It’s the first question property investors should ask themselves: am I looking for a positive cash flow property, or is negative gearing the way I want to go?
What is a positive cash flow?
It’s the safer, more conservative option.
Add up your expenses like interest, maintenance, rates, and insurance. If your rent is more than you pay out, you’re generating positive cash flow.
Advantages of positive cash flow
Having a positive cash flow means you’re likely to be making a profit from day one. It'll give you a higher income which you can start putting aside for another deposit—and thus build up your portfolio. Or you might opt to use the positive cash flow to pay down your principal.
Disadvantages of positive cash flow
The main disadvantage is that because you're receiving extra income, you'll have to pay more tax.
If you’d like to learn more read this positive cash flow case study.
How yield affects cash flow
Yield is the percentage figure of your gross annual rent, divided by your investment property’s purchase price (note: this doesn't take into account costs like rates and fees.) Divide Chris's gross annual rent of $24,000 by his apartment's purchase price of $425,000, and you have a yield of 5.64%.
As a general rule, the higher your yield, the more likely it is you’ll have a cash flow positive property. As The Successful Investor's Michael Sloan stresses again and again, it's crucial you crunch the numbers prior to buying.
Property prices in Australia are at historic highs (relative to rents), which means yields are at a low ebb.
What is negative gearing?
A negatively geared property is one where the cost of owning a property is more than the income it generates. Because this strategy is predicated it on making a loss, it can seem risky. However, you can deduct this loss from your taxable income.
Advantages of negative gearing
While you’re making a loss, your property’s capital value is (hopefully) growing. Negatively geared investors are banking that this loss will be offset by their property's potential capital appreciation. Just remember there may be tax implications like capital gains tax that you’ll need to factor in when you sell.
Saving tax shouldn't be the sole reason for choosing an investment strategy. But nor should you ignore the tax benefits associated with negative gearing.
Disadvantages of negative gearing
You have cover the losses yourself before tax time each year, so you’ll need enough cash flow to tide you over. Plus, running properties at a loss can make it harder to build a portfolio.
Lastly, if you’re more highly geared—if you're deeply in debt—you'll be vulnerable to rate rises.
If you’d like an example of how this works, read this negative gearing case study.
Choosing to negatively gear
Before you negatively gear a property, work out if you can support the ongoing out-of-pocket expenses. If rates go up, you can’t offset this by just increasing your rent and you don’t want to have to sell your investment property before any capital growth kicks in.
Get help from the experts
Always speak to a professional—to an accountant or financial adviser—before you settle on an investment strategy.