Seasoned property investors will tell you they invest in real estate for the cash flow. Most media commentators will have you believe they’re in it just for the capital gain. So what’s the difference between investing for cash flow or acquiring properties for the capital gain?
In this blog article cash flow and capital gain are defined in layperson’s language. Plus why property investors are often mistaken for property speculators.
What is Cash Flow?
Investopedia have a good definition of cash flow, and it’s worth reading their article for a comprehensive overall. For this article here’s a layperson’s explanation. Cash flow the movement of money in and out of business. Now you may be wondering if it’s just for business how does it relate to property investment? Well, investing in an asset that returns an income is for all intents and purposes ‘a business’ and property investors will say as much.
Just like a business, the acquired rental property is an asset which needs to return value to the shareholders, i.e. the landlords. As cash flows in from the rental property income, cash also flows out to pay for all the expenses associated with the rental property ownership.
Examples of typical rental property expenses are rates, insurance, mortgage, maintenance. Just like a business, there needs to be enough cash flowing in to cover the money flowing out and also provide a profit. It’s the profit that motivates people to go from a novice to building a property portfolio, and this leads into the definition of capital gain.
What is Capital Gain?
Wikipedia has a comprehensive definition of capital gain. A profit is the capital gain from the sale of an asset like property, shares, a business. To achieve the gain or profit, you need to a higher sale value than the purchase cost. Plus if you’ve bought a home and renovated it , the renovation costs are deducted from the sale price and what’s left is the capital gain or profit.
There is a lot more to a capital gain, of course, so ask your trusted financial advisor and accountant for more information pertinent to your position.
Make sure that when you decide to invest in real estate, your goals are defined. Are you investing for the cash flow or is your motivation just the capital gain?
Property Investor vs Property Speculator
Property investors are investing in rental properties for the long term. They’re interested primarily in the cash flow, and their rental properties return a surpass of cash after expenses. Most property investors only have one or two properties, and they’ve got them as part of their retirement plan. These investors are ‘ma and pa’ landlords.
The properties must be cash flow positive, when their personal income can not cover any shortfall, i.e. the expenses exceed the rental income. Getting started as a property investor early on in your career is helpful as your income is sure to go up and with it the opportunity to grow your property portfolio.
Later on in your career, you’ll want your investment properties to either return a very healthy profit to replace your wage or have a very low LVR (loan to value) ratio which has come about from years of paying down the principal amount of the loan.
When you retire, you can either hold onto the properties and live off the profit from cash flow positive portfolio, or sell up for a capital gain. The long term hold of rental properties is what defines a property investor as opposed to a property speculator.
Purchasing property or real estate to sell for a quick profit is speculation. Speculators are not just in the real estate sector they are also in share trading and other activities where there is a high risk of loss from their investment, but the rewards are equally as high.
The activity of high volume buying and selling homes to make a profit receives negative publicity in the media as the pursuit causes fluctuation in sales prices in the property market. Owing a property is the dream of most people so when speculation first homebuyers inflate prices can be locked out of the property market. Media often group speculators with investors as ‘property investors’ in their commentary when they are not the same.
Property investors provide homes for tenants and hold on to their portfolios for the long term, whereas speculators buy and sell in the short term.