By Margaret Lomas
February 2008
Sometimes, investors become very worked up about whether to buy for cash flow (that is, property with the lowest personal input required) or for growth (property which may cost more from your own pocket to hold, but which will grow more quickly).
During the past 10 years, the property market has behaved differently, and it is not as easy to predict growth as it used to be. Years ago you knew that buying in a city meant lower yield but more growth, and buying regionally meant lower growth but higher yields. More recently it has become harder to predict just which areas are going to grow, with many high yield regional properties delivering unprecedented growth.
There is still no real hard and fast rule, but for those investors who worry about the impact of low growth on their ultimate aim to achieve a retirement income, consider these two case studies:
Mary earns $60,000 a year. The equity she has in her own home allows her to purchase two properties in the city valued at $300,000 each, which both have a negative cash flow of $60 each per week. Her debt to buy these two properties is $620,000, as she has $10,000 costs on each.
Her commitment of $120 a week means that she is unable to buy any more than these two. She holds them for 15 years. At that time, her position is as follows:
– At 8 per cent per annum growth rate, her properties are worth $1,900,000.
– Her debt is $620,000. This is because she has only been able to make interest repayments and has not reduced the principal from its original amount.
– Her net worth is $1,280,000. Assuming a return of, say 5% (either left as property providing rents, or sold and invested in a capital stable option) her income on this investment would be $64,000 per annum, around what she was earning pre-retirement.
– As Mary has had to pay $60 a week on each property, then in a sense she has invested $93,600 ($120 per week for 15 years) in order the receive this return.
This scenario looks quite good from here, and it appears that Mary’s strategy has paid off and provided her with an opportunity to replace her current income and so leave the paid workforce. It must be pointed out that the $120-a-week forced savings did result in some sacrifices for Mary along the way and, at times, she was concerned that rising interest rates or vacancies would force her to sell earlier than anticipated.
Peter also has a $60,000-a-year income. He buys regional property a positive cash flow of $20 per week (net return to him after all costs and claiming all tax deductions). As Peter has no cash input he can buy another property for $150,000 every six months, each year.
Peter holds these properties for 15 years. At that time, his position is:
– At 5 per cent per annum growth, Peter has property valued $6,800,000.
– His total debt, considering $5000 worth of purchasing costs on each, was $4,650,000 (Mike used the cash flow to repay his debt a little quicker).
– The net value of all property is $2,400,000. Assuming the same 5% return as Mary, Peter would receive $119,000 of the rent (or as a return on a capital stable investment) as personal income.
– If Peter had experienced the same growth as Mary (8 per cent), his property would be worth $8,633,631 gross, $4,218,631 net and he would have a net income of $210,931 per year. If Mary saw the same growth as Peter (5 per cent), her portfolio would be worth $1,247,356 gross, $627,356 net and provide her with a yearly income of just $31,368.
From these illustrations, you can see that:
• At the end of the period, Peter has the potential to make almost double the income that Mary can, even with 38 per cent less growth.
• If they both experience the same rates of growth, Peter would still be considerably ahead.
• Although Peter’s property was cheaper and experienced a lower growth, he was able to buy more property and so gain a greater exposure to a growth market, even if that growth was lower.
Before rushing out and buying property that you think may show exceptional growth, consider the wisdom of lower priced property which you can afford to retain for the long term. Overall, more property, even with lower growth, can provide a greater and more stable retirement income than fast growing property with a high personal financial commitment!.
Margaret Lomas is a financial adviser, property author and founder of Destiny Financial Solutions.