Final round sharing — cash flow is the king

OK. I think I will make this as my very last sharing post of what I learned over the weekend. I typed enough, and some people are probably getting sick of me “showing off” my learning.

Anyway, this sharing is all about the king of all topics — Cash flow is the King!

One of the biggest mistakes that we make (I made the same mistake back then) when buying investment property is that we buy for appreciation, but not for cash flow. Hands up to all readers who thinks capital growth is more important than cash flow?

Most of us are adopting this approach, because we think we capitals raise in value that way, even if it means the properties are negatively geared. (and some people prefer negative gearing because negative geraing is tax deductible, hooraayyy!).

Two problems with this approach:

1. It only works when market is going up.
2. Even if the market will never go down, it relies on us having high paid jobs.

Imagine this:

a) I buy a house at 500K, with 400K loan, and negatively gear it at -$200 per month.
b) 5 years later, my property increase in value, so I pull some equity out, buy a second one, again at 500K, with 400K loan, again negatively gear it at -$200 per month.
c) Rinse and repeat again 5 years later, buy a third one, again at 500K, with 400K loan, again negatively gear it, this time at $-150.

Sure by the time the 3rd property comes into play, the first property value might have increased to 800K and the second one increased to 600K, life is good right? But do we see where the probem is with this approach?

Yep, I can’t quite my job. In fact, I must have a higher paid job (which means busier job with less time and freedom) or else I don’t have any serviciblity left… and what is my goal? Financial freedom, but am I getting anywhere closer to it? No… I am being pushed further and further away from yet.

Suppose let’s say at age of 70, I retire with 3 investment properties. The average Australian pensions are crap in terms of value, so I will probably be inclined to sell one of the 3 properties, and let’s see what happens:

a) Before we sell it, we need to consider that 5.5% of that 500K original purchasing cost were stamp duty, so that’s quite some profit taken away from me.
b) Next, comes Capital Gain Tax, so bye bye 25% of my profit.
c) Finally, the remaining profit is treated as my personal income.

Then I live for 5 years, used up all of that profit so what I do? Sell the second one, then 5 years later sell the third one. Finally, another 5 years pass, I don’t have any more to sell and I might as well just hope to die or suck it up with living with average pension. Good luck having a quality retirement life on pension.

Even if we are not talking about retirement. Let’s say we are talking about us living in our 40s and 50s, and property market conintues to go up, there is still a problem. What happens when I lose my job? What happens when I cannot find another job for 9 months? All of a sudden I have 0 income and with 3 properties that are sucking away over $500 from my saving account each month because they are negatively geared. What happens if the area where the properties are gets hit hard and job loss rate goes up high, tenants move out without new tenants moving in for 1 or more of those properties? I could be looking at bankruptcy overnight even in a raising market.

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Which is why we want to focus heavily on cash flow rather than appreciation. This is not to say appreciation is bad, we all love it when our properties go up in value, but cash flow should take a much higher priority.

Getting good cash flow, pretty much 99% of the case means, we buy below market value. When we buy below market value, our loan value is less, which in term means our monthly repayment is less, and this translates into a bigger chance of getting positive cash flow.

Why cash flow so important? Because it protects us when we lose our jobs or when market goes for a down turn.

Imagine this:

1. A crisis simliar to the year 2008 GFC (Global Financial Crisis) hits, and massive job loss takes place as well as housing value slumps down the bottom.
2. Suppose say I bought my investment property at 500K with 400K loan, and imagine my property value drops to 250K
3. The bank is not going to say “hey, your property value dropped to 250K and you have a 400K loan with us, so you need to send us a pay chequeue of 150K in value”. No! They will just keep the loan as it is and as long as I can make my repayments, then I will be safe.
4. Some people might be jumping in now and say “hey its a financial crisis, so won’t the rents go down and kill my cash flow too?”. The answer is NO, in fact, rent will increase and here is why.
5. A financial crisis like that, so many people will default on their home loan and unable to pay. What happens in this case? Banks will repossess their properties.
6. But those people who had their properties taken away by the bank still need a place to live right?
7. My property has healthy cash flow, and is thus protected, this means while massive number of properties are being repossessed by the banks (thus are not avaliable for rent), mine is still avaliable to be rented out.
8. What does that mean? More demand for rent and rent will increase rather than decrease as a result and I get even better cash flow.

It sucks from a people’s perspective but from investment’s point of view, this is an opportunity rather than a danger.

In other words. If you ask me if the market will always go up, my answer is I don’t know. If you ask me do I know when the market will go down, my answer is again, I don’t know… But I do know one thing, I am protected due to good cash flow whether the market is going up or down. If the market goes up and I get more equity, that’s fantastic. If the market goes down, well I am still protected.

Statistically, of all the property investors in Australia, more than 70% of the investors never go past owning 1 investment property while those who own more than 5 make up 1% of the investor pool. I frequently get many Real Estate Agents and developers telling me “everybody is rushing to buy in a booming area, you should go and buy now or else price will sky rocket shortly”.

When someone says something like that to me. Now seriously, my two instinct reations are:

1. Are you buying any of those properties yourself?
2. When you say “everybody is rushing to buy now”, does that “everybody” constitute the 70% of the investor pool or the 1%? If it is the 70%, then why should I listen to you and end up beoming one of those 70%? If it is the 1% we are talking about then by all means introduce me to them so I can team up with them and invest together.

Most people who “rush to buy a booming area” are not financially educated as well as buying for appreciation rather than cash flow. So no thanks, I won’t buy.

So hopefully this explains why cash flow is so so so so so much more important than appreciation.

Cheers
Steven