It’s the cash flow – stalk the liquidity dragon
When deciding what type of property to buy, the focus must first be placed on the income that the investment property will generate and only then on the potential capital gains.
Your primary focus as an investor should be on the investment’s suitability as a source of rental income, rather than its potential to deliver a quick capital gain from a short-term rise in the property market. Generally speaking, where the majority, or all, of your property investments are financed, regular monthly contributions will be required until such time as the rental income exceeds the bond repayments and other costs. Other costs could include expenses such as rates and taxes, property insurance, maintenance and repairs. By focusing on the cash flow first you will ensure that your investment will break even sooner than if you were focusing exclusively on capital gains.
The surest way to lose your property is by getting the cash flow wrong. Provided you get the cash flow right, property can – over time – forgive almost every other mistake that you may make.
Gearing (borrowings, such as a mortgage bond) is at the heart of property investment risk. High gearing now means more purchases now and more income later. But what it also means is more chance of losing everything. If you’re young, eager and ready for risk, high gearing is fine, provided you know when to go for it and when to wait and consider your options. But, if you’re older and/or risk averse, lower gearing will be more appropriate.
A helpful tip when deciding on your appetite for cash flow risk is to do some scenario planning. This is achieved through running “what if” cash flows. The starting point is to determine the likely rental, as well as monthly costs that the investment property will incur. These will include your gearing level and the cost of servicing the bond, maintenance costs, rates and taxes, levies, and any other expenses that may be applicable. Then play around with various scenarios. For example, increase the interest rate, escalate operating costs, make provision for maintenance expenses, and make allowances for vacancies. This is to ensure that you will have the cash flow to cover these eventualities.
Many speculative investors were swept up in the emotion of the boom times, and ended up being burnt. They over-geared and when the property market and interest rates turned, they lost their properties. It is a key rule of property investment that the investment must generate sufficient cash flow over the short to medium term to cover operating costs.
The second rule in this series of articles is about understanding and using the value of time when making investments - keep posted.