Fiscal literacy and surviving the GFC

[nonrecourse]

This thread is about surviving the global financial crisis. Fiscal literacy or lack of it is why the world is faced with the greatest financial disaster since the great depression.

A poor understanding of simple accounting principles such as what is a balance sheet and a profit and loss statement is the normal rather than the exception for most people including the majority of so called property investors.

Robert Kiyosaki's best selling series of books that first gained international recognition with Rich Dad Poor Dad are testiment to the poor financial grounding that most of us start out with and why his books were and continue to be international best sellers.

The sommersoft series of books approached building wealth by using other peoples money. Like any investment strategy used conservatively can yield tremendous results.

The problem with negative gearing is that too many investors focus on the tax advantages rather than the underlying numbers as the be all and end all of investing. Negative gearing also increases your losses as well as your capital gains.

Property is like every other asset class has periods where Mr market is irrational and if your gearing is not conservative you can lose your entire investment.

The argument that property in an investment cycle of 7 - 21 years is always a winner presumes that black swan events never happen. That is a pretty brave call. Considering our short investment life span never is a very big call.

Albert Einstein's comment that compounding interest was the eighth wonder of the world I think was even better than his E=mc2.

If you lose your initial seed capital then your compounding effect = 0

 

[Aaron Sice]

agreed. period.

 

[JIT]

Hi NR,

A poor understanding of simple accounting principles such as what is a balance sheet and a profit and loss statement is the normal rather than the exception for most people including the majority of so called property investors.

Proprie...(what's the word again?) = A - L
Profit = I - E

I did Y12 accounting some yrs ago .

The problem with negative gearing is that too many investors focus on the tax advantages rather than the underlying numbers as the be all and end all of investing. Negative gearing also increases your losses as well as your capital gains.

True, but many of us are now approaching a neutral gearing position based on today's 5-10 year fixed interest rates...

Property is like every other asset class has periods where Mr market is irrational and if your gearing is not conservative you can lose your entire investment.

You yourself have said that if serviceability is OK you think it is unlikely that banks will call in loans...so as long as one can keep their JOB...it should be OK right?

Thanks.

 

[nonrecourse]

Hi NR,



Proprie...(what's the word again?) = A - L
Profit = I - E

I did Y12 accounting some yrs ago .



True, but many of us are now approaching a neutral gearing position based on today's 5-10 year fixed interest rates...



You yourself have said that if serviceability is OK you think it is unlikely that banks will call in loans...so as long as one can keep their JOB...it should be OK right?

Thanks.

Hi JIT;
The Key is continued occupancy so that it is not your job that makes the numbers work but the internal rate of return IRR, the efficiency or quality of an investment rather than the net present value which indicates value or magnitude

 

[plusnq]

Hi JIT;
The Key is continued occupancy so that it is not your job that makes the numbers work but the internal rate of return IRR, the efficiency or quality of an investment rather than the net present value which indicates value or magnitude

One of the few times I have agreed with you....had to happen eventually, given your frequency of posting. Occupancy is to residential/ commercial property as sales is to retail. No income...no joy. Dickens was right.

Cheers

Shane

 

[JIT]

Hi JIT;
The Key is continued occupancy so that it is not your job that makes the numbers work but the internal rate of return IRR, the efficiency or quality of an investment

Hi NR,

I understand and agree with this bit, well said.

If my RIP's were all vacant for a prolonged period of time then I agree, I could potentially be screwed (but I do have a modest cash buffer/loan redraw for this anyway).

Although I can see rental demand easing (/rents stagnating or even falling) in some areas/types of property, prolonged vacancy for well-selected RIPs that appeal to a wide variety of potential tenants at affordable rental values...? - I'm not so sure...

Your thoughts?

 

[yieldmatters]

The problem with negative gearing is that too many investors focus on the tax advantages rather than the underlying numbers as the be all and end all of investing. Negative gearing also increases your losses as well as your capital gains.

Yes - the focus on negative gearing is sometimes odd (i.e. losing money on purpose so you can pay less tax). Mind you - it is becoming more attractive to me just on a spite basis - I am sick of funding all this stimulus through my taxes.

 

[BayView]

Simple solution:

make sure your income is more than your outgoings.

Also; Banks like to see LVR less than 80%.

 

[jaycee]

Yes - the focus on negative gearing is sometimes odd (i.e. losing money on purpose so you can pay less tax). Mind you - it is becoming more attractive to me just on a spite basis - I am sick of funding all this stimulus through my taxes.

I don't get how this works, what I mean is, it sounds as though someone new to the game woudl think this to be a good idea, but is it really something more experienced people would focus on rather than the end goal ?

or is that it, that so many of us (me included) dont actually have a defined goal and therefore we get distracted ?

Negative gearing for me is a means to an end i.e. purchsing an IP - I couldnt have afforded the shortfall comfortably without it.

 

[nonrecourse]

Keith you have put up a straw man arguement. Your confusing mum and pop single dwelling home purchasers with property investors.

The reality is we know that if it is your home you will go to purgitory and back to keep a roof over the wife and kids hence the low default.

The 30% gearing is entirely appropriate when you are talking about a string of investment properties all geared.

 

[chilliaa]

hehe Keith i see you too logged on to Berkshire to read Warrens annual pearls of wisdom.
I got back last night around 3am and logged straight in as well,
as always well worth the read. PDF file took a couple of minutes to dowload as well so i imagine their servers were working overtime.

 

[chilliaa]

Keith you have put up a straw man arguement. Your confusing mum and pop single dwelling home purchasers with property investors.

The reality is we know that if it is your home you will go to purgitory and back to keep a roof over the wife and kids hence the low default.

The 30% gearing is entirely appropriate when you are talking about a string of investment properties all geared.

Yes but the residential market is 70% owner occupied, so its the owner occupiers that determine the floor in the market, not private investors (this is a major risk differential between commercial and residential property)

 

[JIT]

The 30% gearing is entirely appropriate when you are talking about a string of investment properties all geared.

For commercial I would probably agree.

For residential...maybe if you were heavily invested in high-end property in prestige suburbs (eg. Toorak, Brighton) or in lifestyle properties (eg. in Portsea, Sorrento)?

In this case having a much lower LVR may be far more relevant, and prolonged vacancy could me more of a reality that could cause you to hit the wall...irrespective of IR's and JOB security.

 

[evand]

Well you wouldn't have bought the property without it.

Negative gearing for me is a means to an end i.e. purchsing an IP - I couldnt have afforded the shortfall comfortably without it.

 

[nonrecourse]

Surviving the soft depression

Hi NR,

I understand and agree with this bit, well said.

If my RIP's were all vacant for a prolonged period of time then I agree, I could potentially be screwed (but I do have a modest cash buffer/loan redraw for this anyway).

Although I can see rental demand easing (/rents stagnating or even falling) in some areas/types of property, prolonged vacancy for well-selected RIPs that appeal to a wide variety of potential tenants at affordable rental values...? - I'm not so sure...

Your thoughts?

The efficiency or quality of the investment is dependent on much more than having a good tenant. Being a fundamental investor means that the purchase price meets that old investment criteria that you make your profit when you buy not when you sell.

Long before you go out and purchase that quality investment you need to have a clear vision of the structure your investment is going to be held in, how you are going to finance that investment and the outcomes you will require through an iron clad lease agreement that gives you space to move if and when that black swan event occurs.

Surviving the soft financial depression if and when the property market values collapse. The average punter be it in shares or property doesn't plan to fail. However because he doesn't plan he does fail.

 

[keithj]

Property is like every other asset class has periods where Mr market is irrational and if your gearing is not conservative you can lose your entire investment.

You can only lose your entire investment in a few v. specific set of circumstances.... the main one being you stop making repayments & subsequently the lender forecloses, (the other is fraud). I'm sure you'll agree that it's not guaranteed that less conservative investors ALWAYS lose 100%. You definition of conservative appears to be <30% LVR. Most here consider 75% to be a conservative LVR in the current environment.

Buffet had a bit to say about foreclosures in his Newsletter. Berkshire-Hathaway owns a big US home builder called Claytons
From page 10-

....much of the industry employed sales practices that were atrocious. Writing about the
period somewhat later, I described it as involving “borrowers who shouldn’t have borrowed being financed by
lenders who shouldn’t have lent.”
To begin with, the need for meaningful down payments was frequently ignored. Sometimes fakery was
involved. (“That certainly looks like a $2,000 cat to me” says the salesman who will receive a $3,000
commission if the loan goes through.) Moreover, impossible-to-meet monthly payments were being agreed to by
borrowers who signed up because they had nothing to lose. The resulting mortgages were usually packaged
(“securitized”) and sold by Wall Street firms to unsuspecting investors. This chain of folly had to end badly, and
it did.

......

This 1997-2000 fiasco should have served as a canary-in-the-coal-mine warning for the far-larger
conventional housing market. But investors, government and rating agencies learned exactly nothing from the
manufactured-home debacle. Instead, in an eerie rerun of that disaster, the same mistakes were repeated with
conventional homes in the 2004-07 period: Lenders happily made loans that borrowers couldn’t repay out of their
incomes, and borrowers just as happily signed up to meet those payments. Both parties counted on “house-price
appreciation” to make this otherwise impossible arrangement work.

....

Clayton’s 198,888 borrowers, however, have continued to pay normally throughout the housing crash,
handing us no unexpected losses. This is not because these borrowers are unusually creditworthy, a point proved
by FICO scores (a standard measure of credit risk). Their median FICO score is 644, compared to a national
median of 723, and about 35% are below 620, the segment usually designated “sub-prime.” Many disastrous
pools of mortgages on conventional homes are populated by borrowers with far better credit, as measured by
FICO scores.

Yet at yearend, our delinquency rate on loans we have originated was 3.6%, up only modestly from
2.9% in 2006 and 2.9% in 2004. (In addition to our originated loans, we’ve also bought bulk portfolios of various
types from other financial institutions.) Clayton’s foreclosures during 2008 were 3.0% of originated loans
compared to 3.8% in 2006 and 5.3% in 2004.

Why are our borrowers – characteristically people with modest incomes and far-from-great credit
scores – performing so well? The answer is elementary, going right back to Lending 101. Our borrowers simply
looked at how full-bore mortgage payments would compare with their actual – not hoped-for – income and then
decided whether they could live with that commitment. Simply put, they took out a mortgage with the intention
of paying it off, whatever the course of home prices.

Just as important is what our borrowers did not do. They did not count on making their loan payments
by means of refinancing. They did not sign up for “teaser” rates that upon reset were outsized relative to their
income. And they did not assume that they could always sell their home at a profit if their mortgage payments
became onerous.

.....

Commentary about the current housing crisis often ignores the crucial fact that most foreclosures do
not occur because a house is worth less than its mortgage (so-called “upside-down” loans). Rather, foreclosures
take place because borrowers can’t pay the monthly payment that they agreed to pay. Homeowners who have
made a meaningful down-payment – derived from savings and not from other borrowing – seldom walk away
from a primary residence simply because its value today is less than the mortgage. Instead, they walk when they
can’t make the monthly payments.

....

If you lose your initial seed capital then your compounding effect = 0

Yep, goes without saying.

However, how likely is foreclosure ?

Reread the last paragraph espec the bolded bit NR. IRs are roughly half of what they were 12 months ago, so making repayments is far easier..... imagine a (highly unlikely) 50% vacancy rate, so income is halved, but outgoings have already close to halved. Inablility to pay is unlikely therefore foreclosure is unlikely.
Most here are long term investors, a lower value will prevent then from increasing their asset base, but it's unlikely they'll lose their seed capital.

 

[willair]

NR,Funny you bring up the "Black-Swan"I have read Taleb's books several times now ,and bought several copies and given them away to people that i know, investors come in 2 groups or varieties optimistic or pessimistic or someone like myself who focus on what you know and don't worry about the unknown,the price of property to me is not important,there is more
money in the equities market right now,buy monday sell friday..

The line i like the most is what my long time accountant told me several years ago, if you work out what you paided for the properties -shares many years AGO??, and work out what they have given back,and work out how you reinvested the money then they owe you nothing,maybe look at it that way,and walk down the local bottle shop and have a drink and smell the "roses"..imho..

..imho wilair..

 

[nonrecourse]

Financial independence for 2% of the population

Getting back to the reason for this thread namely fiscal literacy and surviving the GFC I'll continue, knowing full well that 98% of the population will not follow this course.

Eighty percent of the population will provide the government with lots of revenue from alcohol taxes as willair alluded to. This 80% will be content to accept a government pension and bemoan how tough life is for the working bloke

The current fiscal crisis is part of a larger cycle that is outside the norm and for most is something that they don't see coming. Its not rocket science if your a student of history. But the masses are doomed to repeat history because it is not on their narrow radar screen.

You hear a lot about the oxymoron of diversification. Being diversified does not mean having lots of different shares. Paper equities are just that; little pieces of a company that you have no control over.

I like to describe diversification as the four pillars model that our labour and Liberal governments use when talking about bank stability.

Pillar number one is your home and personal assets. This may include some properties in your name if you have started your investment property journey. At the start there is nothing wrong with owning properties in you or your spouses name. As you grow and your wealth increases you become a target and you will need to diversify.

Pillar number two is your superannuation. I'm not talking about retail super funds or industry funds that are designed to keep the working class and the middle class subserviant to government and the financial spin industry. There is only one type of super for the fiscally literate and that is an SMSF. But again the SMSF is only diversified if you are in the drivers seat. That means purchasing business real estate using a property warrent and a limited recourse loan and a bare trust that holds the commercial property.

Pillar number three involves a family trust and there is a fork in the road at this junction. If you are self employed then your business operates from this structure. With most businesses this involves trading and is distinct from owning an asset such as a property. Having said that we have broke the rule and own one property in our family trust because it gives us a redraw facility that is cheaper using property as security compared to a business loan.

I mentioned a fork in the road with the third pillar. If your an employee your business may be investing in ASX companies via the share market because you have no choice, you either don't have the knowledge, skills and or the capital to start a real business. Why do you need a family trust to own shares you ask ? Well it gets down to diversification. Shares (except for the Warren Buffets of the world who are into fundamental investing) are largely traders which again is OK in a family trust distinct from assets which should be held in a seperate structure from your trading company and shares.

Your fourth pillar is unit trusts and Hybrid trusts that will hold the bulk of your real estate assets. This is where it gets tricky. You want the assets in your unit and Hybrid trusts to be owned outright. How can you possibly do that you say? If you think back to number one pillar when you initially started your property investing journey you should have some property along with your home that you have held for some time. If you were smart your initial loans would have been interest and principle and you will have some equity to play with.

You may not initially have unencumbered property in your unit and hybrid trust. All the units in the unit and hybrid trust should be held by your family trust also known as a discretionary trust as this structure will provide you with the best asset protection.

There is a trade off for this asset protection. If the units are held in the discretionary trust, then if you have losses they will be trapped in the discretionary trust until such time as you show a profit. i.e. no negative gearing

Of course the loans that are held in your or your wife's name including the borrowings that you used to purchase property in the fourth pillar outright are deductable if structured correctly.

The sophisticated investors skill is to own unencumbered property in unit trusts that are controlled by your discretionary trust.

Because the property held in your wife's name your home and your name is makes up the 30% debt I spoke about over your entire portfolio when you sell these there is nothing left in that pillar. When the creditors come after you, those properties are used to clear the debt with the banks but the properties held in your second third and fourth pillar are sequestered and inaccessable.

This strategy is not about avoiding your liabilities. The banks will always get their share and some back. This is more about making sure in a financial meltdown you will survive opportunistic tall poppy cutters who want part of your stash. This is not something you can achieve over 1,2 or 5 years. The bankrupcy act since Westpoint has stringent claw back provisions up to 5 years.

Your best protection in the early years is your SMSF because this is outside your creditors reach.

 

[chilliaa]

I use a similiar strategy thats probably less effective (but also less costly in terms of accountants and asset structure fees).

I use a discretionary trust for my properties.
I borrow from the discretionary trust in my own name on commercial interest terms (currently paying 6.5%) which is fully documented.
I then invest that money into direct shares to collect dividends.
The franking credits offset my personal tax and the balance is refunded (to my understanding this cant be achieved if the shares were bought under the trust structure)

One day when the share market recovers and i am not being adequately compensated for holding shares (in terms of gross dividends) i will execute a gradual disposal of the share portfolio (reducing capital gains tax by reducing my PAYE earnings through my business (which opperates under a company structure) and move the profits back into the discretionary trust.

This reduces the net asset value of assets held in my own name.

 

[Mindmaster]

Getting back to the reason for this thread namely fiscal literacy and surviving the GFC I'll continue, knowing full well that 98% of the population will not follow this course.

Hi Nonrecourse, your post was really interesting, thank you. I'm one of the 98% planning on being one of the 2% after education and experience and want to learn more about the legal structures for property.

Do you have any websites, books etc on legal structures for assets that you could point me and any other interested people towards?