For as long as people have been investing in property, there have been two distinct schools of thought regarding which is the best way to build a portfolio. In the red corner we’ve had the staunch capital growth supporters, and in the blue we’ve had the cash-flow advocates, led by their captain-in-chief, Robert Kiyosaki. I tend to advocate a more balanced and less dogmatic approach to investing in property, understanding that at different times on one’s journey a more cash-flow focused approach can be more beneficial and vice versa. Put another way, what works for one investor may not work for another, depending on where they are in their investing journey. It’s this key insight that means a black and white, fixed, approach to picking a property strategy may be disingenuous.
Whilst I can understand why some commentators and advisors remain fixated on finding cash-flow above anything else (for one thing it’s an easy sell to a client), it is short-sighted to think that you can build a portfolio that will generate salary replacing income on $20 a week positive cash-flow properties alone. Equally, blindly following growth at all costs can leave investors with such a negative weekly cash-flow that they might struggle to save for anything apart from topping up their portfolio.
However, there is one particular part of an investor’s journey where I believe it’s important to focus on one type of property over another. And that is right when they’re starting out.
A focus on capital growth properties early on is critical
There are two main reasons I focus on helping clients find properties with strong capital growth prospects when they are just starting out. One is to do with mindset, and the other is to do with simple mathematics.
When someone decides to invest in a property, they’ve taken a decision to move forward. They might have had to overcome significant obstacles, beat procrastination, convince a partner or any number of other things. After overcoming all of that, the last thing they want is to purchase a property that sits idle for a long time and doesn’t add meaningfully to their wealth position. If, for a few years, they watch the value of their property tread water, the mind games can kick in and make them more prone to prematurely selling an asset, and therefore delaying their long-term wealth creation. It’s human nature to second guess decisions, and to the degree that they’ve told friends and family about their investing decision, you can bet that others are reminding them about how their property investment is going. On the other hand, if they can experience some solid growth early on, these fears can be allayed and a positive mindset can be developed. It’s been proven time and again that small wins are a really important predictor of future success. Having early wins in property investing, via capital growth, is no different.
The second reason is more pragmatic. In order to purchase a second or third property, the investor either needs to have saved up enough for another deposit, or be able to tap equity from another source. Having a property that has grown in value enough to provide for these deposits, or at least part of it, is a key part of the early stages of developing a property portfolio. If you’re a big earner, it’s not as much of a concern. For the rest of us however, it’s an important step in the process.
By way of illustration, if we take a $400,000 property that grows at 7% per year (with a 4% yield) vs a $400,000 property that grows at 4% (with a strong 7% yield), the difference in capital value after 5 years is over $74,000 in favour of the former. Servicing allowing, that provides the 20% deposit and purchase costs for an additional $300,000 investment property that would otherwise require savings or another source of funds. Whilst there are cash-flow benefits that accrue from investing in the latter property, if an investor is able to target a property like the higher-growth example, they are more likely to be able to generate a deposit to invest in a second property. It’s true that banks look favourably on properties that are ‘washing their own face’, but in reality, if you don’t have a deposit for a second property, then the bank are unlikely to be willing to fund another purchase anyway.
So, just focus on capital growth then?
I advocate for investors to build balanced portfolios that have a healthy mix of capital growth focused properties and some that are purchased to add some income to a portfolio. However, it’s worth noting that even though we’re focusing on capital growth early on, we’re not ignoring cash-flow. The idea is to first find areas that have all the requisite growth drivers in place, and then overlay this with a cash flow story. Some areas can have great growth prospects, but at a very low yield. We’re more interested in areas that are poised for growth, but also have decent yield. This might mean there’s negative gearing to start with, but over time it’s generally the case that these properties become cash-flow positive. That’s certainly been the case with my own portfolio. Properties that I bought early on are now producing significant weekly positive cash flow, without me paying down any debt on them. Down the line investors can look to add cash-flow to the mix. Commercial property can have a role to play here, and can be particularly interesting for investors who have built up a significant equity position via residential property.
At the end of the day, it all comes down to what an investor is looking to achieve from their investing and how they look to structure their portfolio. One approach taken by many investors is to pay down debt as they enter the consolidation phase of their portfolio. Having high growth properties that are purchased early on in the portfolio are more likely to be properties that could later be sold to release funds to help pay down debt on other properties, and thus increase cash-flow.
In future blog posts I’ll explore the other key stages necessary to build a long-term, income producing, property portfolio. For now however, the key take away is to recognise that without a solid foundation of properties that are appreciating in value, creating a lasting property portfolio becomes very difficult indeed.
Please note: the above information and analysis does not constitute financial advice in any way, and it should not be relied upon. It’s important that you seek guidance from licensed professionals, who can provide advice based on your individual needs. No investment decision or activity should be undertaken on the basis of this information without first seeking qualified and professional advice.
