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Everyone likes cash, don’t they?
While most of us don’t have much of it in our wallets anymore because it’s been replaced by a bank card, that doesn’t mean that we don’t spend much of our lives wanting more of the stuff.
Whether it’s through a salary or starting a business, most Australians would like to have more cash at their disposal.
The problem with such a mindset, though, is that the desire for cash drives some investors to buy the wrong type of property.
They see the phrase “cash flow property” and they start daydreaming about filling a bathtub full of $50 notes – just because they can.
The thing is, while you need cash flow via rent to make the mortgage repayments every month, it will not make you rich.
Indeed, chasing high cash flow properties may actually be detrimental to your wealth.
Here are three reasons why.
1. I’ll have some of that
If you buy a property that is a positive cash flow, then that extra money is classed as your income.
What that means, in reality, is that bathtub full of $50 notes turns into $20 notes instead because you will have to pay a proportion of it to the tax department.
It might feel nice to have extra funds coming your way from rent, but no one got wealthy on an extra few hundred dollars a month, did they?
2. Slow capital growth
Now, while the cash might be flowing in your eyes, the property that you have bought probably isn’t growing in the capital very much.
That’s because so-called cash flow properties are usually located in the outer rings of cities or in regional areas, which are generally quite sensitive to economic cycles.
Also, because there is usually less demand from buyers, properties in those locations don’t tend to increase in value as much as they do in our major cities over the long term.
3. Finance wobbles
At the end of the day, banks are in the business of lending money, but that doesn’t mean they don’t have certain types of borrowers that are their ideal customers.
Usually, they’re the ones that are buying investment-grade properties in locations that have a proven history of capital growth, such as major cities.
Lenders often get nervous when a loan application for a property “out the back of beyond” lands on their desk.
Now that doesn’t mean they’ll knock it back, but it might mean they will only lend a smaller proportion of the purchase price.
Say, in the city, you may be able to secure a loan with a loan to value ratio of 90 per cent, using a 10 per cent deposit of your own funds.
However, in a regional area, you may have to cough up a 20 per cent deposit, which lowers your leverage and ultimately your potential returns.
It’s important to realise that almost all investment properties become positive cash flow at some stage because rents rise but your repayments stay the same.
The thing is that it usually takes a number of years, by which stage your investment-grade property has already grown in value significantly.
Let’s say over a five-year timeframe, rent on your $500,000 investment property increased from $500 per week to $600 per week and your mortgage repayments have remained the same at $450.
So, that means you have an extra $400 or so a month in your bank account – before costs of course.
Now, if that property was in an inferior location, its value may not have improved much over the period.
However, if it was a blue-chip location, for example, its value may have increased by 50 per cent, which is $250,000.
Simply, that equates to tens of thousands of extra dollars per month if you were to sell the property!
I sure know which one I’d rather be investing in.
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