Benefits of Diversification when Capitalising Interest

[keithj]

Following on from recent threads regarding the dangers and successes of capitalisation of interest and LOE.

The attached spreadsheet shows what a $400K cash deposit invested in either -

• 50% in high growth IP and 50% an average basket of shares (Scenario 1) or
• 100% high growth and highly negatively geared IP (Scenario 2)

It attempts to demonstrate that an investment in high growth IPs combined with a relatively small share portfolio can produce a positive cashflow far sooner than a solely IP strategy can.

Assumptions
The leverage I've assumed is 80% for IP, and 50% for shares.
For the first scenario the $400K cash is split equally into 2 deposits and gives a total investment of $1M of IP and $400K of shares.
So the 2nd scenario gives total assets of $2M of IP.

The IP growth and yield I've assumed are 9% growth and 3% nett yield.
For shares - 7% growth and 5% nett yield (this is after grossing up for franking).
So they both add up to a 12% total return.

Rents grow at 3% pa, while dividends grow in line with share growth. This is an important difference between the asset classes.

Feel free to adjust them to figures that you are comfortable with. The output is fairly sensitive to some small adjustments, so DO use your own assumptions.

I've assumed the rent goes towards the IP loan and the dividends pay off the Margin Loan.

Some of the assumptions I've made which probably don't reflect reality -

• interest rates are constant (@8% IP & @9% for shares) for the 20 yrs
• no additional equity drawdowns for either LOE or investment
• growth is constant throughout the period
• tax isn't considered
• the $400K deposit is all cash and doesn't attract interest

Output
Using my assumptions the output shows that

• the IP only strategy never becomes cf +ve, and every year cashflow becomes increasingly negative
• the IP only strategy ends up with more gross assets and has 40% more equity after 20 yrs
• a 50/50 IP/shares split becomes cf +ve after 17 yrs
• the combined strategy margin loan is fully paid off after 13 years
• the combined strategy has a lot less debt after 20 yrs with lower LVR
• the combined strategy becomes less cf -ve after the 3rd year

The bottom line for me is that a diversified strategy can -

• reduce volatility
• produce +ve cashflow sooner
• has some lower risks, higher SANF
• help significantly with servicability issues
• lower overall borrowings so less sensitivity to IRs
• no need to sell IP (& incur CGT) to create a cf +ve portfolio for retirement
• however, the downside is less equity after 20 years

 

[topcropper]

You are, if not already, fast approaching being the most valuable forum member keith.

Great stuff.

 

[Land]

Interesting

Keith,

Thankyou from all of us for that very interesting and informative analysis.

The primary positive that I can see from the diversified strategy is with assistance with serviceability. However, if one was to use no doc loan products so that serviceability isn't an issue, surely it would be better to simply capatilise the interest and buy purely IPs. The IP strategy results in nearly 1.8M more in equity than the diversified strategy and a low LVR of 37.25%. I other words, there is a signifcant amount of equity available to live off before you hit a max LVR of 80%, which would last many years in which time the value of the properties are likely to rise again.

In the diversified example, the cashflow is only about 16.5K per year which really isn't doing a lot for me in terms of living off it. Of course, that cashflow could be used to buy more debt which is very useful.

Also, my aim is to get into as much debt as possible, so why would I want a strategy which reduces the amount of debt I am in? I am intending to leverage myself up to my eyeballs over the next 5-10 years, and then enjoy watching my LVR drop at the same time as watching my equity grow.

If I've missed some fundamentals there, I am happy to be corrected, after all, the aim of the game is to learn as much as possible right?

Thanks once again for the post Keith, I'm sure it took some time to put together.

Cheers

 

[Belu]

i think there is an issue with the rental yield, as in 20 years time you are only receiving 1% rental yield from the properties.

i have adjusted the figures to always have 3% yield of value of the property, which i think is fair and prudent.

find attached and look at the difference.

 

[Simon]

Keith,



Also, my aim is to get into as much debt as possible, so why would I want a strategy which reduces the amount of debt I am in? I am intending to leverage myself up to my eyeballs over the next 5-10 years, and then enjoy watching my LVR drop at the same time as watching my equity grow.

Because then you can increase your debt again to take advantage of opportunities.

 

[keithj]

The primary positive that I can see from the diversified strategy is with assistance with serviceability. However, if one was to use no doc loan products so that serviceability isn't an issue, surely it would be better to simply capatilise the interest and buy purely IPs. The IP strategy results in nearly 1.8M more in equity than the diversified strategy and a low LVR of 37.25%. I other words, there is a signifcant amount of equity available to live off before you hit a max LVR of 80%, which would last many years in which time the value of the properties are likely to rise again.

In the diversified example, the cashflow is only about 16.5K per year which really isn't doing a lot for me in terms of living off it. Of course, that cashflow could be used to buy more debt which is very useful.

Also, my aim is to get into as much debt as possible, so why would I want a strategy which reduces the amount of debt I am in? I am intending to leverage myself up to my eyeballs over the next 5-10 years, and then enjoy watching my LVR drop at the same time as watching my equity grow.

Hi Land,

Sure, your max LVR, max debt strategy is a great one. I'm putting forward a v. simple (no-frills) alternative that has the downside of less equity at the end, but more benefits earlier.

This is one of the features of capitalising interest - more benefits (like retirement) earlier & less later - a more balanced approach?

Regarding 'the cashflow is only about 16.5K per year', the alternative of -$200Kpa for a solely IP strategy. I'm sure you can think of a way of convert one IP pa (to reduce CGT) into +ve c/f .

Cheers Keith

 

[keithj]

i think there is an issue with the rental yield, as in 20 years time you are only receiving 1% rental yield from the properties.

i have adjusted the figures to always have 3% yield of value of the property, which i think is fair and prudent.

find attached and look at the difference.

Hi Belu,

Glad to see you making your own assumptions. However, I feel that making the assumption that rental yields for high growth properties stay constant doesn't reflect my reality. That would imply that rents went up at 9%pa - ie in line with IP growth.

Cheers Keith

 

[Mr. Fabulous]

Good examples. You can also use the option of capping your margin loan interest whilst aquiring assets in order to achieve a passive income sooner. Of course, this strategy requires you to monitor your LVR and use outside funds to buy more shares or pay down your margin loan.

As I've said many times on here, I don't understand people who use property or shares exclusively. There are people on this site who have been investing for more than 10 years who still cannot leave their jobs as they don't have enough income from their rents in order to live off.

Hopefully Keith's spreadsheet may get people to take their blinders off and see what is possible for them. If it takes more than ten years for a person to go from, let's say, a PPOR to fully financially free (assuming reasonable expectations of course) then it's taken too long.

Mark

 

[Land]

Benefits earlier

Hi Keith,

Yes, good point you make about achieving benefits earlier. I guess a lot of it depends on your timeframe. I still have decades of working life ahead of me (although I'm aiming to reduce that somewhat!), so I can afford to put off earlier benefits for later benefits. I see a lot of wisdom in your strategy and it's great to have it illustrated in such a comprehensive manner, however, I am keen to push the envelope and guess that's why I'm talking about a slightly more aggresive strategy.

However, it would be very interesting to apply some timing to your strategy to line up with the varying cycles between property and shares to 'leap frog' from one up to the other. I believe that Michael Whyte has done this very successfully from a thread he started a few weeks ago discussed how he's paid of his PPOR.

Simon -I'm still a little confused why i would want to reduce my debt, so that I can increase it again. Wouldn't it be better for me to just max my LVRs and debt as much as possible a stay that way until I am satisfied with the size of the portfolio I have built before letting the LVR drop a little by slowing down the purchase of additional properties?

Thanks all for the educated discussion.

 

[Belu]

Hi Belu,

Glad to see you making your own assumptions. However, I feel that making the assumption that rental yields for high growth properties stay constant doesn't reflect my reality. That would imply that rents went up at 9% - ie in line with IP growth.

Cheers Keith

Hi Keith,

I guess my issue then is that the investments then become un-even, which of course will lead to shares showing a better income stream.

Initially you have:

IP: 9% growth + 3% rental = 12%
Shares: 7% growth + 5% dividend = 12%

So all things are equal, but then at the end it is:

IP: 9% growth + 1% rental = 10%
Shares: 7% growth + 5% dividend = 12%

So this means that one of the assumptions you make is that properties will yield a poorer result in years to come.

 

[keithj]

I guess my issue then is that the investments then become un-even, which of course will lead to shares showing a better income stream.

Initially you have:

IP: 9% growth + 3% rental = 12%
Shares: 7% growth + 5% dividend = 12%

So all things are equal, but then at the end it is:

IP: 9% growth + 1% rental = 10%
Shares: 7% growth + 5% dividend = 12%

So this means that one of the assumptions you make is that properties will yield a poorer result in years to come.

Hiya,

Yeees - that's something that didn't occur to me until I did this spreadsheet. Although it should be obvious. Column O shows the diminishing returns of IP based on rent not keeping up with growth. The big difference is that income does keep up with share price over the long term.

I think that reality may be somewhere between yours & mine - ie rents of high growth property grow faster than CPI/wages, but slower than IP growth. What are yields in London, NY, etc ?

Cheers Keith

 

[redsquash]

Trying to KISS is a good idea but in this case it may be very misleading.
Keith however did say to use your own assumptions. This is food for thought only.

Lets look at the difference between the first year results only.

cash flow is -$32000shares Vs -$68000 property.
In subsequent years the difference grows.

The difference between the 2 figures is $36,000
So property is more negatively geared by $36000.
Assuming a tax rate of 30 cents in the dollar that would result in an additional
12000 dollars ie $36000 x .3

The opportunity cost at 5% compound interest if this difference remained constant is about $480, 000 over 20 years.

However the difference is not constant but increasing substantially so my calc is way under in estimating the opportunity cost, particularly in the latter years .
year 18 for example compounded until year 20.

-$24000 and -$178000 results in $154000 difference negatively geared
At .3 tax rate this is an extra $46200 to invest.

so in the last 2 years you could
increase your funds by nearly $100,000

 

[Twitch]

Keith, first, terrific thread!

Just noticed that Column "L" has an error, it should also add column "I", the share loan. Also, the overall LVR (column M) fails to also take into account the share loan.


cheers.

 

[MTR]

Hi Keithj
I can only reiterate what TC has stated, thanks for the detailed, informative great posts and please keep them coming.

Cheers

 

[keithj]

Trying to KISS is a good idea but in this case it may be very misleading.
Keith however did say to use your own assumptions. This is food for thought only.

Lets look at the difference between the first year results only.

cash flow is -$32000shares Vs -$68000 property.
In subsequent years the difference grows.

The difference between the 2 figures is $36,000
So property is more negatively geared by $36000.
Assuming a tax rate of 30 cents in the dollar that would result in an additional
12000 dollars ie $36000 x .3

The opportunity cost at 5% compound interest if this difference remained constant is about $480, 000 over 20 years.

However the difference is not constant but increasing substantially so my calc is way under in estimating the opportunity cost, particularly in the latter years .
year 18 for example compounded until year 20.

-$24000 and -$178000 results in $154000 difference negatively geared
At .3 tax rate this is an extra $46200 to invest.

so in the last 2 years you could
increase your funds by nearly $100,000

Hi redsquash,

Thanks for mentioning tax benefits. Obviously both scenarios benefit, the IP strategy benefits most towards the end and the combined strategy benefits most earlier on.

I've added a column showing the tax benefit @30%, and assumed it goes towards paying off the IP loan in both scenarios.

The end result after 20 yrs is more equity in the IP-only scenario. However, investing in both gives a constantly decreasing -ve c/f, the margin loan paid off after 13 yrs and +ve c/f after 14 yrs.

The benefits of IP investing are weighted v. heavily towards the end of the investment period - via the power of compounding & exponential growth. I tried to keep things as simple as possible to demonstrate one way of trading off the later benefits of IP with the earlier benefits of a combination strategy.

And I've also fixed both the errors Twitch noted - thanks.

Cheers Keith

 

[anrke]

I don't want to divert from the great discussion, so I'll keep this short and sweet.
Thanks!
From a budding new learner.

 

[Belu]

i would just like to say that if someone would like to lend me $400k i will test out one of the theories...

 

[jingo]

Hi Keith,

Thanks for doing this spreadsheet. This is a very useful tool.

Regards Jason.

 

[redsquash]

Hi redsquash,

Thanks for mentioning tax benefits. Obviously both scenarios benefit, the IP strategy benefits most towards the end and the combined strategy benefits most earlier on.

I've added a column showing the tax benefit @30%, and assumed it goes towards paying off the IP loan in both scenarios.

The end result after 20 yrs is more equity in the IP-only scenario. However, investing in both gives a constantly decreasing -ve c/f, the margin loan paid off after 13 yrs and +ve c/f after 14 yrs.

The benefits of IP investing are weighted v. heavily towards the end of the investment period - via the power of compounding & exponential growth. I tried to keep things as simple as possible to demonstrate one way of trading off the later benefits of IP with the earlier benefits of a combination strategy.

And I've also fixed both the errors Twitch noted - thanks.

Cheers Keith

Keith , if you now include rent to alsways be 3% of IP value, I think you will have a much better guide using this spreadsheet.
I don't know how to modify this. can you add another spreadsheet with this

 

[Belu]

twitch and redsquash, i did this yesterday and posted the spreadsheet?