Knowing where you stand before buying your investment property is essential. Property cashflow can appear to be a straight-forward calculation but doing the right level of due diligence now can save you time, money and peace of mind down the track.
It’s important to make sure that you do the numbers. Ultimately, the cash position of your investment property is a comparison of the total income the property generates less the total cost of holding the property and. But you also need to know what your investment property’s cashflow position will be before and after any tax rebates are factored in.
The best way to calculate the cashflow position of your property is to approach the calculation in steps.
Step 1: Find out if you are positively or negatively geared
This step involves working out your prospective investment property’s pre-tax cashflow position.
Essentially this means working out whether your intended investment property earns more in rental income (only) than the property costs to hold – before any tax considerations are factored in. To do this, you will need to estimate the likely monthly rental income and then deduct all of the costs for holding the property.
In working out the initial cashflow position of your potential investment property, it’s important to ensure that you include all of the direct expenses in your calculations and have a realistic range for rental income.
Working out the expenses
To work this out on a property prior to purchase, you need to firstly add up all the costs involved with your ownership of the property over a year and then divide the total by 12 to get the monthly cost of holding the property.
Typically, these will be costs like the interest proportion of any repayments on the loan used to buy the property, council and water rates, maintenance, insurance, vacancy costs and rental management fees.
For new properties, some of this can be provided by the developer. It is also part of the information pack we prepare for each of our clients when helping appraise any of our off-market opportunities. These will be a mix of monthly and annual numbers so the best approach is to convert them all to an annual number and then divide the total by 12 to get an averaged monthly amount for your expenses.
Then, you need to know what the monthly rental income will be. While we provide this for our clients, it pays to know how to approach this as an individual investor.
Working out the rental income
Sometimes a developer will give you an estimate of the rent you can expect based on other similar properties in the same area. In other cases, you will need to do the detective work yourself. Either way, it is worth validating the estimates to ensure that you are comfortable with the rental estimates. These are, after all the numbers that you are basing your purchase decision on.
It’s critical to get as close as you can to a like-for-like comparison.
Same area, bed and bath numbers and same (or as close as you can get) amenity level. At this stage, you’re also looking for a range rather than a definitive single number. Real estate portals like realestate.com.au and Domain can be a good way to gauge the rental costs in an area. Once you have a sense of the high and low levels for similar properties, it is wise to use a rental value toward the lower end of the range you have worked out. This gives you a buffer in case the achievable monthly rental is slightly lower than you anticipate.
Work out your pre-tax cashflow
Once you are here, deduct your property’s estimated monthly expenses from your estimated monthly rental income.
If the balance shows income after the costs are deducted, your property’s pre-tax cashflow position is positive. This means that the property makes a profit – without any reliance on tax rebates or deductions.
Your investment property is considered positively geared.
Conversely, if the property’s costs are more than the income it generates then there will be a deficit. On the face of it, the property will do a loss. This means that you will need to tip in additional funds over and above the rental income funds on a monthly basis to ensure that the costs of holding the property are covered.
How can I tell if my property negatively geared?
If your property’s costs are more than the income it generates, then your property’s pre-tax cashflow position is negative and the property is considered negatively geared.
Here’s the ATO’s explanation of negative gearing…
“a rental property is negatively geared if it is purchased with the assistance of borrowed funds and the net rental income, after deducting other expenses, is less than the interest on the borrowings.
The overall taxation result of a negatively geared property is that a net rental loss arises. In this case, you may be able to claim a deduction for the full amount of rental expenses against your rental and other income (such as salary, wages or business income) when you complete your tax return for the relevant income year.
Where the other income is not sufficient to absorb the loss it is carried forward to the next tax year. If by negatively gearing a rental property, the rental expenses you claim in your tax return would result in a tax refund, you may reduce your rate of withholding to better match your year-end tax liability”.
Being negatively geared gives you the ability to claim certain tax deductions and receive rebates that you can add back into your cashflow equation. In a way, these rebates act like extra (indirect) income from your investment. This does two things – it can offset some of the money you are tipping in, and it can tell you if your investment property is likely to be ultimately cashflow-positive or negative on an ongoing annual basis.
Now you can work out if your property is cashflow positive
This means finding out what the same cashflow calculation looks like once you factor in the tax claims and rebates that apply to investment property.
The higher the level of legitimate deduction and rebate, the greater the chance that your property might work out to be a positive cashflow property.
Step 2: Work out your post-tax cashflow position
When it comes to tax, it’s important to remember that everyone’s tax circumstances are different. You may not be able to access any tax rebates until the end of each financial year, so you need to know your monthly pre-tax position first.
Now that you know your pre-tax position, it’s time to calculate your property’s tax deductions and see what effect this has on your cashflow outcomes.
There are a number of legitimate claims that you can make against your property. As at the writing of this article, these include the interest proportion of a loan taken out to purchase an investment property, maintenance and repairs, capital improvements that are directly related to the income-generating capacity of the property, capital works and depreciation.
It is important to note though that capital improvements and construction works are treated like asset depreciation. This means that they are not recognised in total during the tax year in which they occurred. Instead, they are claimed progressively over a span of years.
The ATO guidelines are very specific in respect to what can and can’t be claimed – so these should be reviewed carefully to ensure that the claims and rebates you factor into your calculations are legitimate.
The ability to depreciate capital works and construction claim items over time can be particularly significant for new investment property builds. Many items that form part of a new house & land package (when used strictly as an investment property) can be depreciated over time.
This bit can be complex. Many developers and companies like Finvest will often provide an annual costs sheet and a depreciation schedule to help clarify the typical costs and depreciation component. It is important to get help to calculate your likely tax claims and help work out the likely return.
Once you know what your claims and rebate value will be, it’s time to revisit your Pre-tax Cashflow calculation and add in the anticipated tax rebate from your expense and depreciation claims.
Step 3: Post-Tax Cashflow calculation –
Divide the estimated return by 12 to get a monthly estimate. For the purposes of the calculation, it might help to think of it as a new source of income.
If you add this in as a new income line, what does this do to your cashflow outcome?
After you factor in rental income and the tax rebates you can reasonably expect to get back, is your investment property’s income higher than the expenses you worked out previously? If it is and your investment property now showing a surplus, your property is considered to be a negatively geared, positive cashflow property.
Positive cashflow properties are frequently preferred by investors because they are essentially self-funding.
If you own more than one investment property then you also have to take into account the balance between the performance of the portfolio as a whole.
If you are looking for off-market apartment, townhome or house and land opportunities and would like to start or add to a property portfolio, we can simplify the process (and all of the calculations) for you.
Book a free personal session with one of our coaches or learn handy tips and hints in our free online academy.