The reason why the vast majority of us are investing in property is to provide ourselves with financial independence at retirement. However many investors seem vague on exactly how they will be able to derive an income stream from their assets once they have reached that stage in their lives.
The Acquisition Phase
The key to building a substantial property portfolio over time is the use of borrowed funds. Investors may start with their principal place of residence and tap in to existing equity in order to leverage themselves in to their first investment property. If the deposit plus buying costs are borrowed from existing equity investors are in effect borrowing 105% of the purchase price. Most investors prefer to opt for interest only payments, so the principal is not being reduced. If each time you borrow 105%, you may end up with a large equity base, but you will also end up with a very hefty mortgage.
For example, if we say that the average price of a good quality investment property today is $400,000, then in one doubling cycle it should be worth $800,000. Based on an annual compounding growth of 10%, if an investor purchased 1 investment property a year for the next 8 years they would be sitting on a portfolio of over $6 million. However their combined mortgages on these properties would probably be around $4 million. Now of course rental income should be substantial, but once all the outgoings are paid there probably be won’t be enough positive cash flow left to fund a wildly extravagant lifestyle.
At this stage many investors see the only option is to sell off enough properties to retire the debt completely and live off the rents, even though they know that they will lose a lot of money in the transaction. For example you may have to sell 6 in order to pay out the debt on the remaining 2 as you will end up paying a lot of Capital Gains Tax, agent fees etc.
The key to your future financial independence is the size of your asset base. The bigger the asset base the more wealth you will have created. So how can we derive a passive tax-free income from our assets in retirement without selling off the goose that laid the golden egg?
Well, why not continue to leverage against your increasing asset base, but use the funds to cashflow your lifestyle rather than for down payments on more properties? If your portfolio increases in value by $600,000, why not borrow a small percentage of that, say $100,000, to live on? Because this is borrowed money it is tax-free. Of course you will have an additional interest cost which is non tax deductible, but you only have to increase your rents by an average amount each year in order to generate enough extra income to cover the cost of your drawdown. And because you are only borrowing a small percentage of the increase in value, each year your loan to value ratio will reduce as your asset base increases much more quickly than your drawdowns reduce it.
Say you were keen to pursue the first option. That is, on retirement you sell 6 properties in order to own 2 outright. You have in effect reduced your asset base to $1.6 million. After a further doubling cycle your properties will be worth just over $3 million. But if you had kept the original 8 properties and lived off the equity rather than trying to live off the rents, you would be sitting on an asset base of $12 million. $12 million instead of $3 million. I know which one I would prefer.
It is good to be aware of all the different options available to the investor when it comes to deriving an income from their investment assets in retirement. However in the early years when investors are in the acquisition phase they don’t need to be too focussed on exactly which option they will utilize. It is suffice to know that if you invest in a number of well-researched investment properties over a number of years you will be in a strong position when the time comes to retire, and you will be able to review the options and decide on the one that is most appropriate for your circumstances at the time.
Ian Hosking Richards is a successful property investor with a portfolio of over 30 properties. He is the CEO and founder of Rocket Property Group, a leading independent real estate agency that helps hundreds of people each year enter the property market or grow their existing portfolios.
For further information or assistance, please visit www.rocketpropertygroup.com.au or call 1300 850 038.
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