Developing an overall PI strategy

[Peter Parker]

(sit down with a cup of coffee for this one!)

For a while, let's put to one side the work finding deals, managing property managers, getting finance, not to mention debates like property vs shares discussions and think about our own long-term financial strategies and how we construct our portfolios to meet our objectives.

Some of the property invesing books concentrate on buying and managing individual properties rather than managing the portfolio as a whole.

In this posting I outline an approach for everyone to pick holes in. Some of you might be following something pretty close to it, while others might think it would hold them back.

Some assumptions first. The investor is fairly conservative, but willing to take measured risks in order to obtain their objective. For the sake of this exercise, they want $30-40k pa in passive income when they retire. They are currently employed and earn a modest income ($30 - 40k). They don't want to incur too much debt.

The investor wants a strategy that has a high probabily of them achieving what they want. However they are more flexible as to when they want it. However they would prefer early financial independence if possible and are willing to take some risks to make it happen. But on no account is the achievement of their target income threatened.

Believing that everyone needs somewhere to live, they decide that low to middle priced property in a good suburb in stable or growing country town will be their preferred vehicle for investment. They can get about 8-9% gross return. Any capital gain is a bonus that is nice to have but not essential to the success of the investing strategy. The idea of buying a property every 2-4 years and spreading risks appeals to them.

So they save up 20% deposits and take out 30 year P&I loans on each property. After tax deductions, the rental income more than covers the outgoings, like interest, rates, body corporates, insurance, etc. Thus they find that they can pay each loan off in about 20-25 years. They want no debt when they retire (which could be age 40 or age 60).

So they end up with approximately 6 properties with various length mortgages left. There has been some capital growth, but they don't want to sell any properties to pay off debt as this would eat into their retirement income.

I said earlier that they wanted to speed up their retirement. So they put some savings away every month. 50% of this is in a secure fixed interest fund for deposits on the next house. The other half is in growth Australian and international shares. After they've bought their last house they put more into the growth fund. Depending on the performance of the share growth fund, they can cash it to pay out debts. At this point they can retire.

If the share fund performs poorly, they will have to wait longer for retirement. But if it does well they might be able to retire in 15 years or less. But no matter the performance of this fund, they will own 6 houses outright on retirement.

Therefore they have reasonable security of their retirement income, but there is some uncertainty as to when they get it. But they're happy to live with this, knowing that if there is a big share crash they are still OK with their properties.

So what do forumites think? Are any of you using it, or a more agressive variant (eg interest only loans and sinking funds)? Comments please!

Peter

 

[D.T.]

Hi Peter,

Great post, albeit alot more conservative than I think most people actually are.

Please correct me if I'm wrong, but from what i've understood of your post, your suggesting get rid of the debt and live on the rents of 6 IPs. This isnt a strategy I agree with. Lets say that these 6 IPs rent for an average $250 a week, and there's no vacancies. That'd be $78,000 pa. I'd expect about 15% costs (maintanence, management, repairs, etc). This results in an after tax and after expense figure of $60,000. This is quite a bit more than the figure you posted, but its still about 20 - 25 years in the making because of the conservativeness of it.

Why take that long when ya can do it in 10 with less tax?

I welcome your reply

-Regards

Dave

 

[Peter Parker]

Hi Dave - I suppose the reason for the conservatism is to have a strategy that's almost guaranteed to work, even if interest rates are high.

I've suggested something that may be 99% likely to work in 30 years, 95% likely in 25 years, 90% in 20 years and maybe 70% in 15 years. So I've put most of the uncertainty into when rather than if. But at the same time put in steps to provide the possibility of it happening sooner.

One thing I missed mentioning was to put an LVR limit on the entire portfolio - let's say 50% across the whole lot, including the shares. This is lower than the banks will lend on so obtaining finance will never be a problem. But this as well as the supplementary savings program will keep you afloat even if interest rates double.

As soon as the LVR drops down to 35-40% it's time to buy another IP. As for when, this depends on how much you save. If you're looking at $100k IPs that return (say) $170pw, you'd need to save $50k in 2-4 years to be able to buy it while maintaining LVR. About $20k would be from your fixed interest fund to provide the deposit, with the remaining $30k coming from the share portfolio and any capital appreciation on IPs.

My observations is that $250pw is a bit high for IPs that most people can afford to live in; the average rent in WA is $156pw. The properties that would attract $250pw rent would normally cost at least 300k (unless buying in mining areas where you might only pay $150k). Unless you were willing to tolerate 80-95% LVRs or get lucky with capital growth, it's going to be hard for someone on $30-40k a year to get six $300k properties. Hence my preference for lower priced, higher-yielding but still sound properties renting near or below the median rent.

Also with costs, this percentage might drop with increased rents, but I'd allow 25-30% rather than 15%. Yes you could borrow more with interest only loans and have repayments 100% tax deductible, but you don't own anything at the end unless you save up the principal to pay it back. Thus you might as well do it through a P&I loan.

Peter

 

[lissie]

It seems to me that there are 2 ways to achieve the same aim - CF properties or capital gain.

Note this is a NZ point of view your mileage may vary.

CF properties : 10%gross in the country, or cheap suburbs , standalone houses preferably 3 bed, garage, fenced Buy & hold forever - pay off the loan and you have an inflation indexed income for life

Pro: dont have to decide to sell, just manipulate the debt levels to acquire income No selling costs. Predictable income - over the long term rents will move in line with inlfation.

Con: hard to find at the moment. Seems that its not going to get any easier eitehr if Oz is an example to go by. Long term maintenace (make sure you buy a good one in the 1st place). Sometimes the tenants are less reliable Income is taxable but in NZ we do have unlimited depreciation which helps.

Capital Gain. Buy hold and hope for above average CG. Buy and either sell when you need the capital to pay off other properties OR draw against the equity.

Pro: CG is tax free in NZ (so long as you are not a trader). Its still possible to get CG which pays for itselft (after tax).

Con: expensive , CG is not guaranteed and appears pretty hard to predict - it seems more of a gamble - but this also means the proftis may be better than expected. Will probably have to sell at some time so you have to pick that time .

Basically we are attempting to combine the 2 strategies:
We have a PPOR worth $410k - nothing owing . In retirement (hopefully no more than 10 years away) we could easily live in a place worth half of this - so I consider this a $200k CG property.

We have 2 cash flow properties - joint income $340pw - worth $159k combined 100% financed
We have another CG property (coastal) $95k - 100% financed - covering its costs.

This weekend we are looking at another cash flow property - $140 pw and also another coastal CG at $110k - would cover costs. Either or both will work for us - uf we can get the deals!

Basically our aim at the moment is to have about $50k of passive income - from cash flow property returning say 7% nett - this is about $710k worth of property. To me its meaningless to talk about number of properties you want - its more about total value and return. Though personally I would rather have 7 properties at $100k on average rather than 2 at $350k each! Better diverstification of tenants !