Cashing in your chips - which is the best strategy?

Hi all,

I seek to test two exit strategy theories on my fellow SS members. Which of these should one use when converting their buy and hold property portfolio into a passive income stream;

Assumtions: 50% LVR on 10 million worth of property (5 million equity).

Goal: 200k pa income stream.


Strategy 1 - live off income

Sell half of your properties to end up with 5 million of property debt free.

Assuming approx 4% net yield this gives 200k pa income. The drawback on this is that it would be taxable.


Strategy 2 - live off equity

Keep all properties. Each year borrow 200K from the bank to cover your living expenses. I assume this would be tax free because it is not income.


Rough workings:

After 1 year;

- Loan is 5.2m after the 200k increase.
- Difference in market exposure between the two strategies is 5m .
- Assuming a conservative average 4% price growth, the difference in equity gain between strategy 1 and 2 would be 200k.

- Equity:
> Strategy 1; 5.2m
> Strategy 2; 10.4m portfolio value minus 5.2m loan = 5.2m (at 4% growth both strategies produce equal equity gain).

- Cashflow (4% net yield):
> Strategy 1; 200k taxable from rental income
> Strategy 2; 200k equity pull from 200k extra equity gain over strategy 1, non taxable. Plus rental income 100k taxable (400k - loan interest [avg 6%] 300k).

So for an equal equity outcome between the two strategies the cashflow benefit of the 'live off equity' strategy is an extra 100k taxable income per year plus the tax free saving from the 200k equity pull. This is based on 4%pa growth and 4% net yield. A higher average growth would significantly increase the benefit of the 'live off equity' strategy 2.

The only drawback of strategy 2 that I can think of would be the extra CGT liability should you decide to sell the lot.

Am I missing anything? Any thoughts?

Ps. the usual disclaimers - this is not financial advice of any kind. I know that I should be talking to an accountant for such advice. Just thought I would put it out there first to see peoples thoughts.
 
Strategy 1. Very simple, because:

a) You've made assumptions about the interest rates. What if interest rates increase to 8%? How do your numbers look?

b) What if your property suddenly becomes vacant? You can survive in Strategy 1, but can you really in Strategy 2?

c) The best time to get into the market is when everyone is going bankrupt. Pretty hard to do it under Strategy 2 because your 50% LVR might soon look like 70% LVR in a down market. A few interest rate shocks and missed rental payments and you'll join the bankrupt to be foreclosed queue.

In a bad case scenario, under Strategy 2:

i) Your debt will blow out to $6m after 5 years.
ii) At 8% interest rates, that's $480k pa
iii) Some missed rental payments brings you down to $350k net rent
iv) You now need to find $130k to bridge the gap
v) Your valuations have fallen, so you can't draw money out to fund that $130k gap
vi) Even if your valuations stayed broadly firm, you have no serviceability. Using debt to pay interest is a sure formula for bankruptcy
 
Since borrowing for personal expenses won't result in the interest being deductible you could borrow to pay expenses and to live on rents - strategy 3.

But you still have to convince a lender to lend.
 
I hate the feeling of selling appreciating assets which will provide growing income in future.
How about making a slower transition rather than simply cashing in and losing your asset base?
Over a short period of time your passive cash flow will increase and you'll get to keep your whole portfolio.
 
I hate the feeling of selling appreciating assets which will provide growing income in future.
How about making a slower transition rather than simply cashing in and losing your asset base?
Over a short period of time your passive cash flow will increase and you'll get to keep your whole portfolio.

It depends what you value most money or time???

MTR:)
 
It depends what you value most money or time???

MTR:)

I'd assume most people would not wait until they had 5 mil net worth before doing a snap transition from working life to complete retirement.

Of course, everybody's situation is different and age comes into it too.
 
I had a client who had 6 properties all fully paid off - and all Sydney properties too. All pre-CGT so no tax on the sale at all. She recently retired from work and has started selling them off. Her rational was the upkeep was too much, land tax was huge and rental yields were low. She is putting the money into shares.
 
wouldn't Strategy 1, selling $5m off incur some CGT that's not accounted for?

say the properties doubled over the 10 years you kept it, so $2.5m gain/increase in value is subjected to CGT.

Say 20% tax on $2m profit, is $400,000 tax payable if you decided to liquidate the assets.
 
Not to mention transaction costs which will no doubt further dent your remaining equity.

Strategy 4: draw down against the equity and put it into high yield shares. This gives you an ever growing income stream, whilst also preserving your asset base (and thus not forgoing further capital growth).
 
Strategy 1 mirrors mine in the next 12 months....though I don't think I will be pulling out of work...yet...

If you have structured correctly..you should have 120-150k net (after all expenses) coming in. Of this I plan to have about 60k in depreciation allowances so actual tax taxable amount will be 60-90 which will result in about 12k to 17k in tax so you should keep about 108k-133k in income! ;)
 
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I'd assume most people would not wait until they had 5 mil net worth before doing a snap transition from working life to complete retirement.

Of course, everybody's situation is different and age comes into it too.

My guess is most wont make $5M equity

Regardless of age it still comes down to what you value most time vs assets, there is no right or wrong

MTR:)
 
MTR

You can't wind back time....but money you can always make it...just need to learn to fish.... ;)

I know which camp you are in. :D

My guess is most wont make $5M equity

Regardless of age it still comes down to what you value most time vs assets

MTR:)
 
Thanks everyone for such detailed feedback.

Deltaberry, some excellent points. It appears strategy 2 incurs quite significant risk when the fundamentals are not favourable. It's clear at the very least that a sizeable cash buffer would need to be in place for such occurrences.

I realise that later in life one would typically opt for less risk, never the less I wonder if you would be able to look at said strategy over a long time frame. Ride the volatility with ups and downs in interest rates and rental yield, take stock regularly and adjust accordingly, maintaining a cash buffer. There is always the ability to sell if needed. Surely when averaged over say a 10-15 year time frame it would still come out in front because of its inherent advantages.

Terry_W, interesting concept and something I would not have thought of. Clearly this is why I need to leave this stuff to the professional. Is 'strategy 3' a typical path for the buy and hold investor in your experience?
 
Thanks everyone for such detailed feedback.

Deltaberry, some excellent points. It appears strategy 2 incurs quite significant risk when the fundamentals are not favourable. It's clear at the very least that a sizeable cash buffer would need to be in place for such occurrences.

I realise that later in life one would typically opt for less risk, never the less I wonder if you would be able to look at said strategy over a long time frame. Ride the volatility with ups and downs in interest rates and rental yield, take stock regularly and adjust accordingly, maintaining a cash buffer. There is always the ability to sell if needed. Surely when averaged over say a 10-15 year time frame it would still come out in front because of its inherent advantages.

Terry_W, interesting concept and something I would not have thought of. Clearly this is why I need to leave this stuff to the professional. Is 'strategy 3' a typical path for the buy and hold investor in your experience?

So what would you do?
 
Hi Marisa
Do you have a link to Steve Mcknights exit strategy? I recall you discussing there is also another strategy instead of buying and holding everything but i dont know when to apply it (when to sell, how many to sell) etc. Is there a certain LVR you should maintain or cash in bank etc?
 
At retiremet (aged 50 & 55) my parents sold all and invested in an annuity. Fast forward now 20 odd years and they live very comfortably with no stress of business or tenants.

The rules have changed a little since Dad bought his annuity, so in the same scenario today they might not get the same amount of pension that they do, but would still be doing ok.

We are sort of looking at a simailar model of investing into super and annuity to create a stress free retirement. I think you need a trusted accountant to help crunch the numbers.

I just know i do not want to be an 80yo dealing with either an office/ factory manger of our businesses or a 20something PM
 
Thanks everyone for such detailed feedback.

Deltaberry, some excellent points. It appears strategy 2 incurs quite significant risk when the fundamentals are not favourable. It's clear at the very least that a sizeable cash buffer would need to be in place for such occurrences.

I realise that later in life one would typically opt for less risk, never the less I wonder if you would be able to look at said strategy over a long time frame. Ride the volatility with ups and downs in interest rates and rental yield, take stock regularly and adjust accordingly, maintaining a cash buffer. There is always the ability to sell if needed. Surely when averaged over say a 10-15 year time frame it would still come out in front because of its inherent advantages.

Terry_W, interesting concept and something I would not have thought of. Clearly this is why I need to leave this stuff to the professional. Is 'strategy 3' a typical path for the buy and hold investor in your experience?

Yes if you could ride through, Strategy 2 will be bigger. That said a lot don't make it.
 
But if you go hard when young you can hit $5m soon and have all the time in the world

I am sure some do, however we had a recent survey on SS, I recall around 9 people who had over $4M in equity. Also another survey most on SS are between 30-40 years of age.

Buy and hold resi is a very slow process, especially if you are on average income.

MTR:)
 
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I think you're right. Trying to get to $5m before say 35 on an average salary is very hard. Then again most people don't ever get there on average jobs - you kind of have to think outside the box, whether it's taking a punt, doing business or something different.
 
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