We have seen the power of capital growth time and time again. There have been strong performances in the past 5 years alone in markets such as Hobart, Melbourne, and Sydney.
Hobart was the strongest performing capital city realising a positive change in dwelling prices (44.9%), followed by Melbourne (31.1%) and Sydney (23.6%) [1].
Even with capital cities consistently presenting a great opportunity for capital growth, investors often get in the argument of whether to invest for positive cash flow or capital gains.
Positive cash flow or capital gains?
At a glance, properties close to well established Central Business District's (CBD) generally offer blue-chip qualities and stronger capital growth prospects, however, typically they come with a lower yield relative to the purchase price.
Investors chasing positive cash flow (higher rental yields), should expect their properties to have a slower growth rate due to often being positioned in fringe locations. This includes tourism-based destinations and regional towns that tend to lack the underlying demand fundamentals of population growth, job opportunities, and additional infrastructure spending.
The reality is, a large percentage of Australian investors only own one property (around 70%). The ATO taxation statistics for FY 2016/17 revealed that only 19% of investors own two properties and less than 10% own three or more.
So more than ever, investors must consider the pros and cons of both cash flow and capital growth focused properties and their long term strategy when creating personal wealth.
Cash Flow Strategy
Pros
Investors could be securing a weekly income and realising the value of their investment in the short-term.
Excess funds could be utilised for additional potential investments.
Cons
Capital growth prospects could be considered negligible due to cash flow focused properties being positioned in fringe locations such as tourism-based destinations and regional towns.
Since investors are earning a positive income, they can’t take advantage of a negative gearing tax benefit and instead have to pay tax on their rental profits.
Capital Growth Strategy
Pros
Increased value of the property over the long term could outweigh the cash flow benefits in the short term.
Investors are more likely to have a negative cash flow before tax and can take advantage of the negative gearing tax benefit.
LVRs are generally more generous because banks are typically more comfortable lending for properties in desirable growth areas, often large cities.
Cons
Cash flow is negative, meaning investors with a capital growth strategy need to dip into their own pockets to cover property-related expenses, such as mortgage repayments and council rates.
Now, let’s look at a scenario for both options over a 10-year time frame.
Scenario 1: Capital Growth Focused Portfolio
Investor 1 purchases 2x $500,000 capital growth properties and the portfolio increases collectively by 50% (over the 10-years).
1 million portfolio @ 50% ROI = $500,000
I’m sure anyone would be happy with an extra $500,000 in 10-years’ time.
If the investor sold one property in 10-years’ time, followed by selling the second property the following year to cash in their $500,000, yes they would have to pay CGT.
The estimated CGT for each property would be $47,800 ($95,600).
$500,000 - $95,600 = $404,400
Once again, many would be happy walking away with $404,400 profit in 10-years’ time.
Scenario 2: Cash Flow Focused Portfolio
Investor 2 purchases 2x $500,0000 cash flow focused investment properties.
Both return $100 per week positive after all expenses (and after paying additional income tax).
Yearly income 52x $100 = $5,200 x 2 = $10,400
Income over 10-years = $104,000
Let’s say that the investor 2 also sells one property in year 10 and sells the other property the following year.
Assuming a lower capital growth rate due to being regional based and historically capital cities have generally had strong performances.
$1,000,000 portfolio @ 40% ROI = $400,000
Also using a salary of $80,000 for this investor.
The estimated CGT for each property would be $36,550 ($73,100)
$400,000 - $73,100 = $326,900 + $104,000 = $430,900
Highlights Of Scenarios
As you can see from the above scenarios, both options can have a solid result if they play out accordingly. In both scenarios, we are assuming the growth rates and the estimated rental yield (return).
We have seen capital cities perform much stronger then the 50% over 10-years used in the above scenario, but we have also seen cities perform much worse.
We also didn’t consider vacancy periods, where typically in capital cities in well-selected markets the potential vacancy periods are much shorter than one can expect in regional towns or tourism-based destinations.
Regardless of the market and the type of property investors choose, careful due-diligence should always be taken before considering whether to select a capital growth focused or a cash flow focused investment property.
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Jarryd Gauci – Property Investment Consultant
P: (02) 9939 3249
Disclaimer: When considering purchasing a property, it's always prudent to seek the advice of an appropriately qualified professional to determine which strategy is most appropriate for your individual circumstance.
References
[1] CoreLogic
[2] BMTS - Property Investment Statistics Trends
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