LOE Model

Discussion in 'Property Market Economics' started by Perth Investor, 5th Aug, 2010.

  1. Perth Investor

    Perth Investor Member

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    Hi All

    Variation on a theme here, mainly in the abstract. Feel free to critique or discuss, something that came to me when I was mentally debating the pros and cons of living on equity or living off the rent. Most serious investors in just resi properties on this site generally agree living off rent is a pretty long term solution and the only real way to do it is to branch out to Commercial or shares. I'm not saying don't do that, but I wanted to look at just resi and see where it takes me...

    So this model might qualify as somewhere in between the two (LOE and LOrent)and might convince some in the second camp to join the first camp?

    This model assumes we are in the "mature" part of the investment time line, i.e. buy a heap of properties now, wait 10-15 years, then do this:

    Assumptions: It's my model, so these are my assumptions! If you don't like 'em, get your own! It might be buy 5 properties at $300K each and then when they double you are in the "mature" stage and ready for this. But the specifics aren't that important...

    Combined Property Value: $3,000,000
    Combined Debt Level: $1,400,000
    Rental Yield 5%
    Interest Rate 7.5%
    Property Costs $1.5%
    Inflation Rate: 4%

    Therefore

    Year 1 (right now):
    Rental Income: $150,000
    Property Costs: $45,000
    Interest: $105,000

    Net Rental: $0

    Amazing, cashflow neutral, you'd think I planned this or something...

    Year 2: (next year...)
    Rental Income: $156,000 (increase with inflation)
    Property Costs: $46,800 (increase with inflation)
    Interest: $105,000 (no change, this is the point of investing, but I'll save that speech for another thread...)

    Net Rental: $4,200

    Right that's it, that's my portfolio in X years time, depending on cap growth etc... Now what's the theory?

    LOE would involve saying something like: With a $3M portfolio, increasing at ~5% pa, I can take $150K pa and live on that, and I'll be sweet. And just borrow the $150K pa. In 10 years you will owe heaps more than you owe now, and this MAY stall if we have another banking / credit crisis, or very flat growth for 6years or so.

    Living off rents would involve saying something like: Increasing at $4,000 per year, my net rental needs to keep going up for about 15 years before I can live off the rents. By then the equity will be so massive I might as well live off that!

    I'm not discounting either of those two options but I'd like to look at it a slightly different way.

    My net rental of $4,200, what will that pay off? Well, at 7.5% interest, on interest only (is there another way?) it pays off a loan of $56,000. So if I got a loan of $56,000 and lived off that for a year(tax free, and the interest is being covered by the net rent, so I get the whole $56K) then my net rental stays the same, year in year out. My net equity increases by $100K pa, if 5% property value increases happen each year. If they don't then I'm only decreasing my equity by $56K, which means in the above example, I can go about 18 years before I get to the 80% of the $3M values, and that's a long time for prices to stay stagnant.

    So am I living off equity? Yeah I think so, but that is covered by rental, so I will never need an income to cover my interest expense.

    Is $56K enough? Well that's debatable, but not really worth debating. If it's not enough redo the numbers based on $6M worth of property and you will probably be able to live on $112K. If that's not enough (tax free remember!) you better buy more property.

    Obviously I would borrow more than $56K on day one. I would try and borrow $1M if I could get it (I'm quite persuasive), especially before I throw in the job, but the specifics aren't important...

    So anyway, that's what I'm thinking, what do you all think?
     
  2. bene313

    bene313 Member

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    IMHO pulling out equity to fund a lifestyle is a terrible idea for the following reasons:

    - The objective should be to reduce non-deductible debt, not increase it

    - Drawing on equity to spend the drawings relies on future capital growth taking care of LVRs and the continuation of such a plan

    - Equity can be used in other ways to create income, with far less risk and reliance on capital growth
     
  3. alexlee

    alexlee Member

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    LOE has two important assumptions: 1) there is future growth to create equity and 2) you can continue to borrow on the equity.

    Future growth is likely, but it will be lumpy. You might hit a period of years when nothing much happens. There's a risk you run out of equity before the next uptrend. And as we know from recent events, refinancing with no other income isn't always available. Equity doesn't mean a lot if you can't get the loan.

    So the solution seems to be, you have a LOT of equity, and a low LVR. But with that level of equity and LVR, you might as well start buying income-generating stuff (commercial, bonds, high-div shares) a few years before you plan to LOE, let it build up, and live off income instead.
     
  4. Dazz

    Dazz Banned

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    I agree with your points alexlee.

    Having travelled down this path, my comments would be ;

    • LOE hinges on the whim of valuers and credit squirrels
    • LOR is predictable and under your control
    • I found LOR to be LOE + 3 years
    • LOR is fabbo
     
  5. Rixter

    Rixter $uper Investor (Retired)

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    3/ having the knowledge to structure one's portfolio for 1 & 2
     
  6. Token Funder

    Token Funder Token Funder

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    What Daz said.
     
  7. alexlee

    alexlee Member

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    Fair enough. I, personally, can't confidently LOE without having a level of equity and LVR where I might as well start switching to living off income a few years earlier.
     
  8. VYBerlinaV8

    VYBerlinaV8 Member

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    I think I'd rather work a few more years until I could live substantially off the rent (and yield from other portfolio assets). My idea of retirement is that my portfolio will be low risk. Not very exciting and lower overall returns, but easy to manage and not nearly as susceptible to negative market issues.
     
  9. peastman

    peastman Member

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    I like it. It's very close to my idea of buy a property every 3 years.
    After 15 years you have 5 properties.
    Then buy another and sell the first property.
    Repeat every 3 years.

    It gives you an income of 15 years growth every 3 years.

    If you bought in 1985 for $100k, it would conservativly be worth about $300k now. That would give a net return after costs and CGT of $153k or about $1000 pw after tax. Property growth has actually been far greater than this really, but I am being consevative.

    Of course future groth may slow, but with a 15 year window, booms and busts iron themselves out.
     
  10. HiEquity

    HiEquity Member

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    Am I missing something or would this just incur huge transaction costs - stamp duty, CGT and agent's fees?

    And how do you afford to buy the next property after 15 years once you're retired?

    I'm struggling to see any benefit of this compared to just sitting on five properties and refinancing if you need to and are able to...

    But I'm probably missing something!
     
  11. peastman

    peastman Member

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    Yes there are costs, but they are not too much when looking at the overall picture. About $20k buying and selling costs plus cgt.

    Borrowing equity is not tax free money. The tax does not have to be paid till the property is sold, but one day it must be paid. So it is really just defering the inevitable. I prefer to pay the tax as I use the equity. That way there is no big tax bill on money that has already been spent.

    The cash payout every three years can be then placed into an account that a bank will accept as income which together with rent income will enable the next purchase.
     
  12. alexlee

    alexlee Member

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    Will a bank consider gains from selling a property every 3 years as part of your serviceability?
     
  13. peastman

    peastman Member

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    It depend on how it is structured. By placing the proceeds into an annuity or similar (lots of other posts explaining this) the bank will accept it all as income, but ATO only charges tax on what the capital earns.
     
  14. Rixter

    Rixter $uper Investor (Retired)

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    aka half a cashbond structure. ie without the borrowing component to purchase the annuity.
     
  15. peastman

    peastman Member

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    Yes Rixter, thats about it.
     
  16. Deltaberry

    Deltaberry Member

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    Last I discussed with experts here, 5% yield is apparently pretty naive. You shouldn't consider something so low. That's why your LOR is not working.
     
  17. want2bewealthy

    want2bewealthy Getting wealthier

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    Interesting.

    Heres my 2 cents.
    I quit my full time job after 3 and a bit years of hard work and investing 4 weeks ago. It's been one of my main ambitions for 8 years but only really got started 3 years ago.

    I had a bit of luck with equity growth, but believe me I didn't bank on that at the time of any of these purchases as everybody was saying the same things they always do like 'prices are too high and they will drop soon' they never did and thats part of the reason I did nothing except for save my pennies early on.

    So I got a little lucky and capital growth has been, on average 20% per annum across my portfolio.

    I fulfill a life ambition and quit my job.
    1 week later I ask for my job back because I'm bored shiteless.
    I never thought that would happen, being a driving force for so long.

    So anyway I have a new objective. Now that I enjoy work alot more.
    I will live off equity whenever I feel like taking a 'mini retirement'
    I have another 40 years or so before I hit 'real' retirement age anyway.
    I will continue to buy more property as time goes on also, increasing my wealth. I have absolutely no hesitation to LOE whatsoever as I can't spend this equity fast enough so long as I stick to a reasonable budget. Been there done that..

    The grass is always greener on the other side, but I'm glad I've learned a lesson and working really is alot more enjoyable for me now.
     
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  18. D.T.

    D.T. Property Lookerafterer

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    The solution to your problem, 'Want2bewealthy' is to find more hobbies. If I had the resources to retire today I'd do so in a heartbeat (I'm 28).
     
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  19. landlubber

    landlubber Banned

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    LOR might be great if you're portfolio is commercial IPs, AND you have them all rented. But the "risk" with CIP is loss of tenants and the long vacancies periods that can ensue in a downturn. With respect to Dazz, I admit in a boom economy like Perth the risks are possibly less, but in the "rest of the world" these risks are real and can wipe you out. If your portfolio is all resi IPs, you will need many, many years to achieve LOR IMO. If you think you have an XL spreadsheet that dis-proves this, feel free to PM me. I'm all resi & LOE and very happy with that situation.
    LL
     
  20. alexlee

    alexlee Member

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    And resi property also has its risks, especially in times when bank lending tightens. To me, the biggest risk with LOE is that it sails along happily for 10-15 years or whatever, and suddenly the combination of a down market and tightening lending means I can't borrow any more, and at a time when I'm not longer employable.

    How long it takes obviously depends on when you start, what resources you have and how fast you can build the assets. Everyone has to make their own decisions on the trade-off. And there are other options besides resi IPs for yield: regional property, dividends and bonds, say. A mix will lower the risk.

    Just because you're happy with LOE off resi doesn't mean it'll work for everyone. It depends on age, how much you need / want to live the way you want, and how much buffer you're comfortable with. LOR is less risky, if only because if you're able to LOR, your portfolio would also include a large amount of equity. So LOE becomes the backup.