As promised here is a more in depth example of the workings of
Optimised Investment Structure:
Before we kick off, perhaps I should spell out some investment philosophy to basically set the scene:
1)
Investments should by necessity be diversified:
I recommend the most standard investment split . . .
1/3 Property: 1/3 Cash: 1/3 Shares
a) Property for Maximum leverage:
Property remains the favoured asset class for leverage. (Well certainly in the Banks eyes) One can obtain loans against the property asset in excess of 90%. I generally advise the more conservative approach of Property LVR = 80%
So for every dollar invested in property you can hold assets of 4X (80% LVR)
b) Cash for liquidity and serviceability:
The cash fund is a low returning medium; however the purpose of holding amounts in cash is as a risk management exercise so as to cater for difficult circumstances. (Examples: Increasing interest rates, lack of tenants, maintenance et al.)
The second use of cash is to create a cash flow . . . which takes its literal meaning: to create a flowing income stream which is very useful for serviceability to acquire more assets. (Cashbond) Also, once one has acquired sufficient assets to generate enough capital to live off, then the cash flow is very useful, rather than continually having to revalue and draw down equity.
There is obviously no leverage with cash.
c) Shares for best Percentage increase:
Shares offer the best percentage return in the long run, are highly liquid and can be leveraged, but to a lesser degree than property and also with the higher risk of margin calls.
Currently on a conservative share portfolio you can get 67% leverage against your shares. I recommend up to 60% maximum, with the balance as a buffer over and above of your cash buffer.
So for every dollar invested in shares you can hold assets of 3X. (60% LVR)
EXAMPLE:
An investor has a $500,000 unencumbered home, no other investments and wishes to create an ‘efficient’ portfolio.
1) Approach a lending institution and borrow 80% of the value of the asset.
On the assumption that the investor has income sufficient for this loan a cashbond is not required. The result of the banking exercise is a LOC of $400,000.
Proceeds are to be invested as follows:
Property: $133,000
Purchase a $450,000 property with a 20% deposit. [80% loan <$360,000>]
The balance of the cash is used for costs.
Total property assets = $500,000 (home) + $450,000 (IP) = $950,000
Total Loans = $400,000 (LOC) + $360,000 (IP) = $760,000
LVR = 80%
Now just to point out that many resist this LVR as being too high. (No sleep factor.)
What they are failing to realize is that there is still $267,667 to be held in cash in the LOC and in shares as a buffer.
Shares: $133,000
Purchase shares to the value $332,500 with a 40% deposit, [60% loan <$199,500>]
Cash buffer of $133,000.
There are some choices as to the form of the cash buffer:
a) LOC . . . the dollars are readily available, no cost until drawn upon.
b) Further shares (No Leverage) . . . liquidity readily available, cost of dollars is offset by dividends / income plus potential capital gain / loss.
c) Cashbond . . . utilized only if extra serviceability required, cash available as a monthly income stream, resulting income can be re-invested into shares, or paid down to reduce a loan or placed into the LOC or the offset account.
d) Offset Account
Consequences: (Assumed capital growth on all asset classes = 5%)
If the investor did nothing:
$500,000 home growing at 5% p.a. = $25,000 p.a.
(But hey . . . NO RISK . . . you should be able to sleep easy and look forward to your pension)
Structured Investment:
Property Portfolio of $950,000 at 5% p.a. = $47,500 (Capital Growth)
Rental income say 4.5% on $450,000 = $20,250 p.a.
Share Portfolio of $332,500 at 5% p.a. = $16,625 p.a. (Capital Growth)
Dividend income say 4% = $13,300
Income from cash say 4.5% = $5,895
Total Return: $47,500 + $20,250 + $16,625 + $13,300 + $5,895 = $103,660 p.a.
Cost of the loan: $760,000 property + $199,500 shares at 6.5% = $62,367 p.a.
Net effect: $103,660 - $62,367 = $41,219
Add back depreciation benefits and tax savings and you will see that this is more than 2X better than doing nothing.
NOTE: The portfolio is negatively cash flowed:
Costs = $62,367
Income (Not including the capital growth) = $39,445
Therefore the cash flow cost p.a. = -$22,922 p.a.
What about the RISK??
Well if you are thinking what risk? REMEMBER the dreaded 80% LVR against your properties.
Okay so the LVR against property is 80%.
However the overall LVR is 67.78%
Total Debt = $959,500 / Total Assets: ($500,000 home) + ($450,000 IP) + ($332,500 shares) + ($133,000 cash) = $1,415,500.
If the portfolio averages 3% pa for the next 5 years = $1,667,498 (Gain of $251,998)
If the portfolio averages 5% pa for the next 5 years = $1,834,204 (Gain of $418,704)
If the portfolio averages 7% pa for the next 5 years = $2,014,065 (Gain of $598,565)
This compares very favorably with the gain over 5 years on just the home
at 3% p.a. = $106,182
at 5% p.a. = $165,768
at 7% p.a. = $230,029
Aaaah yes . . . I nearly forgot:
WHAT HAPPENS IF INTEREST RATES GO UP TO 10% AND THE LVR ON YOUR PROPERTIES IS 80%
So total loans = $959,500 x 6.5% = $62,367 p.a.
If interest rates are 10% then the cost increases = $95,950 p.a.
An extra cost of $33,583 p.a. which will be VERY DIFFICULT to sustain, if say your Gross Income is $60,000 a year. (Ahem Bill.L’s question
)
Total Cash Buffer = $133,000 / $33,583 = 3.96 years. (4 years of cover)
So at the end of the 4th year assuming interest rates have remained at 10%, you might need to draw down some of your equity gain to survive.
Assume it was a VERY bad 4 years and you achieved less than the cash rate, say 3% pa.
Portfolio value end of 4th year = $1,614,075 (Equity gain of $198,575)
80% of the gain is available = $158,860 at a cost of $15,886 pa (Also at 10%)
$158,860 / 33,583 + 15,886 = 3.21 years.
So you are covered for a further 3 years. (Even if your portfolio is only averaging 3% p.a.)
I believe this to be of a very low risk profile.
NOTES:
1) In the building phase, (Acquiring the assets for financial independence) the only income spent is used to cover the holding costs of maintaining the asset base.
2) A buffer is maintained upfront to allow for extra (unforeseen) costs that might occur before you have accrued an equity gain.
3) Although the Property LVR = 80%; the overall LVR = < 70%
4) The scenario at the end of 5 years based on a 5% p.a. portfolio growth =
Net equity of $874,704 at an LVR = 52.31% (Loans = $959,500 and Equity = $1,834,204)
5) Cashbonds are only used if and when extra serviceability is required.
6) One
“ONLY LIVES OFF CAPITAL FOR RETIREMENT” when you have accrued sufficient assets to provide
Capital Growth in excess of your needs less the costs of maintaining the asset base.
7) Circumstances change continuously; so does your budgeting.
8) Value adding by re-investing your equity gain each year into further assets (Duplicating) will double your asset base every 5 years. (Dollar working 6X)
I hope this clarifies some of the many questions,
Regards,
Steve
