So, if I was following that strategy I would be looking at the positive cashflow property not in terms of how much it can deliver into my hands each week, but what it can deliver back towards paying off or paying for my other growth properties. - Kevin post #6
Sorry for the late reply, Kevin. I think we all agree that growth property is the way to long-term wealth for passive investors. To maximise your wealth will require you to continue getting loans to buy more growth property. Continually buying negative geared property, however, will prevent you from maximising your borrowings because of your poor serviceability. So at some point you may have to add some positive cashflow/low growth property.
I personally would not sacrifice growth for cashflow as Darren is suggesting because, as you pointed out Kevin, the net return of the cashflow property versus the growth property over ten years is too poor. If the cashflow property were to grow at the same rate as inflation ie 2% then the deal might be acceptable. Growth would be approx $22,000, net equity would be $32,000 to go with the $50 per week ($26,000 over 10 years) after-tax cashflow which could be re-invested to pay down other loans. The use of the extra cashflow then has value above monetary value because it is both improving your LVR and serviceability. Improving these two factors will enhance your ability to borrow more for further acquisitions.
In the future, I hope to develop a spreadsheet which will allow people to experiment with property purchases that have different cashflow scenarios - both negative and positive and show the impact to their overall LVR and DSR which in large part determines their borrowing capacity and, therefore, the value and timing of their next property purchase. People often ask how many properties are required to achieve a particular equity goal that can be converted one way or another into retirement income. I hope the spreadsheet will answer that difficult question reasonably well.
I am, nonetheless, a little confused. My "simplistic" mental calculation said a $100K property growing at 8% is delivering $8000 of increased equity each year. The PIA figures show a holding cost of $9 per week for the first few years, or $39 per month. $8000 pa growth is $154 per week. Subtract $39 (holding cost) from $154 (equity increase) you get $115 per week "nett equity increase".
So how does receiving $42 after tax in your hand compare to getting $115 per week as an equity increase?
In hindsight, IRR by itself is not an effective way of comparing "apples and oranges" ie growth and cashflow properties. I believe it is better utelised in comparing properties with similar cashflow characteristics. The NPV shows in todays dollars what the combined equity and cash return is for the two properties. After tax, you would have two or three times more equity after ten years with the growth property.
I asked Ian Somers to comment on using IRR to compare growth and cashflow properties. He has kindly agreed to let me post his thoughts here.
Quote - Its a very good question, but its not a simple one and I don't think that there is a simple answer.
Certainly the IRR is a very good measure of rate of return on a series of cash flows, and your analysis does provide a comparison of two sets of parameters that produce "equally good" cash flow series. Both have an equal initial investment, but from there the trajectories are quite different and you have to be a little careful with how the IRR (& NPV) formulae treat "dividends" as opposed to "investments" in the cash flow series. e.g. what if the dividends were reinvested? Note how the IRR varies (Graphics/IRR) in different trajectories for the two properties. The high growth property gains a lot of tax benefits compared to the other, and these of course, diminish over time.
A more realistic assessment would be to compare how quickly you can reach a pre-defined net wealth using the different property types (and even then what happens in reality is that you probably end up with a mixture anyway). In so doing, you would use whatever resources you had available at any point in time to continue to purchase properties of that type while ever the banks would continue to lend you the money. With high growth properties, the limiting factor will be servicing the debt (DSR's too high) while with high yield properties, it will be the equity which will be limiting (LVR's too high). To keep it realistic, any excess cash should be used to reduce debt (i.e. credit line model in the Wealth Builder).
Sounds a bit complicated? Well in fact you can do just this in the Wealth Builder spreadsheet and even use the "Maximise Wealth Builder" function to have the software do it for you. It is one of the exercises in the workshops Jan & I have been doing around Australia. Our conclusion is that each type can be equally effective at building wealth. Positive cash flow properties simply mean that you end up with a larger number of properties, you have to manage a larger debt on the way, you are less dependent on property growth, you are more vulnerable to rental vacancies and your build up in equity is based on mortgage reduction more than property growth.
Hope this helps.
Regards, Ian
