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When Cashflow Matters More

Ideally, the rental income that your investment properties produce each month should be more than enough to cover the cost of financing, and the cost of managing and maintaining them.

In the real world, that often isn’t going to happen.

It certainly won’t always happen if you invest in a market where capital growth is very rapid and the rental market hasn’t yet become established. The rental market will eventually be created because of the affordability barrier – but there will be a lag.

Certainly there are circumstances where you might feel it’s fine to subsidise a property for a period of time – this is likely to be the case when you want to take advantage of the extraordinary capital growth in central and east European markets, for example.

Cashflowing in the early years

This is known as cashflowing and is a common part of investment strategy in rapidly rising markets, especially in the early investment years.

But this makes cashflow highly important – you will want to optimise it, even if it is negative initially.

In the UK market at the time of writing we are entering a period of slower capital growth and yields are compressed – some regions have been in this phase for a while now. In this situation, a small increase in yield equals a big impact on profits.

You can’t do a lot about cap growth if you’re already invested, but you can have an impact on a yield.

High capital growth means frequent refinancing and repurchase.

Conversely, weak capital growth means refinancing is restricted and an investor will instead look towards:

(i) Security
(ii) Future refinancing

Yield is therefore much more important, which means active management is vital.

Avoiding cashflow crisis – think like a business

Every business knows that cash flow can make the business or break it. It doesn't matter that a business owns substantial assets, or is owed money – if it can't pay its suppliers and staff when it needs to, then eventually it must take action, or it will go bust.

And to pay its overheads a business needs money coming in all the time; minimally enough to cover all expenses. It also needs a vision of where it is going.

When you build a property portfolio, using finance, the same principles apply.

If you can't keep up the mortgage payments on your property or properties (which should be your biggest outgoing), the lender will take them away from you and you will be a credit pariah for the foreseeable future.

You also need to have a view on where you are going with your investments.

Strong businesses use excess cash flow to acquire new assets that then create additional cash flow.

Likewise as you build a portfolio you should be able to refinance your properties to acquire additional ones that will at least pay for themselves – hopefully with some excess, which again will let you acquire more in the future, or at least provide you with a safety net.

But, as we said earlier, for most property investors this represents an ideal world and at an ideal phase of growth in a market.

While it is wise to think and plan like a business, there is a subtle difference between a business and a property portfolio, and that is that primarily you will be looking for a capital appreciation of the property assets over time – rather than profitable income (as this is taxed at 40%), at least when you start out and begin building the portfolio.

Later you may choose to take more income by paying down the debt, but often this is the beginning of an exit strategy for many and a time when the capital growth is being, or has been realised.

When interest rates are low and property is inexpensive it should be pretty straightforward to buy and then let a property that cover’s your expenses. The sums are easier.

In times when interest rates are increasing or high, then you need to exert some controls over how you acquire, finance and rent your investments.

UK and Eurozone interest rates are rising (although we are still in a relatively low interest rate environment and are almost certainly nearing the top of the cycle in he UK). Property prices (particularly in London, for example) have shot up in the past year.

Certainly the banks will be becoming more cautious.

Irish banks are making their big property players leave cash on deposit before they lend on property.

There are two reasons for this:

• Because property prices have risen astronomically and have compressed yields down to around two per cent; and
• Because they are worried that if the market falls dramatically they will have highly geared clients on their books with 30% less on their balance sheets. i.e. investors near to, or actually in negative equity situations.


When banks cover their backs, so should you!

So, we need to be sensible and do all we can to minimise cashflow shortfall and, if possible turn our investments into cash positive ones. Obviously, this is easier when interest rates are low.

That is why is makes sense to use cashflow positive periods to store cash reserves to take you through the negative times.

Typically, cashflow will be at its least attractive at the start of an investment and will gradually improve over time.

As a rule, for cash flow during the first couple of years, you will be lucky if your rent pays for all your costs. Bear in mind, however, that the amount you have borrowed stays the same and rents will go up and cash flow should catch up with costs in the coming years.

The cash flow will sort itself out eventually – so long as you can put up the rents every year. And a frequent rent increase will mean that you need to keep your property in good condition (i.e. you need to spend reasonable sums maintaining it) over the years.

Right now – in Q2 2007 – we find ourselves, in the UK market at least, in which yields are squeezed, due to slowing capital growth and higher mortgage repayment costs because of higher interest rates. But, crucially, we are almost certainly (nothing 100 per cent certain, of course), but almost certainly at or very near the interest rate cycle peak.

In markets overseas that are of interest because they represent accelerated capital growth, yields will typically be squeezed for the opposite reason – because the cost of capital is cheaper and easier to access, and everyone wants to buy if they possible can afford to do so.

So, the key objective remains – how to increase profits by maximising your yield.

Can you put up the rent up every year?

It is normally stated in a letting contract that the rent will go up with the Retail Price Inflation (RPI) if you are doing a lease extension.

However, some years it can go up a great deal more than that. Other years it might not increase at all.

The biggest influence on rent increase is supply of available property for rent.

If lots of new properties to rent have just appeared next to yours, then increasing rates will be difficult.

Conversely, when the cost of buying property increases too sharply, more people stay renting and so the extra demand often feeds through into higher rents being achieved.

Bear in mind that the increase will be uneven. It is also easier to make larger increases when you change tenant.

Copyright © Property Secrets 2007

“Property Management Secrets”
Reproduced with the permission of Property Secrets.

Further information on this topic can be found in “Property Management Secrets”

For extensive, regularly updated information about UK and Overseas property investment and to purchase this book, go to http://www.propertysecrets.net

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