A common discussion amongst investors is whether an investor should focus on capital growth or cash flow. A capital growth approach would focus on purchasing assets that will outperform the market. In contrast, a cash-flow property will have a higher yield meaning the investor will be in a better cash position. Alternatively, many investors choose a blend of both of these approaches, which may be represented in a single property or across a larger portfolio.
When referring to capital growth and cash flow it is important to note almost all properties have capital growth (over time) and cash flow (generated by rent). Although every property has both components, which approach should be at the forefront of an investor’s game plan? Each strategy can have numerous financial advantages, should an investor tailor their investment strategy towards one particular option?
The Case for Capital Growth
Firstly, let’s discuss a capital growth focus on investing. An investor may choose this approach if their goal is to increase their net worth and want to utilise leverage in order to build up as much capital as possible. It is important to note that a capital growth focus is likely to outperform nearly all cash-flow approaches over the long term for the modest buy-and-hold investor. This is because the potential returns from capital growth can outweigh the week to week cash-flow on nearly all leveraged properties.
For example, If investor A bought a 500k investment that had 10% growth in the first year it would equate to a 50k equity gain for investor A. Alternatively If investor B had bought two 250k properties, both of which are 5k positively geared he would have made only 2% on his total 500k investment (assuming no growth occurred). So, it can be easy to see which investor outperformed the other numerically. Of course, this doesn’t factor in numerous other variables such as investor A’s rental yield and Investor B’s growth, however, the potential returns of a property with capital growth can be clear as day.
Cash Flow is King
Please note, Cash-flow is fundamental to building an extensive portfolio. Without Cash-flow, the portfolio will cease to exist as even a capital growth focus needs some form of income to sustain the property’s expenses. However, the rental yield on properties is vastly different and some investors focus solely on obtaining high cash flow investments. There are many ways to find cash flow investments and investors aren’t limited to stock standard houses or units. Commercial property and alternative forms of property such as student accommodation, blocks of units, and short-term rentals (Airbnb) can have excellent cash flow. In fact, some investors have utilised this method over time in order to replace their income.
Additionally, there are cases of standard detached houses being converted into shared housing where they are able to achieve exceptional cash flow from subletting to tenants. Although, these approaches are catered towards a more active approach to property investing and in most cases require a larger proportion of time to manage. Regardless of the approach, cash flow within a property portfolio is a necessity and has been used as an exceptional tool by many investors to leave the 9-5 or supplement their income. Solely, focusing on cash flow may be a lucrative approach to investing if the investor has the knowledge of how to think outside the box and maximise their returns.
Compare the Pair
So, both concepts can be seen to have a significant influence on assisting an investor to achieve their goals. When thinking outside of the box, high cash-flow investments are most definitely achievable and highly rewarding. However, the focus of this discussion is fixated on Capital growth vs cash flow within the same investment strategy (buy and hold). So, let’s compare two scenarios with the same capital over a five-year period.
Investor A is considering purchasing a property with the 100k he has saved. He is contemplating purchasing two x 300k properties or one x 600k property. Here are how the numbers would play out given the following:
- Two 300k properties: 7% yield and 5% growth compounded.
- One 600 properties: 5% yield and 7% growth compounded.
Two Properties at 300K
With the 100k, 50k each would be devoted to the 300k purchase price. Both purchases would require LMI, stamp duty, soliciting fees, and building and pest expenses. This would likely equate to about 15k per purchase which would allow for a 10% deposit with additional funds placed into an offset. Thus, after purchasing each property the loan amount would be approximately 265k for each property.
ROI: After 5 years the investor’s two properties are collectively worth 766k with a loan of 450 (after adding the additional 20k of cash-flow after the 5 years). Investor A’s total equity is 316k from his initial 100k investment. This is an annualised ROI of 25.87% over the 5 years.
One Property at 600K
The 100k would be used to purchase a 600k investment. The purchase would require LMI, stamp duty, soliciting fees, and building and pest expenses. This would likely equate to about 35k per purchase which would allow for a 13% deposit. Thus, after purchasing each property the loan amount would be approximately 532k for each property.
ROI: After 5 years the property is worth 841k with a loan of 485k (including the additional funds of 12.5k each year). Investor A’s total equity is 368k from his initial 100k investment. This is an annualised ROI of 29.77% over the 5 years.
So once comparing the two scenarios we can see that the Capital growth play was superior to the cash-flow example. However, each year the investor was required to make additional funds to hold onto the capital growth property. It is important to note that adjusting the annual growth rate and yield will alter the final outcome. Should either investment see varying growth or yield it will obviously impact which approach is optimal.
A Common Misconception
The assumption from the above scenario would suggest that more expensive = more growth and this holds no validity. The price point of a property does not dictate the growth of the investment, the demand for that property underpins the capital growth. Now, it is important to note if cash flow is the focus of an investment, investors will generally be drawn toward cheaper properties and this is because they inherently have greater yields. Though, sometimes focusing on cash flow can ignore numerous metrics which drive demand and in turn drive growth. While having a higher budget for a single property (closer to the national average) would allow the investor to broaden their search and potentially purchase an asset with greater demand. Despite this, investors shouldn’t assume higher property prices lead to a greater percentage of capital growth.
It is possible to purchase investment properties that have a blend of both capital growth and cash flow. Neither entity needs to be thought of exclusively and can be achieved with the right investment approach and strategy. Alternatively, solely buying a capital growth-focused property and a cash-flow property separately can demonstrate a good blend. From an anecdotal perspective, it appears most investors chose to purchase around the 400-600k mark. This would likely provide a balanced combination of growth and cash flow.
Ultimately, your goals and circumstances will dictate your investing approach. When wanting to build wealth in property capital growth is imperative and should be at the forefront of any investor’s plan. Cash flow is necessary to counterbalance expenses and support the foundation of a strong portfolio. Educated investors understand the importance of both growth and cash flow and aim to incorporate both into their investment strategy. Remember, capital growth is what builds the portfolio, but cash flow keeps you in the game.