Property investing can be an effective strategy to grow your wealth; however, there are many choices when it comes to structuring your loan and your repayments. We break down the difference between investing for cash flow or capital gain.
Once you’ve purchased your first home and built up some equity, you might be eligible to begin your journey as a property investor.
This strategy can be an effective way to build wealth when done correctly. The challenge is to choose the appropriate property and also the most suitable type of loan to suit your goals.
As well as having to select a lender and shop around for interest rates, you need to decide whether to structure your loan as Interest Only (IO) or Principal + Interest (P&I). This can have an effect on your taxes and your monthly cash flow.
We had a chat to Sheena Stow-Smith from Secure Wealth Advisers in Baulkham Hills to get an understanding of different borrowing strategies and the difference between borrowing for cash flow or profit.
Borrowing for cash flow
Also known as ‘positive gearing’, borrowing for cash flow means you’re earning money from your investment property once all your expenses have been covered.
For example, your loan repayments plus other expenses (council rates, leasing fees, repairs, etc.) might come to a total of $2.5k per month. If you’ve purchased a property and are able to lease it for $700 per week, you’ll be cash flow positive, with your tenants covering all the expenses of your investment property and then some.
Positive gearing can make sense if you wish to have cash in your pocket right now. However, if you’re selecting a cheaper property in order to do so, you need to make sure you won’t be stung for major repairs that could obliterate your profits.
Financial planner Sheena helps individuals and families in The Hills District to manage their money and plan for their financial future. In her opinion, the strategy of positive gearing is effective but can be difficult to set up unless you have a big deposit to put on the property.
With prices still strong in The Hills District, positive gearing “can be hard to pull off in the current property market”, says Sheena. If you’re looking to earn cash from the get-go, “You need the help of a good real estate agent to help you find the most suitable property for your budget.”
Positive gearing relies on property values and steady rental yields.
If you’re planning to invest in a property and be cash flow positive, it’s still important to be able to service the cost of the loan repayments yourself. You might have a gap in tenants or unexpected expenses could come up within the building. For both cases, it pays to keep some money aside.
Capital gains / negative gearing
Negative gearing equates to the income you make from your investment, minus the expenses. An investor who is using a negative gearing strategy might have repayments of $3k per month, with a rental income of $2.7k. This means around $300 per month is coming from their own pocket to fund the loan and other expenses involved with owning the property.
With negative gearing, profit comes from the property appreciating in value.
If you purchased an investment apartment for $700,000 and sold it ten years later for $1 million, you’ve made profits in the vicinity of $300,000 (minus the money you’ve spent servicing the loan and maintaining the property). When you look at it this way, negative gearing can pay off.
In the past, borrowers have relied on tax breaks that come with negative gearing in order to minimise their outgoings. However, as Sheena points out, the goalposts are constantly moving when it comes to financing an investment property. Recent updates to government regulation means the banks are not lending as readily and there’s always the potential for tax breaks to change.
“Financial planners recommend that strategies like negative gearing shouldn’t be taken for the purpose of tax deductions,” says Sheena “It’s an attractive idea but people should be looking to make an investment for growth potential rather than to pay less tax.”
At the start of 2018, several banks dropped rates on interest-only loans, making it easier to service a negatively geared loan. However, Sheena also points out that interest rates are anything but stable. “It’s important to always factor in the possibility of a rate rise when planning to invest in property and to give yourself some breathing room,” she says.
Choosing how to invest in property in The Hills
When making a real estate investment, your personal circumstances are highly important.
Whether you want to invest for positive cash flow or create a more long-term strategy, you need to be very clear on your own finances as well as the potential for things to change in the future.
Sheena reiterates that the first step for investors is always to have an idea of what they can afford.
“You need to make sure you’re covering your current budget before bringing on more expenses” she suggests. “When buying an investment property, you try to have a deposit of as close to 20% as possible. This makes your loan more palatable for the banks. You’re getting a better rate and your expenses will be more manageable.”
Careful planning is required to figure out what you can afford and how you will cover the repayments. “Buyers need to look carefully at what they’re buying and keep their emotions in check. Seek out an investment with growth potential and speak to knowledgeable real estate agents so you’re fully informed,” recommends Sheena.
You also have to make decisions about interest rates. “P&I is a good strategy that can result in interest rates at around 4.1%,” says Sheena. “If you’re going for Interest Only, be aware that the terms of these types of loans do expire; you need a solid long-term strategy that takes this into account.”
“Surplus cash flow is essential when investing, especially for capital gain.”
No matter how you’re planning to pay off your loan, Sheena’s advice is to sort out your insurance as well as your loan.
“In a worst-case scenario, you or your partner might be unable to work, which means you can’t service the debt. You could react by immediately selling your investment property, but if someone is injured or unwell it’s not a great time to make this kind of decision. You need to be able to factor in safety measures so your investment will provide the returns you’re hoping for.”
Property investment in The Hills
Despite the homes of Sydney and The Hills District seemingly being lined with gold over the past few years, the market is coming into a less meteoric period of growth.
This doesn’t mean there isn’t money to be made; however, it does call for long-term strategies. “Do your research, know your own market and speak to people who know what’s happening in the future in terms of property in your area”, advises Sheena. “No matter what strategy you decide to go with, make sure you take the time to speak with a financial planner, a mortgage broker and a reliable real estate professional.”
The team at Stone is always on hand to discuss your long-term property investment strategies and recommend purchases in accordance with your chosen strategy. Contact us for a chat today.
Disclaimer: Sheena Stow-Smith is a Financial Adviser at Secure Wealth Advisers, an Authorised Representative of RI Advice Group Pty Limited ABN 23 001 774 125, AFSL 238429.
The views expressed in this publication are solely those of the author; they are not reflective or indicative of Licensee’s position, and are not to be attributed to the Licensee. They cannot be reproduced in any form without the express written consent of the author.
The comments provided do not consider your personal circumstances and is general advice only. It has been prepared without taking into account any of your individual objectives, financial solutions or needs.
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