Theory: Taking A Closer Look At Profit
I might be showing my age here, but Castrol once ran a famous TV ad that said “Oils ain’t oils”. In a similar vein, this month I wanted to spend a moment talking about making money in real estate under the banner that “Profits ain’t profits”.
It probably goes without saying, but every property investment you plan to purchase should be profitable. Yet a recent press release noted that 12% of all Australian properties were sold at a loss (and as many as 40% in Darwin!). How can this be?
Well, I believe many investors make a loss simply because they don’t have a plan to make a profit. That is, they buy something and hope it will be profitable, rather than having a profit goal and then buying a property that will be best placed to provide it.
I’ve done up a little flow diagram for you that reveals the different kinds of profit that an investment can make.
Starting at the ‘Profit’ rectangle at the top, there are only two types of profit that an investment can produce: realised and unrealised.
For a profit to become real (i.e. ‘real’ised) it has to hit your bank account. Otherwise any gain remains ‘unreal’ised and only exits in theory and on paper.
Consider capital appreciation. While the property is owned, what it might be worth is anyone’s guess at best, so the profit is an opinion and only exists ‘on paper’ (hence the arrow pointing down to the ‘Paper’ rectangle).
Consider Anne. Using simple numbers, she bought an investment property for $520,000 and she thinks it is now worth $600,000. She therefore thinks she is sitting on $80,000 of capital gain. She won’t know for sure though until the property is sold, so for the moment it exists only in her mind, or on paper, and hence is not real nor taxable. Even if Anne had a sworn valuation for $600,000, the profit will still only be an unrealised best guess.
For Anne’s gain to become real the property would need to be sold. For instance, if she sold it for $600,000 then she would now have ‘real’ised her gain, and on closing the amount would be able to be banked.
(Of course, in real life Anne’s actual gain would need to be adjusted for purchase and sale costs, taxes, etc.)
Why is all of this theory important? Well, because different properties will return different types and amounts of profit, and the right property for you is the one that is likely to give you the highest likelihood of delivering the type of profit you desire, in a quantity that is sufficient for your needs, that will be realised in a manner that is in harmony with your broader tax planning goals.
That is, you don’t just want any type of profit, you want a specific profit – and hence you need to make a plan to accomplish it, otherwise you’ll get what you get and you might get upset!
For example, you might say that you want to purchase a property that will provide an unrealised profit (from capital appreciation) of $200,000. Great! The next question is ‘how’ will that happen. That is, what property will do this, and on what basis? Answering those questions will begin to help you scope out what kind of property and location you should focus on.
The alternative is to buy a property and hope it delivers an acceptable profit. This isn’t what I call investing though – it’s speculating, or gambling, which is unnecessarily risky.
Now, let’s talk about losses for a moment. The same flow diagram as provided above for profits also holds true for losses. That is, a loss can be unrealised or realised, and a realised loss can be a lump sum amount (i.e. cash), or it can be periodic (i.e. cash flow).
Consider Colin. He has an investment property that has monthly expenses of $500, and monthly rent of $400. He therefore makes a monthly cashflow loss of $100. Colin doesn’t mind though, because he is hoping to make an unrealised capital gain via capital appreciation of $250 a month, thereby leaving him better off overall by $150 per month, plus he can use the realised loss to reduce his income tax burden. This is the classic ‘negative gearing’ situation.
Colin’s strategy will be effective if he achieves the expected capital appreciation. If he doesn’t then he might suffer the double whammy of owning a property that loses money both ways – cash and cashflow.
Take a moment and answer these questions:
- Do you want your investment to make a profit or a loss?
- Do you want that profit to be realised or unrealised (if unrealised, when do you want it to become realised)?
- If realised, are you aiming for a cash or cashflow profit (or both)?
- How much profit do you want, and how do you wish to receive it (in cash i.e. a lump sum, or cashflow, i.e. in periodic amounts)?
As I’ve said, once you have answers to these four questions then you have the beginnings of a plan for what sort of property would be suitable (and indeed not suitable) for you to purchase.