COMMENT: Capital gain vs cash flow
Tuesday 12 March 2019
There are two very different types of property investors and the introduction of a capital gains tax would affect one far more than the other, explains veteran property investor Graeme Fowler.
When it comes to property investors, there are two main types - those that invest for capital gains and those that invest for cash flow
Investing for capital gains is more like speculating. The investor buys a rental property with the hope that it will increase in value. If that does happen, they will often refinance the property and buy another one with the exact same intention.
The gross yield (the annual rent divided by the purchase price) often does not even enter their thinking when buying a property, as it is of very little - or even no importance. This is especially true when it comes to cities like Auckland (where most of the speculators like this buy) where the yields are very low, often 4 – 5%.
Having a yield this low only gives the investor enough weekly rent to cover the interest on the bank loan plus hopefully a little left over for rates and insurance. Often there’s nothing left over for any maintenance.
If interest rates went up 1 - 2% from the low where they are at now, these investors would have negative cash-flow, in other words they would have to top up their mortgages with their own money each week (negative gearing).
The problem with this strategy is that because they choose to use interest only mortgages (only paying the interest on the loan, and not the principal) the debt against the property will always remain the same.
Their only hope is that prices increase so that, at least on paper, they appear to be better off. Their focus is often on looking for small parts of the city they think will go up in value more than others.
While I do have a few investor friends that have been successful long term using I/O loans (buying multi-unit type properties with good yields and some having up to 60 accommodation units per property), 95% + of the interest only investors sell earlier than necessary, and usually regret it later on.
I have many investors come to see me after they’ve been investing for a few years wanting help, having previously talked to their financial advisors/mentors and so called experts, surprised that they have no cash flow.
“What have I missed they ask? Should we buy more?” And I say ‘Yes buy more just like you’ve been doing if you want to go bankrupt! The more you buy like this, the bigger mess you will be in and the more likely you will lose everything.’
For other investors like myself, we invest for cash flow and whether house prices go up or down is of no importance. In the past when I’ve bought rental properties, I make the assumption that the property will go down in value after I buy it, so I need to make sure I buy it well, and also that it has good cash-flow.
Good cash flow to me means an 8%+ yield in a good location in a city with at least 100,000 population. (A 7% yield with a 20 - 30% deposit is fine for most cash flow investors). With a better yield like this, there is enough cash flow to also pay the loan’s principal, in other words using P & I loans rather than interest only loans.
By using P & I loans, a small amount of the loan (principal, or the original loan amount) gets paid off every month. Over time a larger portion of the mortgage payment is principal and less of it is interest.
So when the property gets paid off in full in 20 years or so, the value of the property is of no importance. Whether it has gone up, down or is exactly the same value as when I bought it 20 years ago, doesn’t matter. Only the cash flow is important.
But that focus on capital gains is why I’m increasingly hearing of investors wanting to sell now, especially in the likes of Auckland and Queenstown.
Why? They are afraid that prices may drop and are also afraid of the potential capital gains tax. This would mean if prices went up after 2021 when the proposed CGT came in, any increase in their property prices would be taxed when they’re sold.
Capital gains investors tend to sell at very random times without any real thought or logic. These include when prices start to go down (when cash-flow investors like to buy more), interest rates go up, change of government policies, and also if prices have gone up - they like to sell and take the profit.
This is all very different to a cash flow investor who is it in it for the long term. A cash flow investor doesn’t care about price fluctuations or new government policies, as these things are not that important to the overall long term purpose. CGT doesn’t affect a cash flow investor; as we don’t ever intend to sell.
Whether the government introduces it or not doesn’t concern me, however it will concern a lot of capital gains property investors.
If these investors end up selling now or before any new law takes effect, there will be even less properties for tenants available to rent. That will mean a big increase in the 10,000 plus people on waiting lists for housing – many of whom the government is paying to put up in motels.
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