Cash-flow positive property means your retirement fund benefits from direct income from day one. But are cash-flow positive properties all they’re cracked up to be for SMSF’s?
A cash-flow positive property is generally considered an investment whereby, after the property’s loan repayment (expense) has been deducted from the amount of rent received (income), the landlord has money left over. This differs from a negatively geared property where the loan repayment actually exceeds the rent received and leaves the investor out of pocket each month. Of course, if the investor borrows very little, then loan repayments will always be minimal and the asset will always generate an income. However, in the majority of cases property investment has a high degree of leverage so this shortfall can be quite common.
The face-value question that most people beg to ask is, “why buy an investment that loses money?” Here are some considerations that each investor must think about before choosing a property for their SMSF, as an investment in property is not just about the income.
No doubt, the obvious impact of a negatively geared property is that it costs you money to hold on to it. This statement is felt far more strongly when people equate that to their retirement fund and see their balances being eaten away with no obvious return.
Properties usually always encompass additional expenses as well, such as strata fees, leasing management fees, council rates and water levies. As a guide, these allowances can add an additional 1% of the price of the property to yearly expenses. Add this to the cost of loan repayments and the overall expenses of holding a property can be substantial.
It is important that the investments within your SMSF do not threaten your required draw-down amount that acts as your pension. If your fund can’t sustain liabilities, then a negative gearing strategy may not be for you.
In Australia, when a property loses money (negatively geared), the government allows the investor to deduct this loss from their income before being taxed. Although the investment still loses money, the loss is smaller due to the reduced tax liability you have to pay.
For property within a self-managed fund, this strategy is often disregarded as most people’s income is generated outside the fund. What many people fail to realize though is that your super fund incurs a 15% tax liability on the following items:
- Super Guarantee
- Salary Sacrifice Contributions
- Concessional Contributions
- Investment Earnings (inside the Fund)
Although much less than regular income tax, this 15% liability can be effectively reduced to zero with the right level of guidance from your accountant regarding your levels of debt and leverage.
It is generally accepted that a property investment achieves either a balance of high yields and is positively geared, or has strong capital growth and is negatively geared. They rarely achieve both.
This is one of the biggest proponents against the positive cash flow argument.
Although a high yield, positive cash flow property achieves a net income, strong capital growth equates directly to an increase in equity and will far outpace the net income over the life of the investment, however long.
The issue with capital growth is that it takes time. It is often necessary to be in the market for at least seven to 10 years to go through a full cycle as the market rarely moves consistently. This can be an issue for those investors who may be looking to draw down on their SMSF within that period. If you aren’t prepared to wait or you are approaching a challenging period within your pension phase, then sacrificing equity gains for cash flow may be more appropriate.
Generally riskier investments will attract higher yields, resulting in positive cash flow.
The same can be said for property investing. A higher yielding property is usually only found in regional areas or on the outskirts of capital cities where the risk of owning the underlying asset is much higher than normal. This may be due to a lack of demand in the area due to a lack of infrastructure, population growth or employment. It could also be the result of the damages that the property could incur because it’s in a bad neighbourhood.
Whatever the case, it is important that you evaluate all the risks involved in owning the property to reduce any potential loss in the future.
Pursuing a strategy of positive cash flow over negative gearing undoubtedly has its benefits for those investing in property with their SMSF. A greater need for cash flow from the Fund during Pension Phase may provide an effective leveraging strategy while providing an ongoing source of income.
For those who can weather the ongoing liabilities that a negative gearing strategy holds though, tax efficiencies, lower risk levels and stronger equity growth should amount to substantial financial gains that should far outweigh the ongoing costs of a negative gearing strategy.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.