November 09, 2016
Capital Growth is without a doubt the most important consideration when buying an investment property or growing a portfolio. To understand why, we need to talk about equity and how why it’s such a key to building wealth.
WHAT IS EQUITY AND HOW CAN IT CHANGE EVERYTHING?
Equity is the difference between the value of your property and how much you owe on it. For example, if your home is worth $300,000 and you owe $100,000, you have $200,000 in equity. Put simply, you’d end up with $200,000 if you sold it.
Your equity will increase as you pay off the loan, but it’s expensive and slow because you’re paying for it with cash out of your own pocket. Fortunately, your equity also increases when the property value grows, and this is the way property owners become wealthy.
This increase in the value of your property is called capital growth. If the value increases from $300,000 to $500,000, your equity goes from $200,000 to $400,000 (because you still only owe $100k). You’d now pocket $400,000 instead of $200,000 purely because of the increase in value, and without sinking your own cash into it.
HOW THIS ACCELERATES WEALTH ACCUMULATION
Increasing your equity is the key to adding more and more properties to your portfolio. Why? Because with more equity behind you as security, the banks will lend you more money to buy more properties.
For anyone wanting to own multiple properties and grow their portfolio into a self-funding cash machine for retirement, this is exactly how it happens.
WAIT, ISN’T POSITIVE GEARING MORE IMPORTANT THAN CAPITAL GROWTH?
No, and yes. Let me explain…
Who doesn’t want cash flowing into their bank account each month, right? A property portfolio that is providing positive cash-flow is of course the ‘end-goal’. By the time you retire (or quit your job) to live off your investments, you’ll need a portfolio that is providing a healthy positive cash flow for you to live on.
But first let’s clarify two things about positive gearing…
THE TRUTH ABOUT POSITIVE GEARING
Truth 1: Properties that are cash-flow positive from day 1 are difficult to find. If you insist on a rental yield of 10% or more you will most likely need to invest in a mining area, and these areas bring with them a lot of added risk for the average investor. Mining towns in particular are unstable because they’re often wholly and solely reliant on the success of one industry.
Truth 2: Equity is what makes most properties positively geared. When you think about it, every single investment property you buy could be positively geared from day one if you paid cash for it. But of course not everyone can afford to shell out a few hundred thousand dollars or more in cash, so we have to borrow from the bank. But most properties could and would still be positively geared if you were able to keep the Loan to Value Ratio (LVR) at 50% or under. The majority of investors I know with massivepositive cash-flow portfolios have very low LVRs.
So start thinking about cash-flow as the result of building wealth – not the path to wealth.
HOW TO GENERATE WEALTH MORE QUICKLY
We’ve discussed already how capital growth increases your wealth directly. So how do we capitalise?
- Buy at a discount, then renovate or develop to increase the value and rental yield. This gives you a head start because getting a property $50k under market value allows you to achieve $50k of capital growth on day 1.
- Get hold of multiple properties to multiply the effects of capital growth. Growth increases your equity, which enables the bank to fund your next purchase. Gains from further capital growth are then multiplied for each added property, which accelerates your wealth and ability to purchase more properties. You can keep adding to your portfolio until it comes time to maximise your cash-flow to fund your retirement or semi-retirement.
HOW DO WE FIND PROPERTIES PRIMED FOR CAPITAL GROWTH?
When we find properties for our clients, we do an enormous amount of research to find areas with excellent capital growth potential. Not just above average, but the highest-growth areas in Australia. Then we find and negotiate the purchase of an excellent property below market value to give our clients a ‘quick win’ in the form of instant equity. This includes negotiation to get the best sale price, and sometimes we consider renovations to further add to the value and rental returns.
This is a very popular strategy among clients who want to get a little bit more ‘creative’ with their investment strategy, because they don’t want to sit around and wait 3 to 5 years for their equity to increase to the point where they can invest again. Instead, using this tried and tested strategy, they are able to take control of their investments and kickstart their own growth, enabling them to move on and invest again within 6 months to 2 years.
THE BIG PICTURE
The overall strategy here is to hold on to as many properties as possible over the medium to long term to allow capital growth to do all the hard work for you. When people say that property values double on average every 7 years, it’s just a statistic. But when you own 5-10 properties, that 7 years grows you a small fortune.
Andrew Clough | Mortgage Broker
DISCLAIMER: The information in this article is general information only and should not be mistaken for financial advice. The information shared in this article has been prepared without taking into account your personal objectives, financial situation or needs. Before considering any investment strategy, you may wish to consult a licensed financial adviser – in fact we recommend that you do.