Capital Growth vs Cash Flow Part II: A More Detailed Example

This article follows on from my previous article:
Should You Invest for Positive Cashflow or Capital Growth?

Question from a reader:
Playing devils advocate here what are your thoughts if both properties were sold at the 20 year mark and capital gains taxes applied? Also one advantage of the positive cashflow property is that the extra revenue it generates can be re-invested - if this is figured into the analysis then perhaps the overall difference between the two strategies is closer? Thoughts?

Good question. The initial example was relatively simple however these calculations can get very complicated, very quickly!

Answer: I believe you still come out significantly ahead with the capital growth strategy. Let's make some further assumptions and do some additional calculations, while also taking re-investment into account:

Let’s call the positive cashflow “Strategy A” and capital growth “Strategy B”.

-    Assume a more realistic scenario of a $200k deposit and an $800k mortgage for a $1m purchase

-    Assume mortgage repayments of 5% p.a. fixed for 20+ years (for simplicity)

-    Assume yields for each property remain the same for 20+ years

-    Assume marginal tax rate of 40%

-    Assume no other ongoing property costs (only mortgage interest)

-    Assume no purchase/sales costs (as they are the same for both)

-    Assume extra revenue from positive cashflow re-invested at a return of 5% p.a. (in shares or similar)

Strategy A (Positive Cashflow) - 4% Capital Growth, 6% Yield

• Total mortgage repayments are $40k/year for both strategies. The additional cashflow is invested at 5% return - for Strategy A this is $20k of extra funds at the end of Year 1 (before tax). Subtract the marginal tax rate and we now have $12k available for investment. This is invested at 5% return and the (after tax) positive cashflow for Year 2 is added to this balance and also re-invested (and so on). By the end of year 20, the total balance of this investment fund would be ~$870k (I have used an excel spreadsheet to make these calculations behind the scene). This can therefore be added to the total returns for Strategy A.

• The capital gain after 20 years is ~$1.1m. If you hold an asset for more than 12 months you get a 50% Capital Gains Tax (CGT) discount. Therefore the taxable capital gain is ~$550k. Applying the marginal tax rate to this gain and then subtracting the tax from the total we have a total net equity gain of ~$885k.

• Therefore the TOTAL equity after 20 years is $200k (original deposit) + $870k investment fund balance + $885k net capital gain = $1.95m.

Strategy B (Capital Growth) - 6% Capital Growth, 4% Yield

• As the $40k/year mortgage repayment is fixed, additional cashflow is also received in Strategy B. By the end of year 20, the total balance of this investment fund would be ~$535k. This can therefore be added to the total returns for Strategy B.

• The capital gain after 20 years is ~$2.1m. Applying the 50% CGT discount and deducting the CGT payable, we have total net equity gain of ~$1.6m.

• Therefore the TOTAL equity after 20 years is $200k (original deposit) + $535k investment fund balance + $1.6m net capital gain  = $2.35m. So you have still gained around ~$400k more using the capital growth strategy (200% additional return on your original investment).

Further examples with the same model:

20 years is an arbitrary number. The longer the investment timeframe, the better, as this allows your capital gains to compound unencumbered by capital gains tax (only applicable when you sell, you may never have to!).

• 10 Year Scenario: If we project this same model for 10 years under the same assumptions, the total equity difference is ~$70k in favour of the capital growth strategy. Strategy A = $770k total equity after 10 years, Strategy B = $840k total equity after 10 years. This is a ~35% better return on your original $200k investment. 

• 30 Year Scenario: If we project this model out to 30 years under the same assumptions, you not only have an even larger capital growth difference, but you also have increased cash flow to the point where it is higher for Strategy B ($187k annual yield for Strategy A vs $216k for Strategy B - the best of both worlds - see table below). The inflection point is between years 22 and 23. 

• 30 year figures for Strategy A: Total Equity = $200k (original investment) + $1.7m (taxed capital gain) + $2.2m (investment fund) = $4.1m. 30 year figures for Strategy B: Total Equity = $200k (original investment) + $3.5m (taxed capital gain) + $1.8m (investment fund) = $5.5m. So you have ~$1.4m of additional total equity after 30 years with Strategy B (capital growth).

• 40 Year Scenario: Without calculations shown, the difference in total equity at 40 years is nearly $3.8m in favour of Strategy B! While it is hard to visualise this far into the future, it neatly illustrates the power of compounding and capital growth over time.

Keep in mind we are also ignoring a number of other factors:

• Capital gains tax would also apply to the possible sale of the investment fund/shares which is not factored in here (favours Strategy B/capital growth).

• The additional funds from Strategy A could be re-invested into another property to take advantage of leverage and potentially achieve a higher ROI (favours Strategy A/positive cashflow).

• This model does not take into account negative gearing benefits (favours Strategy B/capital growth). In this case you would get a 40% discount on your losses if operating with negative cashflow. For property investment in Australia, you get punished with additional taxes for a positive return, and you get rewarded with a discount on your losses for a negative return! Note I would not recommend negative gearing as a property investment “strategy” but when used correctly there is decent compensation for operating at a loss.

• Other actual ongoing costs will vary between different property types (e.g. a newer property will be lower maintenance and even less money out of pocket) (more likely to favour Strategy A/positive cashflow).

• Capital gains tax does not necessarily have to apply! Ideally you would never sell your property, in which case the capital gains tax never falls due and your equity is allowed to continue compounding long into the future! (favours Strategy B/capital growth).

• Everyone's marginal tax rate is different - it is most likely to fall somewhere between 20% - 45% (the highest rate in Australia). This can impact the calculations significantly, but does impact both strategies (either changing the additional income tax or the capital gains tax).

Despite the limitations and assumptions, I think the point is illustrated fairly well in this example.

Conclusion:

While I believe capital growth should be the priority, each investor has a different set of circumstances and ultimately a balanced approach is probably optimal. One could consider setting up a positive cashflow property for every 2nd or 3rd investment purchase, either by contributing a larger deposit or by targeting a stronger yield. This will help maintain strong serviceability, offset losses from other negative cashflow properties and act as a buffer for inevitable interest rate rises in the future.

If you want to get in touch, please send me an email:

micahkg@gmail.com