The power of equity?

[fuister]

Hi All,

I am a property owner currently in preparation for my property investment portfolio. Just a little background:
(PPOR)Property price: 350, 000 AUD
Equity: 100,000 AUD
Debt: 250,000 AUD
Loan type: P&I

I am currently deciding on the type of strategy that I should go for. I have read quite a number of books and am aware of a number of strategies. I recently read one from Ed Chan and Tony Melvin which I am sure many of you are aware of. They advocate using equity to purchase, hold a property and live of. I understand this concept, but have several questions that I am hoping some of you may be able to help me with.

1) According to the book, since I have a 100,000 AUD in equity I can use that to borrow more money to purchase my IP. I understand that fully. Now here is the part that I don’t understand.

What happens to the equity in my PPOR? The way I understand it; it is merely used to be a guarantee for my IP. Therefore, say I purchase an IP for 250,000 AUD. My current equity in my PPOR will allow me to borrow up to that amount say, and therefore I do not need to fork out a cash deposit.

So my situation is now like this:

(PPOR)Property price: 350, 000 AUD
Equity: 100,000 AUD
Debt: 250,000 AUD

(IP)Property value: 250,000 AUD
Equity: 0
Debt: 250,000 AUD

In summary: I am using 100,000 AUD equity in my PPOR to borrow more. There is no charge for using the equity in my PPOR as it merely acts as a guarantee. Is this correct?

2) The book mentions paying for the holding cost of the IP with equity. Holding cost takes into account rents, maintenance, tax etc.

So for example

IP Year 1 Year 2 Year 3
Value 250,000 267,500 286,225
Debt -250,000 -255,000 - 260,350
Holding cost -5000 -5000 -5000
Cost of equity 0 -350 -350
(@7%)
Equity 0 11,650 25,025

(1.Assuming 7% growth. I am not focussing on the growth rate. This may be optimistic. I am more interested in the concept
2. Holding cost is 2% as a rule of thumb from the book. Again more interested in the concept.
3. Interest only loan)

I understand the concept and the table above quite readily. But here is what I don’t get. Equity is the perception of value. What I mean is in year 2 I have 11,650 AUD of value, bit it is not cash. At the end of the day, I still have to fork out 5,000 AUD to pay for the holding costs for each year. The main question is how do I convert my equity to a form equivalent to cash? This is what I really don’t understand.

My understanding is to do a revaluation of the IP annually. Any gain in equity can then be used to take out a line of credit (LOC) where it is then used to pay for holding costs. But doing this would mean consistently taking out debt to pay for debt.

Say after 20 years, My equity is twice my debt and I would like to be debt free on that IP. Can I use the equity to cover the debt? And if so, how do I do that because the only way I know how to access equity is though a LOC which is another form of debt.

Very confused…..Please help!

 

[Propertunity]

There is no charge for using the equity in my PPOR as it merely acts as a guarantee. Is this correct?

No - incorrect. You are actually converting this equity into cash by either taking out a 2nd mortgage on the PPOR or refinancing it to another lender. The cash extracted this way attracts interest charges.

Equity is the perception of value. question is how do I convert my equity to a form equivalent to cash?

Same as above you get a 2nd mortgage or refinance to convert the equity into cash.

My understanding is to do a revaluation of the IP annually. Any gain in equity can then be used to take out a line of credit (LOC) where it is then used to pay for holding costs. But doing this would mean consistently taking out debt to pay for debt.

Yes, you can use debt to service debt - it is called capitalising interest. BUT there are things to be careful of using this strategy. i.e. CG does tend to cause a property to double every 10 years on average however, it does not normally do that in a linear fashion. CG can be flat for many of the 10 years and most of the growth can happen in just a few short years of the cycle.

 

[Rolf Latham]

Hiya FUI

This stuff can be very confusing.

In terms of initial options and whys and hows, a good independent mortgage broker can be a good source of information, IF they have the knowledge to work with such deals.

Sounds to me like you would benefit greatly from spending an hour or 2 with someone to take your through the various options.

As already pointed out, there are some fundamental differences between whats "normal" and your perception. This is absolutely normal, and until you get the right information, and do your research from the inside out you cant really make an informed decision

ta
rolf

 

[BayView]

Also something to consider;

with your PPoR equity of $100k, the Banks will normally only let you access 80% of your PPoR's value for this purpose.

So, if your PPoR is worth $350k, you can borrow approx $280k.

But you still owe $250k, so you can only borrow $30k effectively.

Some Banks will allow you to access up to 90% or even 95% of the PPoR value, but this will attract LMI, and is a very highly leveraged financial position with a lot more risk attached in my opinion.

Why?

Say you were to use 95% of the PPoR value - if you use the newly available PPoR funds as your deposit on the next property, you will have used 100% borrowed funds used to purchase it, making your LVR over the two properties at 95%.

If for some reason you had to make a vey quick sale soon after purchasing to access the funds to pay back the Bank, there is a very, very strong liklihood that you would have to sell one of the properties for less than you paid for it, or hopefully what you paid for it.

After deducting all the finance costs, buying and selling costs - you will be left with some debt and no property.

Not saying you shouldn't go down this path, but you need to be acutely aware of the worst-case scenarios - we have done it on every purchase, but we have made sure our rent yields are very high, our tax deductions are very high (depreciation), use IO loans and we actively reduce debt at every turn to minimise risk and lower the LVR.

Using equity is a double-edged sword - it can accelerate you wealth very quickly, but if things go wrong - it can be disastrous to be so exposed.

 

[fuister]

Hi All,

Thanks for the advice so far. I will indeed have a talk with a mortgage consultant as you have suggested Rolf. Its just good to know the theory behind it so I have a good idea of what to expect.

Propertunity:
That was probably my biggest doubt with the assumptions from the book, that property double in value every 10 years. No doubt history has proven this, but it is after all history. The japan property bubble and the recent sub prime- global crisis is just a reminder that history is not an indication of future events. I know Australia is different and all, but we really never know. The black swan event!

Bayview:
interesting comments. Thanks for that. I see your point.

So effectively I will have 30 k to use as a deposit for my IP. And I assume that in order for the bank to borrow me money would depend on my rental income potential, property as collateral, my personal income and my currentl liabilities (being the mortgage on the PPOR)?

 

[josko]

Hi there fuister and welcome,

You've received some great advice already.


Back in the good ole days, Ed was my personal accountant. I recieved alot of good advice and for a while there, he was my Mentor.

I cannot emphasise the importance of this:

Be very, very wary of a "living off equity" strategy.

When markets are good...the sky is your limit.

When all of sudden they are not.....your bank account can go south in an extremely big way. Especially if you have acquired multiple properties.

What sounds good on paper and in theory, may not always suffice in practice.

Regards JO

 

[Buzz]

Also be aware that with lenders tightening their policies on 'cash out' ie for to live off that equity, pay your interest from or for the next property purchase through frequent refinances is quickly becoming obsolete.

It would be interesting to see what Chan and Naylor consider as the replacement for this previously successful strategy.

As an Eg ANZ anounced last week you can't just access equity you need essentially a letter from your financial planner saying you are investing in shares or the signed contract of sale on the next property, ie proof of what you are going to do. If you are using the funds for a renovation some lenders want to see the quotes for works over $20k. Hence parking funds for the right opportunity or as a buffer, although a great strategy is being outfoxed by lenders restrictions.

So when beginning your investment portfolio with the end in mind you may want to consider implications of these restrictions.

Jane

 

[fuister]

I spoke to a mortgage consultant yesterday, and asked them about how to use my equity. I got a clearer picture now also thanks to all your guidance here.

On another issue, I also asked about my ability to purchase in my name, jointly or a trust. She mentioned that it was not a problem at all. However the trustee must be a person. If it is a company, the loan will be considered a business loan. According to the "wealth for life" book, they suggested that the trustee be a company and I also found this being said in a few other books. Can anyone shed any light on this in lay man terms? My next approach is to speak to an accountant but would appreciate some background knowledge. Thanks.

 

[Peter_Tersteeg]

On another issue, I also asked about my ability to purchase in my name, jointly or a trust. She mentioned that it was not a problem at all. However the trustee must be a person. If it is a company, the loan will be considered a business loan. According to the "wealth for life" book, they suggested that the trustee be a company and I also found this being said in a few other books. Can anyone shed any light on this in lay man terms? My next approach is to speak to an accountant but would appreciate some background knowledge. Thanks.

This advice is generally incorrect.

The specific policies do change from one lender to another, but there are quite a few lenders that will accept a corporate trustee and keep everything as a residential loan.

There are several good reasons why you'd have a corporate trustee:
* Asset protection is a major benefit of using a trust. A corporate trustee helps you to keep the trust at further arms length from you.
* A corporate trustee gives you more avenues of income distribution which can help you be more creative in your tax.
* Some trust structures simply aren't as useful as they could be with an individual trustee. A Hybrid trust is an example of this.

Make sure you speak with an accountant well versed in property investment and trusts. I can recommend several if you like. You also need to get better advice on structuring your finances.