You’ve probably heard terms like these thrown around when talking about property investment: capital growth, OPM, cash flow, and so on. Let's run through exactly what they mean.
No matter if you are aspiring to purchase your first home, or to add an investment property to your portfolio, it’s key to understand the financial basics of property.
You’ve probably heard terms like these thrown around when talking about property investment: capital growth, OTP, cash flow, and so on. But while many of us have some idea of what these terms mean from context, we don’t necessarily know the exact details.
But we should – because once you have the basics down pat, you’ll be able to make more educated decisions about your investing.
Let’s run through them now.
Capital Growth vs. Cash Flow
A property has two sources of income: cash flow and capital growth.
Cash flow is the net amount of money that is produced and consumed by your investment over a period of time. It’s usually measured over a full year but can be shown on a weekly basis.
Put simply – cash flow is a simple equation of money in vs. money out. A cash flow positive property will on average earn money week to week. A cash flow negative property will on average cost you money week to week – requiring you to dip into your salary to service the investment.
Cash flow is integral to holding an asset long-term, and it also helps to pay off the loan; however, it doesn’t do much to build wealth over time.
Capital growth, on the other hand, refers to the increase in the value of an asset over time. It’s a key component of building wealth – but as appropriate cash flow is how you hold a property in the first place, you need a balance of both to see strong returns.
Compound Growth
Compound growth is when the growth rate of an asset increases year on year, as the investment base increases over time. It’s usually measured annually and is one of the largest contributing factors to building long-term wealth. Time is the key factor at play here; to maximise compound growth, an investor needs greater time in the market.
Let me give you an example: say your initial investment is $100k with a 10% p.a. return; after one year, you would see a $10k return. Come year two, your base is now $110k. So, year two’s return is $11k (10% of that year, but now 11% of the initial investment). By year ten, you would be on to a return of $23,579 or a simple return of 23.58% of your initial investment!
This potential for exponential growth is why famous investor Warren Buffet labelled compound interest, ‘an investor’s best friend’.
Using Other People's Money (OPM) & Leverage
If the term ‘OPM’ has ever baffled you, now you know: it simply means Other People’s Money, and is an investment term used to help explain leverage.
Leverage is the use of borrowed money to invest, in the anticipation that the profits will be far greater than if you had just used your own money. With leverage, you can increase the amount of cash you have on hand to invest into assets that you normally wouldn’t be able to afford.
It also gives you the option of using as little of your own money as possible, allowing for a diversification strategy (but more on this later).
As powerful as leverage can be, it also can be a double-edged sword, as it amplifies losses as well as returns. However, banks and other lenders tend to see property as being less volatile as other asset classes, hence enabling property owners to take out a mortgage and subsequently achieve leverage by taking a loan against a proportion of the value of the home.
So, there you have it – the basics in a nutshell. If you have any questions about any of the above, I’m here to chat.
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SUMMARY
You’ve probably heard terms like these thrown around when talking about property investment: capital growth, OPM, cash flow, and so on. But while many of us have some idea of what these terms mean from context, we don’t necessarily know the exact details – so let’s run through them.
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