Do I invest for Cash Flow or to Grow my Portfolio ?

WHICH IS BETTER, CASH FLOW or CAPITAL GROWTH???

There has been a war going on out there between the two camps of property experts since day one of property investment:

Cash Flow vs Capital Gain.

According to the law of nature "anything that doesn't serve a purpose will cease to exist".

The fact that we have enough people arguing about the two clearly indicates that they both still exist, and hence serve a purpose!

LET'S START WITH SOME ARGUMENTS IN FAVOUR OF THE CAPITAL GAIN:
I have done some careful analysis over a 20 year period of purchasing the same amount of properties in Cash Flow and Capital Gain categories. Here are the parameters I've included in my calculations:

· No borrowings, so there is no negative gearing benefit in the picture;

· Surplus cash flow after paying tax will be reinvested to get a 10% per annum return;

· Every time we have surplus cash flow, either through rent or re-investment, we'll be paying 30% income tax (assuming the investor is of average income);

· Net Worth is calculated assuming Capital Gain Tax and Income Tax are both paid.

Year Capital Gain Property Cash Flow Property Growth Rent Net Worth Growth Rent Net Worth 10% 4% 4% 10% 1 $300,000 $12,000 $308,400 $300,000 $30,000 $321,000 2 $330,000 $13,200 $336,708 $312,000 $31,200 $346,410 3 $363,000 $14,520 $375,809 $324,480 $32,448 $372,789 4 $399,300 $15,972 $412,725 $337,459 $33,746 $395,488 5 $439,230 $17,569 $452,450 $350,958 $35,096 $416,890 6 $483,153 $19,326 $495,469 $364,996 $36,500 $437,450 7 $531,468 $21,259 $542,267 $379,596 $37,960 $457,524 8 $584,615 $23,385 $593,341 $394,780 $39,478 $477,396 9 $643,077 $25,723 $649,214 $410,571 $41,057 $497,286 10 $707,384 $28,295 $710,434 $426,994 $42,699 $517,376 11 $778,123 $31,125 $777,593 $444,073 $44,407 $537,810 12 $855,935 $34,237 $851,326 $461,836 $46,184 $558,707 13 $941,529 $37,661 $932,324 $480,310 $48,031 $580,167 14 $1,035,681 $41,427 $1,021,337 $499,522 $49,952 $602,276 15 $1,139,250 $45,570 $1,119,187 $519,503 $51,950 $625,108 16 $1,253,174 $50,127 $1,226,773 $540,283 $54,028 $648,729 17 $1,378,492 $55,140 $1,345,078 $561,894 $56,189 $673,199 18 $1,516,341 $60,654 $1,475,185 $584,370 $58,437 $698,574 19 $1,667,975 $66,719 $1,618,279 $607,745 $60,774 $724,907 20 $1,834,773 $73,391 $1,775,666 $632,055 $63,205 $752,250

It's obvious that a typical Capital Gain property will build more net worth for an investor than a typical Cash Flow property after a few years of holding.

There are two more parameters that can also affect the picture here:

· Tax benefit's: if the investor decided to borrow enough finance so that the interest repayment is higher than the rental income (for Capital Gain property), then the investor gets a subsidy (called negative gearing benefit) from the tax man, and it will make the Capital Gain property category look even more attractive in terms of net worth building.

· Finance: to be able to purchase more properties, you need to have equity. Capital gain properties generate equity faster, although some parts of it will be Capital Gain Tax when the property is sold, until then; the investor is free to use the equity to purchase the next property.

Some people might say that you need income to service debt, if you keep building net worth with little income, how can you borrow more money?

The answer is that "high net worth individuals never have a problem borrowing money", there are lenders that will lend you the money as long as you have asset (called asset lend or equity based lending). Think of it this way: if your future income (you think you might still have) can service debt, why can't you mentally put aside a lump sum of money (you definitely know you already have as part of your net worth) from the beginning to service debt?

Some property investors argue that how can an asset increase in value if there is little cash flow? There are plenty of investments that don't generate a cash flow but increase in value, such as painting, vacant block of land, etc.

Why is the cash flow of an asset is not necessarily linked to the value of the asset? The majority of the Australian home owners purchase residential properties to live in, not to generate a cash flow and property investors are taking a ride with the home owners as the home owners predominately drive up the value of residential properties due to the scarcity of land.

It's very obvious that Capital Gain properties rely on Capital Gain, the strategy wouldn't work if you select properties with no future growth. Although well selected residential properties have demonstrated an average 10% compound growth in the last few decades through a few property cycles, it still doesn't seem to convince some investors that well selected properties will continue their historical performance. For most people, the threat of the disaster seems to be more real than the disaster itself.

Asset selection experience, mature investment psychology, reasonable financial resources and discipline are required to execute this strategy. In other words, this strategy is not for the majority.

SO WHAT'S GOOD ABOUT CASH FLOW PROPERTY THEN?

Cash flow property puts money in your pocket from day one! The feeling of making some money sometimes is more important than the actual amount you're making.

I have experienced first hand a lot of property investors just couldn't comprehend that losing cash flow can build more net worth in longer term, some would argue that the capital gain might never come, money in my pocket today, as little as it might be, is better than tomorrow.

Cash Flow properties sometimes can have tremendous capital gain as well; some investors naively believe that some assets can forever enjoy both high yield and high capital gain. Due to a long period of underperformance in some area, some of the cash flow properties have exceptionally high yield (>12% for the current market), the scarcity of the high yield (not the land) can drive the value up temporarily due to strong demand, until the yield becomes average again, then the capital gain will be slow just like any other Cash Flow properties.

Many people would like to invest in Cash Flow properties, the main reasons are:

· Concern that capital gain might never be there - I will at least hang on to my cash flow;

· Lack of sufficient finance resource to cover negative cash flow for a few years until it turns neutral;

· The thought of negative cash flow makes me sick - I might not live to enjoy my wealth;

· Believe only income can service debt - can't get used to the idea of debt servicing debt;

· I feel good about seeing some money coming in at the end of each month - that feeling means more money than the money I actually make;

· I just want to have passive income, what's the good of high net worth? - don't believe that there are ways net worth can be converted into cash flow;

· I want to get in Cash Flow properties while the yield is exceptionally high, and hopefully enough people will come to the area to buy up the price (not hard to do for a small town:), so that I can get out with my Capital Gain. In other words, I'm using Cash Flow as an illusion to make my Capital Gain!

Anyone with the above psychology and financial position really has two options: one is to invest in Cash Flow property, the other is not to invest at all. Capital Gain property is definitely not suitable for them.

Cash Flow properties have lower risk, but also lower return, this strategy has a much wider appeal to the general investors market. It doesn't take much knowledge & psychology to interpret the rental income, as long as you don't buy properties that will need a lot of repairs, you can comfortably enjoy the cash flow every month.

CONCLUSION:
We all started investing for getting passive income that we can retire on one day, building immediate cash flow is an obvious way to get there, and building net worth first is just another less obvious way for some that are ready for it.

It is not which strategy that is better between Cash Flow and Capital Gain; it's which strategy fits your current psychology & financial position the best.

Cash Flow property camp is always much bigger than the Capital Gain camp, much the same as there are more students in high schools than universities. For the teachers (experts in each camp), there is absolutely nothing wrong with people going to high school first before they go to university, there is also absolutely nothing wrong with some people that may never want to go to university and still live a fulfilled and happy life. As a matter of fact, people don't even have to go to high school if they don't want to (although highly recommended)! It is also common sense to know that it takes very different skills to teach high school and university,

they are both challenging jobs if you want to get it right.

On the right hand side is the property hierarchy, the higher you go, the higher risk you take, and hence the potential higher return which also requires better financial position, more experience and more mature psychology, etc.

For the investor readers: your best strategy is always the one that is suitable for your current situation. Your strategy should change according to your current situation.

Here is my two cents for all the participating experts in the two camps: even if you agree with me that there is no need to take side anymore, you can accept the other camp a lot better now. I would then suggest you take one side that you're most comfortable with, and pretend to fight the other side like you really mean it.

Here is why: the fact that you believe in something so strongly can influence people around you, and it will make you a leader in something. Most people follow someone who has the strongest belief, sometimes it doesn't even matter what that belief is, and you will always have an equal number of people support and challenge you on everything you do anyway.

At the end of the day, Right and Wrong are the labels we put on things based on our own value systems. We may all have different value systems, but no one has "better" value systems. Hence there is no right or wrong in any anything you do, you might as well pick something you would do with passion, at least that way you feel like you live for something!

Life is really like a game, you almost have to take side if you really want to play, as long as you remember that you are the one who created the game in the first place, and then you won't take winning or losing too personally.

I've been asked many times before: "Which side do you take - Capital Gain or Cash Flow?" What a silly question! Of course I'm on your side!

This article was contributed by Bill Zheng, Principal of Investors Direct Financial Group.