Investor Mistakes: Negative Cashflow Property Investments
Here's a radical thought: An Investment should pay US, not us pay IT
Disclaimer: Nothing is this article is meant to constitute financial advice of any kind, and is the opinion of the author only. Seek professional advice before making any financial decision.
When you think about investing, do you get really excited at the thought that you can LOSE money every week?
Well, you are not alone. People have been doing this for years in New Zealand and thinking it’s a great idea.
They purchase a property and the rent does not cover the costs of owning it.
“Which costs?” you ask. Good question. Things like: Mortgage interest and principle repayments, Land rates, Water rates (in some cases), Body Corporate fees, Insurance, Property Management fees, and maintenance to name the most common ones.
An example of this type of property would be:
Purchase price: $700,000
Rent per annum: $30,000 ($600 per week x 50 weeks, allowing for two weeks of vacancy and NOT allowing for a Property Manager)
Mortgage repayments: $35,000 per annum (assuming 100% borrowing, 5% Interest-Only loan which would be far more if on Principle and Interest)
Land Rates: $1700 per annum
Insurance: $1500 per annum
Maintenance: $2000 per annum (depends on the age, condition and style of property)
TOTAL OUTGOINGS: $40,200
TOTAL INCOME: $30,000
LOSS: $10,200 per annum ($196 per WEEK)
And it is even worse if we add in Property Management fees and make it a Principle and Interest loan!
The big question is: How many of those properties can you afford to own?
By now you may be wondering; “Why the hell would people do that?”
Or, you are wondering; “What’s wrong with doing that?” (maybe you already own negative cashflow property)
That’s a fair question. After all, we don’t know what we don’t know.
Why would people do it?
Three main reasons:
1. They simply don’t know any better
For many Kiwi’s this is the norm. It is what has been promoted by many property seminars, developers, and even some accountants, for years!
2. Capital gain
Many investors are happy to rely on future projected capital gains to offset any financial ‘top-ups’ along the way.
Although it is true that historically property prices rise considerably over a 10-year period in most areas, there is no guarantee of future performance. AND, you can still get those capital gains on property which PAYS YOU MONEY every week!
I have a DEAL for YOU!
Here it is…
YOU give ME $1000 and in return I will give you $300.
And if you are interested, I will keep doing that deal over and over!
If it does, please get in touch with us at www.assetlab.co.nz and we will do that deal with you (just kidding. Maybe). If it sounds kind of insane, welcome to the logic of thousands of Kiwi’s who love the concept of ‘Negative Gearing’.
They are happy to LOSE money because they get some of it in a refund from the Government. Crazy but true. And very common.
At Assetlab, we would rather our tax bills were $1million per year to PAY rather than receive a refund due to negative gearing! Why? Because when you make money…You pay tax. And we would rather make money than lose money. Pretty simple huh?
At the time of writing the Government are finalising the details of the ring-fencing of losses anyway, effectively removing negative gearing.
Let’s also confuse things a bit by saying there ARE situations where buying negative cashflow property can work for some people as part of a strategic plan. But the main point here is to at least know and understand the options and the numbers so the plan can be made with all of the cards on the table.
The Alternative (getting it right)
Buy Positive Cash-Flow properties.
What does that mean? It means the property PAYS YOU, rather than YOU pay IT.
If you buy property that pays you every week, how many of those properties would you like to own?
What is Positive cashflow?
'Positive Cashflow' is such a misunderstood term that in many cases when it is used in the industry it is a misnomer.
At face value the concept is simple; If more rent comes IN than expenses go OUT, it is 'Positive Cashflow'. But it's just not that simple, as there are multiple components to consider which can significantly change the outcome.
For example, some of the 'moving parts' which could affect the outcome include:
· Rent In: Have you based your calculation on 52 weeks of tenancy, or have you allowed for vacancy? If vacancy is allowed for, how many weeks, 1, 2, or more?
· Property Manager: Is a Property Manager being used to manage the property or is it being self-managed?
· How much are you budgeting for annual repairs and maintenance? This will vary depending on whether you have just renovated the house, the age of the property etc, but there are ALWAYS repairs to be done...
- Is it an 'Interest Only' Loan, 'Principle & Interest', or tranched?
- What is the term of the loan, 30 years, 25 years, 20 years etc?
- Are you basing the Positive Cashflow calculation on the purchase price of the property, or on the loan amount after your deposit is deducted? After all, you can make ANY property +ve CF if there is a low enough loan balance, but that may not serve your purpose for the calculation.
- What Interest Rate are you basing the calculation on, the current rate you will be receiving or adding a 'stress-test' contingency (like the banks do) and adding a set number of basis points (100 - 200) or using a 10-year average to base your figures on?
Each one of these is variable and illustrates the importance of understanding the concept and how each moving part influences the outcome. This helps each investor formulate their own 'rules' for calculating 'Positive Cashflow' on a particular deal.
Have a look HERE for a quick video example of a recent client purchase in Otara.
The Net Yield (income minus rates, insurance, maintenance allowance, other revenue expenses such as Body Corporate fees, Fixed Water Charge, Compliance Costs etc) on this specific property is 6.2% (at 52 weeks tenancy). So, for this case, based on 100% loan amount, no property manager as it's self-managed, 30-year loan term and at the current interest rate of 4.5%, yes, it is still 'Positive Cashflow'. There is around $1200 surplus PA on these numbers. If the loan was Interest Only the surplus is approx. $11,940.
Obviously with Interest rates as low as they are, the risk is that upon the rate term expiry, a higher rate would affect this and it needs to be allowed for in your planning (rents may have increased in that time to offset some of the increase).
So, in summary: Positive Cashflow (‘+VE CF’ to be all fancy about it) = More $ coming IN than going OUT. But you have to set your own rules about what the calculation parameters are.
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