Hi all,
In response to Salsa's question....
"post the risks you think LOE have since others did not post them"
I have put together a very long post (or couple of posts) to try and show where some of the risks are in LOE as portrayed by Alan.
This involves normal market behaviour without a major decline of any type, and those who think "this time it will be different" and we don't have that type of market behaviour any more, please explain why. (by major I am referring to a 50% or more type of decline that we have had at least 3 times in the last century)
Salsa,
I will try to identify the risks to the strategy by using a couple of examples.
Scenario 1.
The first example involves a sharemarket correction over 2 years of 25-30% with a flat property market. Our income fund, because it is a trading fund (anything that pays higher than dividends is trading) also has an equally poor couple of years, but still manages to make 6% per year.
Using the correct figures, you could only borrow $1,816,000 at an 80% leverage against the PPOR and 3 IPs that have a value of $2,270,000. This would have to be a No doc loan as the retiring couple are honest with their lender. Alan allowed 6.7% as the interest (and no other costs). Perhaps a little bit of wishful thinking, but lets run with that number anyway.
Interest on $1,816,000 at 6.7% = $121,672.
We then use that money and borrow a further $1,816,000 using a margin lender to buy into our income fund. On this margin loan we pay 8.5%.
Interest on $1,816,000 at 8.5% = $154,360
Total interest = $276,032.
We invest the $3,632,000 in the income fund.
We are unlucky to have invested near the peak of the stockmarket, and in the first year it falls 15%. Our income fund also falls the same 15% but still has a 6% payout. This means our fund has had a net performance of -9% for the year, which would still put it amongst the better performing funds!!
How does our situation look???
Income from the fund at 6% of $3,632,000 = $217,920
Income from rental IPs = $55,000
Total income = $272,920
We then need to subtract the interest bill of $276,032
Our Net income for the year = -$3112
So our couple have nothing to live off in the first year. They also do not qualify for any financial assistance from centrelink as they have too many assets. Back to work if they can find it for the 50 year olds, and would be desperate to find anything because of the interest cost.
Basically the whole concept of living off the equity has already fallen apart for this couple. They would look back and see that if they had not gone into any debt at all, and stuck to the income from their 3 IPs they would have had an income of $55,000 and enjoyed the company of their grandchildren that year.
Lets go forward to year 2.
They start the year with a 15% loss in the income fund. This equates to a loss of $544,800 in the value of their investment. The value of their fund “units” is $3,087,200
The income fund again makes 6% income but losses 10% the same as the overall market.
The payout is now 6% of $3,087,200 = $185,232
Plus the income from the IPs that has gone up 3% = $56,650
Total income = $241,882
Now we subtract the interest bill of $276,032
Net income of -$34,150 !!!!!
Does anyone really think that this couple would still be involved in such a scheme????
Yet the income fund has still outperformed the market by losing only 13% over the 2 years of a common 25% correction in the market.
To add insult to injury, the value of the income fund is now down another $308,720 to only $2,778,480. Luckily we are still above a margin call but over 65% leverage getting close enough for the couple to start worrying about it.
Lets go forward another year but this time it is much better. The market goes up 10%, so does the income fund and it has an income of 9% as well.
Income from fund = $250,063
Income from IPs = $58,350
Total income = $308,412
Minus total interest bill of $276,032
Net income = $32,380
Net increase in value of fund $277,848
After 3 years in the fund the couple is still working, and has a lower income off their LOE strategy than if they had retired to live off the rent income of their IPs.
Yet in that time the income fund has performed better than the overall market in each year.
Scenario 2 (I warned you this would be a Loooooong post)
The couple are unlucky enough to invest at exactly the wrong time, and the nature of the income fund has it involved with some stocks that underperform the overall market by a couple of percent.
The market has a performance like ’97 or ’98 where it plunges 30% but then recovers and has a slight loss for the year. Our fund near the bottom of the panic has plunged to be down 35%.
The margin lender gives our couple a call.
As they have used all available equity, they will have to sell assets at precisely the wrong time to meet the margin call.
Assuming a maximum leverage of 70%, the minimum value of their investment into the fund could fall to is $2,594,286 before they get the margin fall. (A fall in value of about 28.5%). A 35% fall in the value of the income fund takes its value down $1,271,200 to only $2,360,800. The maximum margin loan on this would be $1,652,560. Our couple would have to raise (by selling assets) $163,340 to meet this margin call( and hoping that the market does not go down again tomorrow as they are leveraged to 70%).
The value of their holding in the fund has now declined to $2,197,460, however this again affects a margin call as we can now only borrow $1,538,222 against this amount.!!!
The reality in this situation is our couple would have to sell $550,000 of their income fund to meet the margin requirements of the 35% fall at the bottom of the market.
The numbers..
Value of fund holdings $2,360,800
Less $550,000 in sold assets = new value of $1,810,800
Pay $550,000 off the margin account = new borrowings on margin = $1,266,000
The couple are now margined at 69.9%
The market then turns around, the fund goes up 40% from these lows to have a slightly down year.
The value of the couples holdings go up from $1,810,800 to $2,535,120
Irrespective of what the income is, our couple have had the value of their fund holding go down from $3,632,000 to $2,535,120 a loss of $1,096,880
While the size of their borrowings have gone down $550,000.
This is a net loss of $546,880 for the year, even though the fund was up 40% from the lows and only slightly down for the year!!!
How confident do you think the retired couple trying to Live Off Equity would be feeling????
bye
No personal attack or malice intended or inferred in any way. Just making a valid point.
