My 15 year plan

[meatgroup]

Hi Guys,

After reading so much and concentrating on getting a plan in place its time for me to take some action. I am committed to making property investment my path to financial freedom. More to the point, in 15 years I want to have the choice as to weather I need to work any longer.

I have attached a spreadsheet of this plan which includes a few sums. Now, I am no Excel wizz so I thought I would put it to the forum to garner some feedback about it and where I might need to adjust.

Assumptions

• Purchases in Year 1 made with 5% deposit + costs down.
• Value of Seven Hills property in year 2 is after renovation (already done)
• No rent is calculated on the Forrest Beach property as it is vacant land
• Purcahses in Year 2 onwards are made on 100% loans and equity is used for purchasing costs
• Assuming captial growth of 7% per year
• Assuming Rental increases 4% per year
• Servicability is how much of my own wages I am able to pay towards servicing loans up to year 15 when I plan to retire
• Rent is initially calculated at 5% yield on purchase price (not including costs) (fairly conservative I think)
• The shortfall of Rent to Loan Cost is made up by drawing down a line of credit.

So here are my questions. I am not 100% on the line of credit thing. I know I will likely have a shortfall between my rent and my loan costs. I will only be able to service a certain amount of this shortfall with my wage ($121,000p.a). Is there a LOC I will be able to set up from the beginning to help with this shortfall given that my sums show that the increase in equity on my properties will cover any drawdowns I make.

Am I right to assume the LOC will let me draw up to 90% of equity?

Is this plan a little too ambitious. Am I dreaming.

I am so enthusiatic about this. I am about to embark on the purchase of "Property 3" so I want to make sure I am on track. I do not own a PPOR but instead choose to rent to improve servicability. I already have the first 2 properties...so this is Year 2 for me and its just begun.

Ask me questions, tell me what I need to consider.

Man this is fun !!

Thanks in Advance
Ryan

 

[alexlee]

Sounds pretty solid, but as you said your interest shortfall is going to be an issue (though I'm sure your salary will increase too). This is a fundamental weakness of using purely lower-yielding, reasonable growth residential in your portfolio. Great growth, not much yield.

I think after 5-10 years, you can start mixing other properties and investments into your portfolio. Commercial, say, or high-yielding shares, LPTs or even debt instruments. Otherwise you're going to have a massive amount of equity that doesn't help your day to day lifestyle at all unless you sell.

That's sort of what I'm planning. Use residential property as my core growth asset, then use shares to make up some of the income. In the future I plan to do small developments and/or commercial.
Alex

 

[MichaelW]

Great work!

What you might find useful is to explicitly state your assumptions each year along the top and refer to these within your formulas. The sort of assumptions I'm talking about are:

• inflation % (you can use this for rental increases, or specify that separately if you think rents will rise above inflation for example)
• Cost of capital % (i.e. loan rates, vary this if you have different loan categories)
• property growth % (be careful of being too ambitious)
• shares yield % (if managed funds or shares are part of your portfolio)

To give you an idea what I mean I have attached my plan here for your reference. Mine is predicated on basically finishing my Mona Vale development then do nothing other than extract the growing equity and invest it in a high yielding managed fund. The intent is to retain my growth assets but transition more to income assets over time to facilitate retirement by living off the passive income. I don't want to do the whole Living off Equity (LOE) thing, so am focussing on generating a strong passive income stream.

My assumptions are conservative and my approach is also conservative. I'm sure as I start walking this path I'll accelerate it, but its good to at least map out the path in advance. I've kept the model really high level and haven't even factored tax into it (either NG return, or +ve CF payable), nor have I factored other holding costs on IPs other than interest. Its a very simple high level model to map out the broad brush impact of executing a plan.

My approach was to start with my strategy, i.e.:

A balanced portfolio of properties for growth and managed funds to offset the holding costs on negatively geared properties.

Then I did up this spreadsheet to translate my strategy into a plan of action. I will refine it as I go along, but already it shows my target retirement date of 2015 has been brought forward to 2012 just by being more active in my strategy execution by developing Mona Vale to create early equity. A more passive, simple buy and hold, might have seen a longer timeline. Of course, more growth oriented markets might get a better outcome too, but I'm assuming limited property growth and will be happily surprised by any upside.

Hope this helps.

Cheers,
Michael.

PS I've also entered assumptions around living costs, and maintaining a cash buffer at $100K. I also discounted future cash flows using present value logic so that its all represented in today's dollars. As AlexLee points out, my focus is on cash flow as well as equity creation. Once my passive income exceeds my living costs I can retire. This looks like happening around 2012 on current projections.

 

[meatgroup]

. Otherwise you're going to have a massive amount of equity that doesn't help your day to day lifestyle at all unless you sell.

Alex

Thats an interesting comment. I would have thought(once the ball is rolling and your equity is ever increasing on solid captial growth over a long period) that a LOE would be a decent way to go.

People like Michael Yardney et al and some other son this forum I am sure quite successfully use this method.

After 15 years the value of the portfolio will increase at an exponential rate - Say $500k a year minimum.Why would it not be sound to take $150k of this a year as a tax free drawdown (so about the equivalent of earning $300k) and use this to finance a VERY comfortable retirement.

Sure I admit that the debt would increase but so would you equity at a much faster rate. If debt was your friend in building the portfolio, surely it remains your friend in retirment too. Its not like you would be passing on a debt burden to your beneficiaries - completely the opposite.

Am I on the wrong path here ??

 

[Alanna]

After 15 years the value of the portfolio will increase at an exponential rate - Say $500k a year minimum.Why would it not be sound to take $150k of this a year as a tax free drawdown (so about the equivalent of earning $300k) and use this to finance a VERY comfortable retirement.

Would the drawdown still be tax free, given that the purpose of the funds is private rather than income producing?

 

[Bill.L]

Hi Meatgroup,

While this type of planning is good to have, and I did the same myself a few years ago, there is a problem that the assumptions are too evenly spaced.

For example, if the average cap growth over time averaged out at 5% pa how robust is your plan?? More importantly can the plan work with 20% growth next year 15% the year after, then nothing (or worse negative) for 3-4 years.

Unfortunately the reality of IP's is that rent growth and cap growth are not even.

It just makes the planning harder and gets you to see how viable the situation really is.

bye

 

[MichaelW]

Would the drawdown still be tax free, given that the purpose of the funds is private rather than income producing?

Hi Alanna,

This is a living off equity principle. Its basically tax free income as you're pulling equity out with an LOC. i.e. you're spending your growth which is not taxed. If you were to sell the property to extract that equity growth then the capital gains tax would obviously be a form of tax on that growth. If you just pull it out with an LOC then you're effectively getting tax free income. Of course, it comes with the liability of interest for life if you just spend it. But the principal is that you're growing faster than you're spending. If your rent is also growing then hopefully this increasing cash flow offsets the negative cashflow from interest on the LOC. Its a pretty complex formula with a whole heap of assumptions around future growth, but the principal is tax free income.

Not yet an advocate myself, hence the approach of just generating a good passive income stream from managed funds so that I don't need to live off my growth. I'll re-invest my growth via LOCs and margined up into those managed funds. The profit of the funds above the interest costs on the LOC and ML becomes my additional passive income. But of course, that profit is taxed...

Now, on the other hand, if I change those managed funds to be high yielding fully franked shares then there's no tax on the income and I get to keep some bonus growth as well!

At the end of the day this is all a structure discussion. meatgroup's strategy is geared around growth property assets. That's a great strategy for wealth creation, but at some point you need to change your portfolio mix to be better oriented to tax free income than to growth. Otherwise you need to find another way to spend that growth, which is where living off equity comes in to growth oriented structures.

Cheers,
Michael.

 

[Alanna]

Cheers Michael
I have read and re-read this principle in various books and just cannot seem to get my mathmatically challenged head around it! I think that I will ask the financial planner to demonstrate it to me using concrete items in front of my very eyes. Thanks for the clarification.

 

[MichaelW]

Cheers Michael
I have read and re-read this principle in various books and just cannot seem to get my mathmatically challenged head around it! I think that I will ask the financial planner to demonstrate it to me using concrete items in front of my very eyes. Thanks for the clarification.

Here's a really quick simplification for you then (or maybe its just a complication, sorry...)

Lets say I own $1M in properties with absolutely no debt. My income is the rental yield of 3% (lets call it Sydney ) which is $30,000 a year.

If I want to keep this as my retirement nest egg, then really that income won't cut it. Lets assume the value is growing at 7% pa, then that's untapped equity of another $70,000 a year.

So I go to the bank and get an LOC for $50,000. I spend the $30,000 rent plus the $50,000 equity I just pulled out.

Where am I at the end of the year?

I now hold a property worth $1.07M with $50K debt.
My income is still $30K (maybe growing at inflation rate pa)
My net worth has gone up from $1M to $1.02M because the growth exceeds the rate at which I'm spending the equity.
But the stinger I don't like is that I now also have a LOC interest bill for life on $50K, so a liability of say $3,500

So next year I'll need to pull more out as my cost of living just went up by $3,500.

Its all good in principal so long as you factor in the income implications. With a big portfolio that $3,500 is nothing.

My preference would be to take that $1M property and sell it. Buy $1M of income oriented managed funds generating 10% pa in income and retained growth of 3%.

Now I get $100K in income which is taxed down to $70K odd. I'm in much the same boat as the LOE example, but I now don't have a growing interest bill. There's 3% growth in my managed funds so at the end of the year they're now worth $1.03M, much the same as the residual $1.02M from LOE.

Now if I buy $1M worth of a listed property trust or some nice high yielding share, then I get say 6% pa dividend tax free ($60K) and some bonus growth. A nice portfolio can be a much better option than LOE with property as your entire structure in retirement. The growth on shares could be much more than that residual 2 or 3% under the other structure options.

Cheers,
Michael.

 

[Dazz]

Lets say I own $1M in properties with absolutely no debt. My gross income is the gross rental yield of 3% (lets call it Sydney ) which is $30,000 a year.

If I want to keep this as my retirement nest egg, then really that income won't cut it. Lets assume the value is growing at 7% pa, then that's untapped equity of another $70,000 a year.

So I go to the bank and get an LOC for $50,000. I spend the $30,000 rent plus the $50,000 equity I just pulled out.

Where am I at the end of the year?

I reckon you'd be further out the back door than Black Mac the racing hack.

You haven't allowed any money for all of these {Council rates / Water rates / Land Tax / Insurance / PM fees / Maintenance / Consumables}.....

With the type of properties you're describing Michael, I think all of these costs will be in the Landlord's lap. Depending on the type of property you own, your nett income shall be severely reduced, or even negative, depending on the way your council and SRO wants to treat you.

I remember reading something from Katherine saying that she needed 5 houses, 1 to generate rents to exclusively pay for all of the other properties, and she could live off the other 4. ipso ~ 20% reduction from gross to nett rent that you can actually spend.

However, you've done a sterling job describing it all. Just the rough edge bits may be significantly rough enough to knock you back from champagne and caviar to water and baked beans.

 

[meatgroup]

Dazzling makes another point

Dazzling ..... i never cosidered it all from that point of view. I have added 20% to my loan costs for the entire 20 years of my plan for that vry reason. Do you think that would be appropriate or am I undervaluing still. (check my first post on this thread)


MichaelWhyte - you make everything really clear and I thank you for that. I guess my question is "What does it matter if I take on debt to fund a lifestyle while my equity is growing at a rate much faster. When I die the financial position would leave nothing but a very nice inheritance debt and all.

I would love to hear more views on the LOC lifestyle versus the "I have millions invested and I live off the earnings rather than LOC" .... this will make interesting reading !!!

 

[MichaelW]

I guess my question is "What does it matter if I take on debt to fund a lifestyle while my equity is growing at a rate much faster.

meatgroup,

There's a few things you need to consider when planning the optimal structure for retirement. Not the least of all is risk. Put simply, when you move from your wealth accumulation phase of investing to your retirement phase, your structure and risk profile should change accordingly. Whilst in growth mode a highly leveraged property-centric model is good, less so in retirement. In retirement you should consider reducing your risk profile and moving more to a tax effective income oriented structure. I intentionally kept the example simple to illustrate the concept, but Dazzling is right in that there's a heap more expenses associated with real estate that aren't associated with shares for example.

Let me see if I can paint the LOE risk profile a bit better:

With LOE, what happens if the growth is less than your income needs in a given year? Or worse still, what happens if you have negative growth like Sydney has experienced recetly? Now you've got that $1M sydney property giving you a 3% yield but at the end of the year its worth $900K as its value has dropped 10%. You're using LOE and strip another $50K out to live on so now hold debts of $50K taking your total net worth to $850K with a life long interest bill on $50K. Not my personal kettle of fish. I think I'd like to restructure my portfolio in retirement to be more income focussed, but with enough growth left over that I can stay ahead of inflation.

That's why personally, and I stress personally, at the moment I prefer the Navra type fund as a retirement vehicle. If I had $1M debt free I could plonk it in Navra or something similar and get 10% pa income and 3% pa growth. The 3% keeps the value of the fund indexed to inflation so I effectively always hold $1M equivelance in today's dollars of units. The 10% is therefore also indexed to inflation so I live off $100K pa in gross income (yes there's tax on this) in perpetuity. Now markets go up and down, but Navra trades the market so regardless of where your gross holding ends up you should still get your 10% distributions. But this too is like living off equity a bit in that your net worth can decrease if the market tanks and the value of units follows suit. Navra holds pretty much the ASX50 so is more downside resistant than other funds which is part of the reason I like it.

Now, if I hold those units in a trust then I can distribute the income to trustees at my discretion, so my wife and I split the income 50/50 and take advantage of individual tax scales. That would mean the first $40K odd would be tax free if the tax free threshold kicks in at $20K per individual for example.

All just another example. There's no doubt better options than the Navra fund. I'm just not into my actual retirement planning phase yet so haven't researched in detail what they should be. When I get there I'll restructure appropriately. But today I'm in wealth creation mode so am using property as a leveraged vehicle to accelerate my net worth growth. Don't care as much about tax effective cash flow at the moment.

Good luck with it mate.

Cheers,
Michael.

 

[meatgroup]

Thanks for that Michael. It certainly is excellent food for thought so I will "chew it over" annd do a few more sums I think.

I have a few questions about how you have structured your Managed Fund calculations for income. Lets take this year for instance.

PPOR LOC Debt = 309
Margin Debt = 500
Total Debt = 809

Income = 121

How did you come to this figure. You have 15% Dividend and 3% growth. I know that the 15% Dividend gives you the income but where do you then put the 3% growth ??


Ryan

 

[MichaelW]

How did you come to this figure. You have 15% Dividend and 3% growth. I know that the 15% Dividend gives you the income but where do you then put the 3% growth ??

Hi Ryan,

Ooooh detail questions, I love it!

OK, if you go to cell D34 which is the "value" of the fund at the beginning of the next year you will see that it has grown by last years 3% growth return plus the additional borrowings (both LOC and ML at 50% LVR). The additional borrowings are basically me using the equity growth in my properties to invest in the managed fund and margining up. You're right that the 15% in 2007 is shown as income of $121K in that year. I then deduct the borrowing costs in that year to get my net income in 2007. Hope that makes sense.

You'll see that my income return assumptions go back to 10% from 2008 onwards. I set 2007 to 15% as it is conservatively going to do that amount this year. In fact its been tracking at around 20% for the last year or two and the last quarterly distribution was 4.5%. And Navra have said that only one month into this quarter and they've already accumulated a record distribution. All looking very nice at the moment.

Cheers,
Michael.

 

[Sleeper]

Thanks everyone - especially Dazzling and Michael for making the effort to reply to Ryans post.

This helps me heaps in trying to fit my own personal jigsaw puzzle together.

Got lots of bits but still trying to position them to make a nice pretty picture