Cash Flow Mortgage

[Bazza]

It is generally accepted knowledge that in Australia a high growth residential investment property will cause negative cash flow for the property investor, this is due to the fact that the rental is about 4% and interest is above 7%, and most property investors would leverage around 80% or more. It’s not hard to see why cash flow will be negative.

The Cash Flow Mortgage™ is a 30 year investment mortgage. Its real benefit is in the first 5 years which is the most difficult 5 years for most property investors when they purchase an investment property.

Let’s say you’re supposed to pay 7.95% interest for the mortgage, but instead of paying the same rate every year, you can start with 3.7% the 1st year, 4.95% the 2nd year, etc, and the interest you haven’t paid will be delayed to future years when the rent becomes higher resulting in positive cash flow.

Full details are at http://www.cashflowmortgage.com.au/cash_flow.html

Since it's difficult to find (or create) CF+ property this may be a good idea if you want to increase the number of properties that you can hold without DSR issues - which is the brick wall most of us will eventually hit. Obviously, delaying interest payment means that you will be paying interest on interest.

Has anyone used this strategy? What are the Pros & Cons?

Cheers,

Bazza

 

[Nullagine]

It is generally accepted knowledge that in Australia a high growth residential investment property will cause negative cash flow for the property investor, this is due to the fact that the rental is about 4% and interest is above 7%, and most property investors would leverage around 80% or more. It’s not hard to see why cash flow will be negative.

The Cash Flow Mortgage™ is a 30 year investment mortgage. Its real benefit is in the first 5 years which is the most difficult 5 years for most property investors when they purchase an investment property.

Let’s say you’re supposed to pay 7.95% interest for the mortgage, but instead of paying the same rate every year, you can start with 3.7% the 1st year, 4.95% the 2nd year, etc, and the interest you haven’t paid will be delayed to future years when the rent becomes higher resulting in positive cash flow.

Full details are at http://www.cashflowmortgage.com.au/cash_flow.html

Since it's difficult to find (or create) CF+ property this may be a good idea if you want to increase the number of properties that you can hold without DSR issues - which is the brick wall most of us will eventually hit. Obviously, delaying interest payment means that you will be paying interest on interest.

Has anyone used this strategy? What are the Pros & Cons?

Cheers,

Bazza

I suggest you answer by estimating the Net Present Value. Here is a simple example:
http://www.meadinkent.co.uk/excel_npv.htm

Be careful that you do not discount the initial (up front) investment. You want an NPV greater than nought and by a significant margin.

With net yields very low, capital growth is crucial.

 

[alexlee]

It is generally accepted knowledge that in Australia a high growth residential investment property will cause negative cash flow for the property investor, this is due to the fact that the rental is about 4% and interest is above 7%, and most property investors would leverage around 80% or more. It’s not hard to see why cash flow will be negative.

That has only been for the last few years, you realise. Not long ago you could find cashflow neutral and +ve properties in the capital cities. Negative cashflow investing requires that your capital gains more than offsets your losses. That can't, and won't happen smoothly. More likely, you'll hit a period when yields just go too low and enough people stop believing, and capital gains slow down or stop. As prices stagnate and rents increase, the yields move up again.

It's NOT generally accepted knowledge. At least, it won't be for anyone who has been investing for more than 5 years.
Alex

 

[cougar_01]

5yrs +

What is the interest rate after 5 years?
and does anyone know what the break costs are?

 

[Melbear]

What is the interest rate after 5 years?
and does anyone know what the break costs are?

I belive that costs are huge for this loan - both in and out. Plus you're capitalising your interest rate at a higher rate.

 

[Goyco]

That has only been for the last few years, you realise. Not long ago you could find cashflow neutral and +ve properties in the capital cities. Negative cashflow investing requires that your capital gains more than offsets your losses. That can't, and won't happen smoothly. More likely, you'll hit a period when yields just go too low and enough people stop believing, and capital gains slow down or stop. As prices stagnate and rents increase, the yields move up again.

It's NOT generally accepted knowledge. At least, it won't be for anyone who has been investing for more than 5 years.
Alex

Alex

IMO that is where we are now. I'm expecting CG to stagnate for a while as yields improve.

cheers

 

[alexlee]

The greatest concern I have with this sort of mortgage (lower initial interest rate, extra amounts capitalised into the loan) is that people will be seduced into taking more debt than is prudent at that stage of the cycle. I don't believe we've had a paradigm shift to 4% yields. I think it's a sign of a market where prices have moved way above underlying rents. Using this sort of loan makes people think that it's perfectly ok to buy a property on <4% yields and they're more likely to max themselves out at precisely the stage of the cycle when investors, especially newbies, should be more careful.

If you go crazy taking these loans because they'll give you neutral cashflow, but end up buying at a point when the market is overpriced...... property can and does fall during the short term.
Alex

 

[alexlee]

Alex

IMO that is where we are now. I'm expecting CG to stagnate for a while as yields improve.

That's what I think too, but using this sort of interest capitalisation mortgage would blind people (especially newbies) to this. They'll just think 'oh, everything will be fine if I just start with cashflow neutral'. That is true if it's a normal loan (and that's only assuming interest rates don't jump up). With interest capitalisation that's a whole different situation.
Alex

 

[Peter_Tersteeg]

At year 5, the rate would be 0.5% to 2.0% higher than the variable rate might normally be. From about year 3 or 4, these loans are very expensive.

The strategy promoted by proponents of these products is to refinance the loan into another cashflow mortgage at about year 3, thus reducing the interest rate again.

This is fine as long as the growth of the property outstrips the capitalising of the loan, and any negative gearing shortfalls. What most proponents don't address is what happens when there's a 2-3 year slump.

I beleive cashflow mortgages in a rolling strategy can be an ultimate recipie for disaster.

I do see a place for them in a balanced portfolio. In a case where you're buidling a portfolio conventionally, you may come across an excellent opportunity but not be in a cashflow position to afford it at the at point. In this case, a cashflow mortgage may allow you to purchase that property and hold it for a period of time.

In the meantime your rents in the rest of your portfolio increase and you get into a position where you can move from the cashflow mortgage into a more conventional loan.

 

[alexlee]

Not that it's the same thing, but the US mortgage brokers who touted 2/28 and 3/27 option ARMs (essentially variable rate mortgages that have VERY high spreads to LIBOR And initially low payments with interest capitalised) made similar claims. i.e. people could, before the payments started adjusting upwards, refinance and avoid the higher rates.

Unfortunately, of course........... it didn't turn out that way.

That is my main concern with people using these products. They start thinking that 4% yields are normal. They're not, or we certainly haven't had enough years of it for me to believe it's really a paradigm shift.

In the hands of an experienced investor, it may have its uses. But that's the case with a lot of these exotic products. A very shap knife is great in the hands of a master chef. In the hands of an amateur, there will be lost fingers.
Alex

 

[ianvestor]

In some circumstances you can simulate the Cashflow Mortgate (tm) without using Investors Direct.

This is because the highest LVR they offer is 80% which then grows with time.

So let's say you had that 20% deposit needed, but instead of putting in that 20% deposit, you could put in 5% (or even 3%), pay your LMI and borrow 95%-97%, then place the rest of your deposit into an account which is then used to dip into a little bit to help with each mortgage payment, thereby making payments as easy as if you had the lower repayments of the Cashflow Mortgage (tm).

The reason I say in some circumstances is obviously because you can't always get a 95% or 97% loan.

 

[Peter_Tersteeg]

ianvestor you're spot on. Using careful cashflow management, you can do the same thing yourself. It will also be significantly cheaper than anything else on the market. BTW investors direct are not the only ones who offer a cashflow mortgage, they simply have re-branded that of one of the lenders (White labeling is quite common these days).

Alexlee I agree completely. Like just about every other out of the box product (think equity share loans), there's a use for them, but many use these as an ongoing strategy rather than something with an exit strategy.

 

[Bazza]

I do see a place for them in a balanced portfolio. In a case where you're buidling a portfolio conventionally, you may come across an excellent opportunity but not be in a cashflow position to afford it at the at point. In this case, a cashflow mortgage may allow you to purchase that property and hold it for a period of time.

I agree totally with Alex that it is a dangerous strategy but I was thinking more like BT_Bear if your DSR is a little down and you do come across a good opportunity then it is an option.

In some circumstances you can simulate the Cashflow Mortgate (tm) without using Investors Direct.

This is because the highest LVR they offer is 80% which then grows with time.

So let's say you had that 20% deposit needed, but instead of putting in that 20% deposit, you could put in 5% (or even 3%), pay your LMI and borrow 95%-97%, then place the rest of your deposit into an account which is then used to dip into a little bit to help with each mortgage payment, thereby making payments as easy as if you had the lower repayments of the Cashflow Mortgage (tm).

The reason I say in some circumstances is obviously because you can't always get a 95% or 97% loan.

Good idea Ian. I will keep that in mind.

Cheers,

Bazza

 

[casper007]

Can't you pretty much create your own version of this loan by setting up a LOC against your PPOR and using it to capitalise the short fall payments on your investment loan.

As this LOC would only be used for the investment prop ... then the interest paid would also be tax deductable therefore giving you a cashflow neutral situation.

I agree with Alex though ... this can give you a sense of false security especially if the CG is not there and yet your debt keeps increasing ... but long term (if you buy right to start with) this could work.

 

[alexlee]

It is generally accepted knowledge that in Australia a high growth residential investment property will cause negative cash flow for the property investor, this is due to the fact that the rental is about 4% and interest is above 7%, and most property investors would leverage around 80% or more. It’s not hard to see why cash flow will be negative.

This is a VERY dangerous line of thought. Why is it generally accepted knowledge? When did this become generally accepted knowledge? Why is 4% rent the 'new' normal state of affairs? Only a few years ago positive cashflow was available. Sure cashflow is negative NOW, but will it continue to be? Think about how cashflow might increase: lower prices and/or higher rents. Most likely both at the same time. If you buy an IP with a low yield (because you think it's a 'new paradigm' and you have a product that lets you do it), will it mean you buy into the top of the market and then suffer years of price falls?

I agree with Alex though ... this can give you a sense of false security especially if the CG is not there and yet your debt keeps increasing ... but long term (if you buy right to start with) this could work.

I’d question even that. I start from the idea that all property goes up at roughly the same rate over time (7-10% a year, I use 7.2%). So if you buy something with a lower yield, there is both the cashflow AND the opportunity cost (simply, I can buy, for example, $500k of property yielding 5% but only $350k if it yields 3.5% - numbers for illustration only). You’d have to find a property that outperforms over the long term, and you run the risk that you’re wrong.
Alex

 

[alexlee]

Can I see a situation where a cashflow mortgage product might be useful? Yes. If you have a plan to value add quickly, and have the experience to do so. I certainly wouldn't be using it for buy and holds. More because of the moral hazard.
Alex

 

[Bazza]

This is a VERY dangerous line of thought. Why is it generally accepted knowledge? When did this become generally accepted knowledge? Why is 4% rent the 'new' normal state of affairs? Only a few years ago positive cashflow was available. Sure cashflow is negative NOW, but will it continue to be? Think about how cashflow might increase: lower prices and/or higher rents. Most likely both at the same time. If you buy an IP with a low yield (because you think it's a 'new paradigm' and you have a product that lets you do it), will it mean you buy into the top of the market and then suffer years of price falls?



I’d question even that. I start from the idea that all property goes up at roughly the same rate over time (7-10% a year, I use 7.2%). So if you buy something with a lower yield, there is both the cashflow AND the opportunity cost (simply, I can buy, for example, $500k of property yielding 5% but only $350k if it yields 3.5% - numbers for illustration only). You’d have to find a property that outperforms over the long term, and you run the risk that you’re wrong.
Alex

Here's a scenario Alex.

If I could pick up an old waterfront in need of a reno (which I have seen before) for say $600k but can only get $400 pw rent due to the condition which is 3.5% yield. My current DSR won't allow more borrowing but I could set up a LOC to cover the shortfall.

I know this waterfront will skyrocket in a few years (which they keep doing) won't it be worth taking advantage of this opportunity now?

Cheers,

Bazza

 

[alexlee]

Here's a scenario Alex.

If I could pick up an old waterfront in need of a reno (which I have seen before) for say $600k but can only get $400 pw rent due to the condition which is 3.5% yield. My current DSR won't allow more borrowing but I could set up a LOC to cover the shortfall.

I know this waterfront will skyrocket in a few years (which they keep doing) won't it be worth taking advantage of this opportunity now?

IF the thing skyrockets. And here is where the experience comes in. If you have the experience to be able to 'see' that (and if you have the experience you should also have the resources to make up the negative cashflow, anyway). If the market turns down (as it does, every so often), you're stuck. Fine if you have the resources to hold it through a downturn, though.

Not a product I would recommend for newbies with no safety net. The problem with a newbie following the 'it's common knowledge that property investing will be cashflow -ve' line of thought is that they apply it to EVERYTHING. They will apply it to any property and just accept that the yield is 4%.
Alex

 

[Bazza]

This is a VERY dangerous line of thought. Why is it generally accepted knowledge? When did this become generally accepted knowledge? Why is 4% rent the 'new' normal state of affairs? Only a few years ago positive cashflow was available. Sure cashflow is negative NOW, but will it continue to be? Think about how cashflow might increase: lower prices and/or higher rents. Most likely both at the same time. If you buy an IP with a low yield (because you think it's a 'new paradigm' and you have a product that lets you do it), will it mean you buy into the top of the market and then suffer years of price falls?

Hi Alex,

I'm just reading Michael Yardney's book - How to grow a multi-million dollar property portfolio (by the way and excellent read - I recommend it) and he says on page 50:
" Over the long term, good property investments tend to deliver a combined return of around 14% pa when you take into account capital growth and yield. This means that if a property has 10% capital growth pa it will give you a rental return of about 4%."

May be everyone else is wrong?

Cheers,

Bazza

 

[alexlee]

I'm just reading Michael Yardney's book - How to grow a multi-million dollar property portfolio (by the way and excellent read - I recommend it) and he says on page 50:
" Over the long term, good property investments tend to deliver a combined return of around 14% pa when you take into account capital growth and yield. This means that if a property has 10% capital growth pa it will give you a rental return of about 4%."

I’ve read it too.

Over the long term, those numbers are probably right. But the problem for newbies, without much financial resources, is survival in the short term. If you can’t survive the short term, the long term is meaningless.

My concern with newbies using cashflow mortgage type products is that they’re more likely to overpay because they think they can afford more, and will base their cashflow on the lower rate. Then when the rates go back to normal, and if markets hit a snag right about then…… Time it right, and they’ll make a lot more because they have more exposure. Time it badly……

Look, I think experienced investors can use cashflow mortgages relatively safely. However, part of the problem they’re having in the US with those option ARMs is that newbies expected property prices to rise by the time their loans started resetting, and never budgeted for increased rates. Tell an 'ordinary person' that you have a product with an interest rate of 4%, resetting to 8% in 5 years. Will they understand the risks? Will they actually budget for the 8% interest in 5 years, or just focus on the 4%? Look at how most people respond to those ‘x months interest free’ ads for furniture and electronics.

I don’t believe 4% yields are normal, or that they will continue to be that low. Would you have wanted to be maxed out on cashflow mortgage-type products in the late 80s or early 90s?

All I'm saying is that a cashflow mortgage-type product is fundamentally a more risky product than a normal mortgage. It has its uses, but more for people who know what to do with them. Put it in the hands of someone who doesn't understand the risks, and it can be a problem. In a lesser way, we use IO loans to great effect as investors. If it was someone who can't save money and doesn't know how to manage finances, I would suggest a P&I loan, and get them to start off with higher payments.
Alex