Brett's 2 year cashflow rule
The '2 year cash flow' is one of the most important concepts you'll learn when building a property portfolio. It's a simple formula that most people forget to calculate prior to committing to buying a property, yet it will guarantee the long term health of your portfolio, even through market downturns.
In most cases people will work out the initial acquisition costs and as long as they have to the funds required to purchase this they will dive head first into purchasing.
Funnily enough, even though some of these people will consider the monthly mortgage they will neglect things like service charges & ground rent. Whilst this is a problem by far the biggest problem lays in the fluctuations in interest rates.
Capital growth will make you money but not having capital growth is nothing more than a frustration. The real major issue is a lack of cash flow to pay the mortgage and interest rates are the thing that most affects your ability to pay your mortgage.
I have never heard of a house being repossessed due to negative equity but l know 100s that have been due to not paying the mortgage (lack of cash flow).
Now this whole issue is negated if you buy when interest rates are at their highest but you never know this for sure (except in hindsight).
I have a client who every time that interest rates go up 0.25% he has to find an extra ?4500 each month. You can imagine how much that would hurt if he hadn't made allowances.
OK, so l think we both realise how essential it is to consider the cash flow of each property. So now lets consider the mechanics of working it out to ensure you both take full advantage of your capital and don't take any unmanageable risks.
Before you consider purchasing an individual property you will also need to consider the cash flow impact of the purchase over the entire portfolio. We will talk about this further soon, lets now jump into the 3 aspects that we must consider with regards to cash flow.
- Your income
- The property's income
- Trading capital for cash flow
You spend your income and I will spend your capital.
Centered at the heart of my portfolio building philosophy is my belief that you spend your income and I will spend your capitalÂ This simply means that you shouldn't sacrifice your lifestyle to build a property portfolio, you should only enhance it, lifestyle that is. This assumes that you have equity available to invest, if you don't then you will need to use your income to supplement, save or borrow the cash flow for the property.
Is 130% mortgage coverage still applicable?
The second aspect of cash flow is creating a difference between the rent you receive and the expenses you pay out. This is rarely positive when you first purchase a new property and if interest rates are high but if you can achieve a positive you will need to consider the effect of interest rate fluctuations. I also believe that the days are gone of having 130% coverage on all property. This is certainly the trend in other similar countries.
Trading capital for cashflow
The third involves a principle l call trading capital for cash flow. It works like this and involves a delicate balancing act between your equity or capital and your cash flow.
In the 100s of clients l have supported over the years, most have their own home and have developed considerable equity in it.
Now assuming you stopped paying the mortgage but you were in a situation where you had a huge amount of equity and owed a little on your mortgage this would theoretically not stop your property from being repossessed. This is because even though you have equity you do not possess the cash flow to pay the mortgage.
Now if you refinanced the property in such a way as to allow access to the equity as you needed it (through what we call a line of credit or sometimes called a flexible mortgage) you would then be able to use this money for whatever purpose especially to fund the monthly shortfall of rental on a property.
We call this trading capital for cash flow and it is fundamental if you are to build a substantial portfolio.
How long should you consider cash flow?
Now the only thing left to consider is how long do we need consider the implications of cash flow. As a rule I use 2 years. This is simply because a lot happens in property in two years, property prices will go up, interest rates will go up or come down or both, the market will change. If you have a new property it will give the property plenty of time to settle into its surroundings and ensure a stable rental market is established.
Given the above, in 2 years you should theoretically be able to refinance, sell, or at least have some flexibility to make changes that will allow you to recalculate the cash flow for a further two years.
Once I explain my 2 year cash flow rule people will ask one of two questions.
Is 2 years too short?
If you track a number different factors that affect the property market you will find that the only time that 2 years may fall short from a cash flow perspective is as interest rates begin the rise. Normally though we can approximately work out how high interest rates are heading and simply adjust the cash flow accordingly.
Is 2 years too long?
The only time it is too long is when the market in at low interest rates and property prices are galloping upwards. In this case you will normally be able to refinance or re-mortgage within the two years and take some more money out.
Regardless of what you actually believe the facts are that you will need to consider the ongoing cash flow of the property in order to fully be prepared for all markets in the property cycle.
Live with passion,
PS. If you would like to read more about the 2 year cashflow then simply click here to read the post about what to do once the 2 year cashflow is up.