How long does it take for an investment property to cover its costs?
Key takeaways
Before investing in property, you must understand how the cash flow of an investment property changes over time and ensure this timeline fits with your long-term plan.
Property in an investment strategy is important to build your asset base over time, especially in retirement when your superannuation balance may be decreasing. You don’t necessarily need your property portfolio to generate a significant income after expenses.
The average property becomes cash flow natural after 25 years of ownership, but due to the increase in holding costs from 25% to 35% of gross rental income, it now takes longer to reach a positive cash flow.
If you own more than one investment property, you may want to consider selling one and using the proceeds to reduce your remaining debt. This will improve your portfolio’s cash flow, but may impair your long-term wealth accumulation.
When an investor first borrows to buy an investment property, almost always the rental income does not cover the associated expenses, including loan repayments.
This means the investor will need to cover any shortfall out of their pocket each month.
While you can claim a tax deduction for this shortfall (known as negative gearing), it still represents a real cash flow cost.
The idea behind investing in property is that, over time, the property’s capital growth will build significant wealth and significantly offset its holding costs.
However, before jumping into the property market, it’s important for investors to understand how the cash flow of an investment property changes over time.
You must have a realistic expectation of how long it will take for your investment property/s to cover all its expenses on its own and ensure this timeline fits with your long-term plan.
Retirement planning and property portfolio cash flow
As I’ve mentioned before, property is primarily a growth asset.
Most of the investment returns you’ll earn from investing in property comes from compounding capital growth, rather than from income. After all expenses, property tends to provide minimal income.
The key role of property in an investment strategy is to build your asset base over time.
This is especially beneficial in retirement when you’re drawing from your superannuation and your balance may be decreasing.
In such a situation, having a property you can sell in the future provides a safety net as you will be able to replenish your retirement funds.
So, by the time you reach retirement, you don’t necessarily need your property portfolio to generate a significant income after expenses.
However, you certainly want to avoid it being a drain on your cash flow.
Typically, the goal for my clients is for a property portfolio to be at least cash-flow neutral.
Another important factor to consider is interest rate sensitivity.
Since you’ll rely solely on investment earnings during retirement, you don’t want your cash flow to be overly affected by interest rate changes.
The last thing you want in retirement is to be forced to cancel a holiday just because the RBA has increased rates!
How long until the average property becomes cash flow natural?
The chart below shows that the annual after-tax cash flow from an investment property becomes relatively insignificant after 25 years of ownership.
These projections are based on a property valued at $1 million, with an initial gross rental yield of 2.5%, rental income growing at 4.3% per year (being the long-term average), an interest rate of 6% p.a., and a 39% income tax rate.
In the past, an investment property would achieve positive cash flow in less than 20 years.
However, due to the increase in holding costs from 25% to 35% of gross rental income, it now takes longer to reach a positive cash flow.
I have not included any land tax expenses in the above protections.
You may need to reduce debt
The chart below uses the same assumptions as before, but with the investor depositing $1,000 per month into the investment loan’s offset account.
This growing offset account balance helps reduce the interest expense which improves the property’s cash flow.
I project that the cash flow will turn positive within 20 years.
Making capital improvements to improve rental income
When buying a property, it’s important to focus on acquiring the highest quality asset you can afford.
This often means spending most of the purchase price on the land itself, in the best location you can afford.
While you can always improve the dwelling in the future, you can never change the location!
However, this approach often leads to the dwelling being less substantial, resulting in a lower rental yield initially.
This has both pros and cons. The downside is the lower rental income.
On the plus side, it gives you room to make improvements, which will provide two benefits.
Firstly, it will increase the property’s rental income.
Secondly, you’ll be able to claim a tax deduction for the cost of these improvements (depreciation), thereby improving your negative gearing tax benefits.
For instance, if you invest $100,000 in cosmetic renovations and boost your initial rental yield to say 3.7% per year, I project that the investment property could become cash flow positive in less than 20 years.
Or do both!
If you renovate your property to improve its rental yield and allocate cash flow towards debt reduction, I project that an investment property could cost you less than $5,000 per year within about 14 years.
Is selling property to reduce debt the right move?
If you own more than one investment property, you could consider selling one and using the proceeds to reduce your remaining debt.
Whilst this approach will improve your portfolio’s cash flow, it does come with a trade-off: you’ll reduce your exposure to growth assets like property, which may impair your long-term wealth accumulation.
However, if you’re confident that your long-term financial position is secure, this might not be a major concern.
Selling a property can serve as a viable backup plan if your other strategies, such as debt reduction or property improvements, don’t produce the expected results.
The benefit of owning more than one investment property is that you can sell one while keeping the other, which affords you more flexibility.
How long until your property portfolio will be cash flow neutral?
A key takeaway from this blog is to forecast the future cash flow of your property portfolio to determine if it will be close to neutral by the time you plan to retire.
If it seems unlikely that cash flow will be neutral by then, you need to figure out what steps to take between now and retirement to achieve that goal.
Two steps: buy well, then improve cash flow
Maximising returns from property investment involves two key steps.
First, when acquiring a property, focus on buying the highest quality asset your budget allows, which typically means prioritising land value in the best possible location.
Second, after the acquisition, work on minimising your portfolio’s negative cash flow.
You can do this by making capital improvements, reducing interest costs through using a good mortgage broker offsetting debt with cash savings, and optimising your tax outcomes.
