Today, I want to go back and talk about the fundamentals of your property investment – Cashflow Analysis. Speaking of cashflow, this is probably one of the most overlooked area especially for budding investors.
I can’t remember how many times when I chatted with people about their investment properties and realised that all they focused on were growth. It shocked me greatly that most of people I’ve spoken with have never done a thorough cashflow analysis for their investment properties.
“Hold on a moment, are you telling me that most of people have no clue about how much exactly will the property cost them to buy and how much exactly will the property cost them to hold when they deciding to purchase?”
Yes, I am and at least it’s my personal experience after hundreds of conversations, if not thousands, I personally had with my clients, colleagues and friends over the years. Isn’t that crazy?
Like most people, you might start thinking – “Why understanding the cashflow is so important to me? Growth is where the money is really made since I cannot bank on 3-4% rental yield.”
You know what, I want to say that you are absolutely right and I also targeted growth over anything else when I looked to invest. However, the case I want to make here is that without a solid fundamental in place, you might not be able to see the days of solid growth.
Here’s what I mean
As we all know real estate is cyclical and in Australia it doubles every 7 – 10 years. It’s a well-known fact and has been proven over and over again in the last 40 years. I always joked around and said that everyone would be an expert in predicting the future if we all held our property in 7 – 10 years. That’s how the market works throughout the history.
However, during the 10 years window, market never went up in a straight line. It actually went up in a cyclical manner and it involved quite a lot of ups and downs. When the market went down in a micro cycle and you needed to contribute an extra $650 for each of your two investment properties because the rents didn’t cover the full running cost of your property, what would most likely to happen next?
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Well, let’s add another picture into the above scenario.
What if the economy become tough and you are made redundant or you suffer from a salary cut?
All of a sudden, a large portion of the market turn on the survive mode and debt consolidation becomes a priority followed by a wave of panic selling…
I guess under a lot of circumstances, panic selling is how a lot of people lost money in real estate.
Now, picture this, what if you had done a thorough cashflow analysis when you purchased the property, and found out that with 70% LVR the property would be cashflow neutral (rents = all the running cost). You had figured that the property will be self-sustainable and required no further capital from you. Knowing it was going to double in 10 years, what’s the likelihood for you to sell the property in panic when the market temporarily trend down?
You see where I’m going with this? If a property’s fundamental is sound, you won’t have the urgency to sell down the stock in discount since you don’t have a serviceability issue. On the contrary, your serviceability will be improved since rents typically go up when property prices heading down. (Less people are purchasing new houses and more people are starting to rent)
Anyway, enough for the theory. Let’s go back to the basics and find out how to explore a property’s fundamentals?
Here’s one of my friend (John’s) recent purchase.
Property value: $515,000 – 2 br/ 2 ba/ 1 car townhouse
Purchaser income – $75,000
@ 30% – $154,500
- Stamp Duty
@ 5.5% – $28,325
- Title Transfer
- Title Search
- Bank Fee
@ $450 / week
- Vacancy Rate
- Net Rental
@ $441 / week
- Council Rate & Water Rate
@ 2,000 / annum
- Body Corp
@ 1,000 / annum
- Land Tax
@ – exempted since it’s below the threshold
- Landlord Insurance
@ $400 / annum
- Building Insurance
@ included in body corp
- Property Management
@ 6% – $1,375 / annum
- Letting Fee
@ 1 week rent – $450
- Interest Repayment
@ 6% (even though you can get 4.7% rate, we still use long term average) – $21,630 / annum
Pre Tax Cashflow Per Week = -75/ week
After Tax Cashflow Per Week = +31 / week.
Now, having conducted a detailed cashflow analysis, John can conclude that before the tax deduction, with 70% LVR, he will need to pay an extra $75 per week to hold the property. However, after the tax deduction, he is not only able to get $75/week back but also make an extra $31/week in a form of tax return.
So, what John finally decided to do is to gear up the property with 70% LVR and put rest of his saving ($77,250) into the offset account to offset the interest (better than interest earned in the saving account). This gives John a pre tax cashflow of +$14/week and after tax cashflow of +$91/week.
Do you see the importance of understanding the fundamentals?