What’s the difference between gearing and cash flow?

In the last post, we looked at the buzzword ‘negative gearing‘ (where the interest you are paying on the loan is more than the income), and why positive gearing (where your income is more than the interest) can be more attractive. But for anyone looking to retire early, or have the financial freedom to quit their job, pursue creativity, or raise a family, the concept of cash flow is perhaps even more important to know about than gearing. And it’s something we all need to know about – not just investors.

According to Investopedia, ‘cash flow’ refers to ‘the net amount of cash and cash-equivalents moving into and out of a business.’

But cash flow is important for individuals and households too, not just businesses.

Like gearing, ‘cash flow’ comes in positive, neutral, and negative variants:

  1. Positive where your income is higher than your expenses.
  2. Neutral where your income is the same as your expenses.
  3. Negative where your expenses are higher than your income.

Positive cash flow at home

Let’s start with a simple example – your household budget.

  • If your weekly household income is $1,000, and you spend $900 and save $100, you have a positive cash flow of $100.
  • If you spent all $1,000 each week, you’d have a neutral cash flow.
  • But if you were to spend all $1,000, plus $100 extra on your credit card, you’d have a negative cash flow of $100.

Positive cash flow investments

When it comes to talking about investment properties, the same principles apply.

  • If your investment property earns $500 a week in rent, and you spend $300 on interest, insurance, management fees, repairs, rates etc. then you have a positive cash flow of $100.
  • If you spend all $500 on interest and other expenses, then you have a neutral cash flow.
  • But if your investment property were to cost you over $500 per week in interest and other expenses, then it will be a negative cash flow property.

Positive gearing vs. positive cash flow

I first came across positive cash flow properties vs. positively geared properties in Margaret Lomas’ book ‘The Truth About Positive Cash Flow Property’.

It is important to consider both the gearing and cash flow status of any potential investment, as you cannot assume that a positively geared property will make you money.

To take an example from the last post, you might receive $2,500 a month in rent, and pay $2,000 per month in interest. This would make it a positively geared property.

However, if you had to pay $60 per month in insurance, $50 per month for water rates, $100 per month for council rates, $250 per month for management, $20 averaged out for tax advice, and $50 on average for repairs and replacements of items damaged by wear and tear and not covered by insurance, that’s a total cost of $530. Combined with the interest costs of $2,000, your property would actually providing negative cash flow of $30 a month, even though positively geared.

Cash Flow Example

Of course, many of these costs may be tax deductible depending on where you live and your circumstances, which may mean that, at the end of the tax year, the property turns out to provide a neutral or even positive cash flow after all. But the lesson remains – positive gearing does not always equal positive cash flow.

If you are looking for a property – or any investment – that will provide you with an income, it is important to calculate the cash flow.

Why would you want a positive cash flow property?

  • It’s safer and more conservative
  • You get to make a profit from day one
  • You can use this money to buy more properties, or pay down the capital on your existing one(s)

The only negative, according to the National Australia Bank, is that “because you’re receiving extra income, you’ll have to pay more tax.”

Sounds like a pretty decent trade off to me!

Why would you want a negative cash flow property?

A property which has a negative cash flow is often a result of the cost of the interest. When the interest is more than the income on an investment, this means it is negatively geared. According to the NAB, the main advantage of a negatively geared (and hence, negative cash flow) property is that 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”. As NAB cautions, however, it is important not to choose an investment strategy on the basis of saving tax alone. Furthermore, there can be other tax implications, like capital gains tax, to consider as well.

The negatives include:

  • You have to cover the costs yourself before tax time each year
  • Running properties at a loss can make it harder to build a property portfolio
  • The more highly geared you are (the more debt you have), the more vulnerable you are to rate increases. (If you have a debt of $400,000, a rate change to 8% will increase your monthly minimum payment on an interest only loan from $2,378 to $2,717. That’s an additional $339 per month you’ll need to find. Had you only borrowed $308,000, the increase would only be $261 per month)

The transition from negative, to neutral – and beyond

A negatively geared property is not necessarily going to be negatively geared – or negative cash flow – forever. As you pay off the property over time, the gearing should approach neutral, and eventually, positive cash flow.

To take an example from our last post, imagine you bought a $440,000 property with a $400,000 loan at 7%. Over a 30 year principal and interest loan, in year 1, you would pay almost $28,000 in interest. This is $5,640 more than the $22,360 rental income.

As you slowly reduce the principal owing, however, the interest will decrease. By year 13, the annual interest will be down to $21,866. This will make the property, at last, positively geared, by $494.

Even better, it’s likely that inflation and increases in the cost of living will have increased rent over this period. So the property may become positively geared far earlier.

This means that even if you took out an interest only loan (and, as a result, were not decreasing the principal and the interest owing each year), the property is likely to become positively geared following rental increases. (Of course, none of this is guaranteed).

However, it may take a while longer for the property to start to have a positive cash flow. Although rental income will hopefully increase over time, and interest hopefully decrease, other expenses – such as management, insurance etc. will likely rise.

Negative cash flow but no gearing?

As a result of these other costs, is possible for an investment property to have negative cash flow for reasons other than interest.

For example, a property which requires many repairs, in area and of a building type which is expensive to insure, with high water and council rates, and with frequent, extended vacancies, or tenants that fail to pay the rent and damage the property, may not make enough income to cover its associated expenses – even if the investor owns the property outright.

Such a property would not be geared at all (as there are no borrowings). But it would still be cash flow negative.

What next?

How's your cash flowIs your household budget positive, neutral or negative in terms of cash flow? Download your free spending plan to find out!

Are you considering an investment property? Download and modify this sample cash flow spreadsheet!

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Today’s featured image is of our most recent rental agreement, a positive cash flow renewed for 2018!

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