher than supply, and so drive up property prices.  This can happen both in cities and in larger regional areas.

Cash flow

Investors seeking positive cash flow properties are typically drawn to locations where the demand for rentals are highest, and this can occur in regional areas and the outer suburbs of some capital cities.

To ensure a minimum injection of ongoing funds, cash flow investors look for properties that ‘pay for themselves’, without a need to support a negative cash flow. Finding property that also has a high amount of building depreciation can also contribute to the inward flow of funds, and so boost the after tax cash flow.

The possible downfall with this approach is the temptation to chase cash flow at any cost, leading you to consider single-industry towns, for example, with slim long-term prospects for sustained capital growth.

The key, of course, is going to lie in discovering properties offering the best possible growth for the highest possible cash flow, and ones which suit your personal short-term needs for either cash flow or growth.

Introducing cash flow affordability

Cash flow affordability is the equilibrium between cash flow and capital growth. It is that balancing point between achieving and acceptable capital growth and being able to support the property’s costs while this appreciation in value occurs. This point of equilibrium will be different for every investor.

Let’s consider two investor scenarios to explain the concept in greater detail.

First story

Wayne is a single man who lives at home with his elderly parents. His living expenses are extraordinarily low and he spends his money very carefully. His total annual living expenses are only $40,000. Wayne earns $215,000 per year as an engineer. Wayne has a high cash flow affordability and so he can target properties with high potential for capital growth even though they may come with negative cash flows. Having said that, Wayne’s objective is still to make these properties into positive cash flow properties in as short a timeframe as possible.

This is achievable as Wayne’s substantial surplus (the difference between his income and expenses) when combined with rapid mortgage reduction principles will reduce his debt, and therefore his interest cost, quickly. This reduction in interest over time (hopefully combined with increasing rents) will create a positive cash flow.

Second story

Mark and Sarah are a married couple with 3 young children struggling to get ahead. Mark earns $90,000 per year and Sarah works part-time on $25,000. Their household expenses are $100,000 per year; leaving a surplus of $15,000. For Mark and Sarah, cash flow is key consideration when investing. In total, they can only afford $288 per week (assuming they use their entire surplus to fund the holding costs of the properties, which doesn’t appear to be a smart option given their circumstances – unless they have other cash reserves).

Mark and Sarah really need to acquire properties with cash flow of say, no more than around $30-$50 per week negative.

Other things that need to be considered are time till retirement and risk profile.  An investor with less available time needs growth more quickly, and one with a low risk profile will need to buy in areas with less speculation.  All investors have different needs which must be considered when making choices about where and what to buy.

Always remember that the ultimate aim is to buy a property with the greatest chance of capital growth for the highest cash flow possible.  Cash flow keeps us in the market, while growth allows us to get out, or at least acquire the assets needed to make choices about our retirement. If you do your research well, you can achieve both of these things.  However, due to the nature of how values and rental (yield) growth initially may occur in opposition to each other, the first few years of a property investment may require that you choose the one which is the most important to you, and knowing more about your personal needs for cash flow or growth may help you decide which is the right property for you now. After those first years, a well-chosen property should be delivering both yield growth and values growth.

Investors need to be realistic when searching for properties, because it is better to purchase an ‘almost perfect’ property now, than wait for years hoping that the ‘perfect property’ will pop-up. They rarely do.

Published: Friday, December 07, 2018

New on Switzer

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