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Many people have heard terms such as ‘negative gearing’, ‘positive cashflow’ and ‘neutral cashflow’ but are unsure what they mean. Even though this article is about neutral cashflow properties, it is useful to explain a number of these terms.
What are they?
In the world of investment, the word ‘gearing’ refers to the fact that money has been borrowed to purchase an income-producing investment. In the case of property, it refers to an investor who buys a rental property and has borrowed money to purchase the property. (When calculating levels of gearing for property investment, it is generally assumed that the investor has borrowed the full amount of the purchase price). To work out whether a property is negatively, neutrally or positively geared, you simply subtract the annual interest paid from the rent received.
With this is mind
A ‘negatively geared’ property has more money being paid in interest than the rent that is received.
A ‘neutrally geared’ property has the same amount of money being paid in interest as is received in rent.
A ‘positively geared’ property has more money being paid in as rent than is being spent on interest.
I’ll use an example to illustrate the point. Let’s say you paid $250,000 to purchase an original1960’s unit that was returning $260 per week. Let’s also assume that you borrowed $250,000 at an interest rate of 5 per cent. Your annual interest bill is $12,500 and your total rent for the year is $13,520.
In this case, you are positively geared ($1,020 more paid in rent than is being spent on interest). However, if this unit cost $300,000 and you borrowed the full amount, you would be negatively geared. The rent received remains at $13,520 pa but the interest expenses have increased to $15,000 pa.
When we replace the term ‘gearing’ with ‘cashflow’, you need to include all rental expenses in the calculations, not just the interest component. This includes items such as council rates, water, maintenance, repairs, insurance, body corporate fees, etc. On the income side of the equation, you also include the tax benefits of depreciation and capital allowances. Now let’s see how this effects the calculations in our example of the $250,000 unit.
Firstly, the rent stays the same at $13,520 pa but we also add $480 from tax benefits, increasing the income to $14,000. However, when we include all costs that are associated with rental properties, the annual bill is well over $17,000. If we were to account for all the rental expenses, we would have a ‘negative cashflow’ property.
To turn this property into a neutral or positive cashflow property, we either need to increase the income or decrease the expenses.
Why buy neutral cashflow property?
The beauty of owning neutral cashflow property, where the rent coming in is the same as the money going out, is that the property costs you nothing to own! In reality, as time progresses and your rents increase at a greater amount than your expenses, you end up with a property where your tenant pays all your expenses and you have some money left over. This is termed positive cashflow.
If your goal is to own many properties, purchasing neutral (and positive) cashflow properties is the best way to achieve this. To purchase property that has a negative cashflow means that you have to dip into your own pocket to help pay the rental expenses. Your pockets are not bottomless pits so there is a limit on how much money you can put in to supplement the rent. (It is usually the bank that will place these limits).
In theory, you can buy an unlimited amount of neutral cashflow properties as it doesn’t cost you anything. However, borrowing money from the bank is not only about cashflow. They are also looking at your equity position, which is how much you own compared to how much you owe.
Even though the cashflow for neutral cashflow properties looks good on paper, the bank also takes into account vacancies, increasing costs and unexpected expenditure, thus limiting your purchasing power. However, if you have a secure job and income and plenty of equity, you can buy many neutral cashflow properties.
How to buy neutral cashflow properties?
The process to buy neutral cashflow properties is no different to buying any other property. You need to present your case to the bank, emphasising the relatively high rent you are able to achieve. Some banks treat rent very favourably and also take into account the tax benefits. If you are serious about owning multiple properties, you and/or mortgage broker need to seek out these lenders.
Where can you find these neutral cashflow properties?
Neutral cashflow properties were almost non existent over the past few years as interest rates were around 9 per cent and rents were stable. Currently, interest rates have dropped to about 5 per cent and rents are increasing. This makes finding neutral cashflow properties easier.
The basic rule of thumb in today’s market is you need to find property that has a total return of 7 per cent if you wish to have a neutral cashflow property. This should be enough to cover all your expenses. Let me illustrate this point with one final example.
Unit – $250,000 (renovated 1960’s unit)
Rent – $320 per week
Interest rate – 5%
Amount borrowed – $250,000
Tax benefits $860
Total Income $17,500
Council rates $300
Body Corporate $1,000
Property Management Fees $1,600
Other expenses $1,000
Total Expenses $17,500
A rental return of approximately 6.7 per cent and a small tax benefit equates to a total return of 7.0 per cent. As illustrated above, this should be enough to cover all expenses. It is very important to note that interest rates will not stay this low forever so you need to have a contingency plan, for example, fix your interest rate.
Neutral cashflow properties can be found in the city and the country. If you are looking in urban areas, it will be units/flats/apartments that you will be targeting as they generally have a slightly higher rental return compared to houses. In country areas, there will be numerous properties that show a total return of 7 per cent.
Neutral cashflow properties suit investors who are looking to have many properties in their portfolio. They are willing to sacrifice some capital growth in the knowledge that the properties pay for themselves in the initial stages and when the mortgages are paid off, they are able to live off the rental income.
If this sounds like you, you should be looking for property right now. With interest rates at 40-year lows it has presented us with a once in a generation opportunity.