Capital growth versus cash flow

Most investors appreciate that there are two components to the returns from investing in property: capital growth – where the value of the property increases over time; and cash flow – from rental income. An investor’s age, earning capacity and asset base will determine whether they are more interested in long-term capital growth or cash flow returns.

Younger, high-income earners may choose to invest for long-term capital gain. They are not concerned if their net cash flow is less than the costs associated with holding the property. In fact, they often seek investments with such a shortfall because they can claim this loss against other taxable income. In essence, that’s what ‘negative gearing’ is all about. This group of investors are sometimes referred to as ‘growth’ investors.

Other investors, on lower incomes or who are less risk averse, will tend to choose property that delivers a net positive cash flow. These are ‘income’ investors.

Opinions differ as to which is the best approach – to invest for growth or cash flow? In the end overall returns from property will be a combination of both.

Property is a long-term investment
It’s important to remember that property is a medium- to long-term investment. The yields will change (as a percentage) over the life of the investment. A property that is cash flow negative when you buy it may well become positive as rents increase and your loan gets paid off (providing you choose a principal and interest loan – which not all investors do).

Where to look for growth
Most new capital city properties will not return a positive cash flow when you first purchase them. This is because rental yields are quite low in terms of a percentage of the purchase price of your investment. Countering this, depreciation allowances on newer buildings are higher and as we noted earlier investors in a high tax bracket can claim investment losses against other taxable income. Well-located, quality real estate in capital cities will usually (all things being equal) attract good tenants and enjoy low vacancy rates, so the cash flows will still be consistent and continuous, while you wait for that capital growth to kick in.

Where to find income
In outer suburban and regional areas, it’s possible to locate lower-priced property with comparatively high rental yields and this is a strategy that many ‘income’ investors choose. Regional areas have not historically enjoyed the same capital growth as capital city properties. It’s not wise to generalise, as the regions are so vast and their economies and growth drivers are very different. Mining towns are regional and many investors have enjoyed stellar short-term growth and unbelievable rental returns in these areas, but they may be regarded as high risk.

Capital gains tax
Of course, any capital growth is taxable when you sell your investment property as you will be liable for capital gains tax (CGT). Capital gains tax is discounted by 50 per cent if you have held the property for more than 12 months and you have purchased the property in individual or joint names. The main way to avoid paying capital gains tax is not to sell your property – ever! Leave that liability to your estate. You can enjoy the cash flow from the investment and leverage against the capital growth to invest in further property, without ever selling and being liable for CGT.

Read more:

How to build more capital and master the market: Part 1

5 reasons not to fall in love with your investment property

3 unexpected benefits of investing in property

Why some properties don't pass the valuation test

The real costs of being a landlord