About Bronwyn DavisAll of us yearn for financial freedom – the power to leave our day jobs and enjoy a long, leisurely retirement.
In reality, we all know that working hard, plying extra cash into our super fund and banking on a nice hefty payout at the end of our career isn’t necessarily going to provide enough wealth for us to retire on. Sure, it might give us some spending money in the short term, but many of us will live well beyond our 60s and 70s. So what do we do when our super dries up?
There’s the pension, but after living on $50,000 to $60,000 a year, will you be happy settling for an $18,000 or so handout from the government?
The good news is that with a bit of foresight, some smart strategies and the old reliable bricks and mortar, we all have the capacity to make our golden years even more comfortable – and a lot more prosperous!
Why property?
“Property is a basic commodity,” asserts Monique Wakelin of Wakelin Property Advisory.
“We have 70% home ownership in this country, so it stands to reason that around 30% of the population rents at any given time. This means you have a consistently significant large pool of people requiring rental accommodation.”
Property has certain advantages over other asset classes, such as shares. It’s less volatile than the stock market and historically, real estate has always increased in value. It has its ups and downs but it’s relatively dependable if investors are wise enough to understand that this commodity requires a long-term commitment to pay decent dividends.
Wakelin advises, “Property is illiquid and carries a high cost for entry and exit. This is why it has to be a long-term strategy and why the bias has to be toward capital growth.” But she assures us that “because it’s a basic commodity, it has a level of inbuilt stability in terms of demand and that underpins its capital value.”
Bill Zheng of Investors Direct Financial Group likes property because it allows investors to leverage other people’s money fairly safely, “which means higher returns at lower risk compared to other asset classes.”
He adds, “The average person retires with $140K superannuation in Australia. You don’t see too many people with more than $300K super, but you can find plenty of people with more than $300K equity in their home or investment properties.”
Because well-bought property will continue to generate capital growth throughout the years, financial planner and property writer Margaret Lomas cites it as a favoured asset class and says if you’re careful about where and what you buy, you’ll always end up with more than what you begin with.
“Providing it’s bought well, a property can become an asset that continues to grow for you into retirement,” says Lomas. “If you have a portfolio which by the time you retire gives you $20,000 a year income, that’s the lowest it’s going to give you because traditionally property will grow over time, as does its rent return.”
The power of equity
Savvy homeowners across the country have learned that the appreciating value of their own home generates equity.
Rather than selling up to release their equity, this astute bunch thinks about the future and accesses it by refinancing and putting it into other forms of wealth generation, primarily property investment.
Zheng notes, “In Australia, most property investors started out by leveraging their own home. If you’re not willing to do this, it’s very unlikely that you can get ahead unless you’ve managed to make a lot more money from other things.”
Wakelin is another proponent of utilising one’s growing equity, firstly in your own home and then in your budding property portfolio.
She says, “The more equity you can control and the sooner you can control it, the greater your level of financial independence. Your increasing equity adds to your asset base because it allows you to use that equity as leverage to buy further assets. Further acquisitions are typically made by accessing part of the equity in pre-existing assets and cross-collateralising.”
Once you reach retirement, your equity begins to work in a different way. After using it to build a generous portfolio, consisting of property alone or a mix of property, shares and other investments, given enough of the stuff, it can start to provide an income that replaces your working-life salary.
Mark Armstrong, CPA with Property Planning Australia, warns however that investors need to adopt some savoir-fare when they swap their day job for a life lived on “equitable” indulgence.
He says the smart approach is all about “getting your equity to generate income for you, so that you’re not actually reducing your equity. Investors should think, ‘I’ve got $1 million worth of equity – where can I now put it to start making it work for me in terms of an income?”
He suggests, “That’s where they might look to the share market or commercial property trusts – a nice diversified portfolio.” Armstrong says these forms of investment can generate surplus cash flow while protecting the primary property portfolio.
“The battle is – how do you protect your equity whilst making that equity provide income to live off? So investors should be aiming to build equity and then make that equity spin off as much cash as possible to provide a very comfortable lifestyle.”
How much is enough?
So if equity is the golden goose that will provide for us in retirement, how much is enough? And for that matter, exactly how much money makes for a comfortable retirement income?
Lomas warns those with rose-coloured glasses that property investment will make few people into millionaires. In reality though, how many of us are raking in a seven-figure salary from our day jobs?
Most financial planners such as Lomas will advise their clients that “a good comfortable goal is to aim to replace your own working income”.
To achieve this, you need to calculate the number of properties and the combined worth of a portfolio that will see you end up in this ideal financial position. Depending on the strategy you intend to use, there are a number of ways you can work out how much property you’ll need and the equity you should be holding in your portfolio to put you in a position where you can finally bid your boss farewell.
These deductions are largely based on the rate of return you can expect to achieve from your property portfolio – both with regard to rental yield and long-term capital gains. Advice varies depending on who you talk to, but the overall consensus remains fairly similar.
Michael Yardney, director of Metropole Property Investment Strategists takes a reasonably simple angle on how much is enough. Yardney theorises that five median-priced properties paid out completely can provide investors with the ability to replace their annual working income.
“In Australia the average rent for median-priced property is about a quarter of the average weekly income,” Yardney explains. “Therefore if you want to replace your average weekly income, you’ll need at least four properties owned outright, each giving you the equivalent of a quarter of the average weekly income in rent. Plus a fifth to pay for rates, maintenance, outgoings and so forth.”
Zheng’s formula is just as easy to work with: “Currently, if a property doesn’t have a mortgage, it returns roughly 14 per cent a year (10 per cent growth and 4 per cent rent). If you only spend the return every year through finance (reverse mortgage or other means), $1 million worth of investment properties can give you $140,000 per annum.”
Armstrong is not so comfortable with the idea of retirees using reverse mortgages and lines of credit to live off their growing equity. He prefers the idea of refinancing and using equity to generate positive cash flow from other asset classes and the potential for a healthy 5 per cent rent return providing adequate income from a well-built property portfolio.
He deduces, “If you require an income of $50,000 a year, you’ll require a residential portfolio with $1 million equity, which will give you that 5 per cent return. Whereas if you have $1 million in equity and decide to flip that over into a more cash flow-driven property sector, like commercial for instance, you may well find that can generate $70,000 to $100,000 a year income. So people need to review their portfolio annually, review their lifestyle requirements and set very clear goals.”
Property that pays
The next step is to consider what type of property provides this kind of return and can generate the level of income we’re talking about.
Most experts say acquiring decent capital growth should be the primary aim of all property investment endeavours.
Traditionally, it has been held that high-growth properties will produce low rental yield and vice versa. So if capital growth is of the utmost importance, yet living off the rental income stream that investment properties can provide is the long-term goal, how do we achieve both outcomes with the one portfolio?
The answer is that properties that begin as negatively geared investments should, if selected carefully and managed proactively, become positive cash flow producing assets in the long run.
Although many investors may be tempted to reach for higher rental returns in favour of having to make up a cash flow shortfall with negatively geared investments, it’s important to realise that it’s the capital growth that makes it possible to retire on property – not just rental yields.
Lomas is a staunch advocate of positive cash flow property investment. However she qualifies that this strategy isn’t about going into the middle of nowhere and buying in a town that relies on one industry for its economic wellbeing, thereby providing property that pays dividends in rent, but returns very little capital growth.
“Positive cash flow is about on-paper deductions and making the bottom line positive,” says Lomas. “Once I get back those on-paper deductions through my tax, it makes up the hole between what I’m getting in and what I’m paying out and I’m very careful to choose properties that more than make up the difference.
“Buying positive cash flow property is about finding a single property that will deliver that cash flow for you. Positively geared property is where you get higher rent returns and low purchase price and you may not get as much growth from that.”
While this might seem feasible, there are those who would suggest that on-paper deductions aren’t the best way to go when trying to make property pay.
Armstrong cautions, “We see too many people go into positive cash flow properties and rely on things like depreciation benefits to generate income. They have very high gearing levels and they actually find that by the time they get to retirement, their gearing levels are still too high and the income they could be earning is being drained away by interest payments.”
“Depreciation benefits have a limited lifespan. Although a property depreciates over forty years, most of the depreciation is used up in the first five to ten, so investors may well find that by the time most of the depreciation’s used up, their portfolio’s not as positively geared as they thought. You can actually find property going from a positively geared position back into a negatively geared position as depreciation is used up. They need to be focusing on reducing debt in some other way to make that positive cash flow more powerful.”
Belinda Robinson, financial planning technical adviser with CPA Australia, puts forward a similar case and says that ultimately, “whether you’re claiming money back or getting it back as a tax break you still have to spend it – so you don’t get rich with tax deductions. Tax needs to be the secondary issue, not what your portfolio’s based on.”
Lomas counters by suggesting that it’s all about how you use positive cash flow property in the first instance and making sure you don’t squander what comes your way.
She says, “The detractors are going to say that on-paper deductions are going to run out and yes they do, but the plan is that while you have those deductions, you plough your extra cash flow back into the debt so that once they’ve run out your debt is more manageable. Your rents will probably increase a little over time and the property then becomes really positively geared because you’ve got low debt and good income. So you’ve reduced your expenses by using your cash flow to do that. It’s a big picture view.”
Most property advisers will suggest that rental income should only become your primary focus when you’re nearing retirement, while during the accumulation phase of a property investment career, it’s more important to keep your eyes on the real prize – strong capital growth.
As Wakelin says, “Strong capital growth leads to compound growth that, in turn, multiplies the overall return. Compounding capital growth achieves this more quickly and effectively than after-tax debt reduction derived from the rental or other sources of income.
“Furthermore the income generated by the higher-growth scenario far outstrips that of the high-yielding, low-growth option on a timeline that coincides with retirement for most investors.”
Wakelin also argues that while rental income-reliant positive cash flow properties might look better in percentage terms, the figures don’t necessarily add up when it comes to counting the actual dollars and cents.
She says, “Let’s consider a $300,000 purchase delivering 5 per cent capital growth and 10 per cent gross rental return. In 20 years the property will be valued at nearly $800,000 and rental income will be just under $80,000. A similar priced property showing 10 per cent capital growth and 5 per cent rental return will be valued at just over $2 million and rental income will be more than $100,000 at the end of the same time period. That’s a difference of over $1.2 million in lost capital growth!
“Rather than thinking so much in percentage terms, people need to focus more on dollars – we live on dollars and we’re taxed on dollars, not percentages.”
Staging your success
There are various stages within the process of successful property investing that go hand in hand with where you’re at financially.
In the beginning your primary focus should be on asset accumulation.
There’s not necessarily an age restriction on when you should start out with property investment, but ideally the younger the better – this gives you time to grow your portfolio while you’re still deriving an income from paid employment, which has a number of advantages in the asset accumulation phase.
As Zheng points out, “If you’re younger, you may consider taking on larger debt, as you don’t have a lot of equity and you can work harder to hang on to mortgages while your properties are increasing in value. Plus you can afford to make a mistake and you’ll still have time to fix it.”
Wakelin says investors need to realise exactly what the primary aim of the growth or accumulation stage is all about.
“Achieving a stupendous rental income is often not as important as capital growth (at this time) because the aim is to amass a sizeable asset base capable of generating substantial equity,” she says.
If you buy good property in high growth areas, you can leverage off the equity that your first investment will naturally accumulate over time to continue to build your portfolio.
Yardney explains that getting the fundamental building blocks right will ensure you have room to move and can continue to grow your asset base.
“You buy a well-located, high-growth property, wait for a few years for that to increase in value and then leverage off the equity in that to buy your next one. Then you have two properties increasing in value to borrow against, so in a few years’ time, you can buy even more properties.”
This is where the true magic of holding onto your assets becomes evident.
Only with property can you leverage your burgeoning equity to help you leapfrog into your next purchase and create more and more potential future wealth.
Wakelin also points out, “As the value of property goes up, the proportion of your rental income is to some extent tied to that increasing value. Added to that you have the effects of inflation and levels of supply and demand in the rental market contributing to increasing income.
“Over time that slowly increasing level of rental income helps to ease cash flow. It’s always those first couple of years that are the most challenging from a cash flow point of view, but as time passes and you get into year three, four and five, it becomes a little easier.”
When you reach this point, you then enter the consolidation (or debt reduction) phase. This is the time to look at reducing your debt as much as possible to prepare for your imminent departure from the workforce.
Armstrong says, “Money is the most powerful commodity known to man – no other commodity generates more money than money itself. The only way to get that money in the first place is by building equity. You do that by growing real estate on the one hand and reducing debt on the other.”
Many property investors have been taught that negative gearing is an excellent way to go when it comes to tax breaks and building a portfolio, and this is certainly true to a large extent. However if you’re heading into retirement too negatively geared, you could end up creating a financial noose around your neck rather than finding the financial freedom we all seek.
Firstly you won’t have a working income to claim any tax against and secondly, you’ll have to find other forms of surplus cash to make up the shortfall between what you owe and what you own.
The third and final stage to successfully creating a property portfolio is the cash flow phase where, as Armstrong says, “you’re heading towards retirement and your rent is starting to supplement your income.”
Armstrong suggests that this should be the time when investors consider flipping their strategy from building equity to acquiring cash flow.
“They might look at the commercial property market or commercial property trusts, where cash flows are a lot stronger and returns are closer to 10 per cent rather than the 5 per cent you get from residential.”
Structure right and save
Most property investors hold their assets in a single name or partnership (husband and wife for instance) structure throughout the life of their portfolio.
While this is often the best way to go during the initial accumulation phase, it’s not necessarily ideal to carry right through for the term of your investment career.
Armstrong says it has its place in the beginning as, “in this stage you might be looking at negative gearing benefits, so you’re better off holding your assets in a personal or partnership structure.”
However he also warns investors that “once you have equity, protecting it is really important.”
This is where becoming proactive, really understanding your taxation obligations and knowing where you’re at every step of the way comes into effect.
Armstrong observes, “One of the biggest mistakes we find people making is within the structuring of their portfolio. It’s so important to maximise your income through the right structure and there’s no doubt that when you’ve got a lot of equity and you’re looking to generate income, a trust structure is a really efficient way to do that.”
Armstrong cautions to steer clear of a trust structure in the growth phase, as you can’t negatively gear through a trust, but recommends it once you have enough equity in your portfolio to live off.
He says, “You can channel that money down through more avenues (through a husband and wife, kids and a family) and that can effectively reduce your tax bills each year. You can even channel income down through a corporation or company and just pay a flat 30 per cent tax rate through the company.”
He does warn however that, “In restructuring your portfolio, there are considerable costs via stamp duty and crystallising any capital gains – so we need to work out whether those costs justify a restructure, but quite often if we set up the right structure and give it enough time, that time will justify restructuring the portfolio.”
For this reason, it’s vital to consider the structure of your portfolio at the start of your property investing journey.
Retiring your debt
The debt reduction (consolidation) phase is of utmost importance and will determine how much income you are able to derive from your portfolio in retirement. There are a number of ways to go about reducing your debt.
Zheng suggests, “If you have held a few properties for many years, you can probably sell one to clear all of your debt.”
Although many advisers caution against selling off your portfolio to generate income, selling one or two properties to go into retirement debt-free is a strategy that many support.
Wakelin provides an example of how an investor might simply achieve debt reduction using this scenario.
“A Victorian cottage that was worth say $65,000 in 1983 would very easily be worth $600,000 today,” she says. “If the original debt on that property was $50,000, assuming that the investor had made interest-only payments for the past 23 years, realistically you’d have to sell very few assets to be able to retire the $50,000 debt on that investment.”
Yardney suggests some other methods of retiring debt could include using a lump sum super payout to put toward your mortgages or just applying some logical forward planning.
“As you’re getting closer to retirement age, you stop growing your portfolio as quickly – you stop adding properties, so your loan to value ratio slowly drops, you have more equity and in time you have more positive cash flow. Or maybe you convert your loans to principal and interest, so rather than paying interest only in the last few years you slowly repay some debt. The whole aim of these strategies is to make your portfolio less highly geared and more cash flow positive.”
Lomas believes that adopting a sound strategy for debt reduction is of the utmost importance – not just as you get closer to retirement age, but right throughout your property investing career.
She counsels, “People have to understand the best way to use debt, the best way to offset interest and the best way to put every single cent that they have into reducing debt, because for every $1of loan that you repay, that’s essentially another $1 of property you own and $5 of property that you can purchase by leveraging and borrowing again.
“The quicker we can reduce debt and gain leverage in our portfolio, the quicker we can gain more growth assets – which when combined together in retirement are going to create that retirement income for us.”
Managing cash flow
To be in a position where you can reduce debt so that your property portfolio ends up neutrally or, even better, positively geared as you reach retirement, you need to be able to adopt effective cash flow management techniques.
Zheng affirms that, “Cash flow management has a lot to do with financial disciplines. Making cash flow management high priority is the first thing an investor must do.”
Hopefully you’ve attained enough discipline saving for your own home to understand how important it is to take a proactive and regimented approach to managing your money.
As Lomas says, “When you’re looking to make an income from your portfolio it’s really important to make the difference between what you owe and the total value of your portfolio as big as you can, because for any return you’re getting, the portion you own is the bit that you’ll get back as income. I think of all of my debt as one debt, so I’m always ploughing my cash flow and every spare cent I have into reducing it.”
Cash flow management should be a part of your overall approach to how you invest. Armstrong believes it’s essential that investors are aware of their refinancing options from the beginning and that they use all resources available to them to ensure they remain in control of their debt, rather than their debt controlling them.
He says, “The banking industry is hyper-competitive. They’re now talking about things like 30 to 50 year loans, which can reduce pressure on cash flow and may provide more cash flow to apply into other areas.
“Banks are also very competitive with interest rates now. So we’d recommend that people look at reviewing their loan structure every two to three years and consider how they can tweak it to save money.”
To give investors some incentive to really take the reins when it comes to their cash flow management, Armstrong declares: “by saving as little as $50 a week in your loan structure, you can save around $120,000 to $130,000 over the life of your loan – that’s on a $200,000 loan over a 30-year timeframe.
“You can easily do this by negotiating a better interest rate. Instead of negotiating a 0.7 per cent decrease, negotiate a 0.8 or 0.9 per cent decrease. Instead of having four or five loans all over the place, all incurring a $300 annual fee, consolidate them into a structure where you only incur one $300 fee each year. There’s a whole range of strategies people can use within the financing industry to take the pressure off cash flow and reduce debt.”
So how do I live off my portfolio?
There does seem to be some contention in finance and property circles as to the best formula for retiring comfortably on a property portfolio.
In reality, as Robinson succinctly concludes, “You have three ways of getting money back out of your investment – you have ongoing income, or the net rent the property’s paying you; there’s the possibility of borrowing against the equity; or you can sell the investment to release the equity.”
While Robinson believes the simple solution is to sell up and live off the capital you’ve built, many property advisers and financial planners will tell you otherwise.
The first issue they have with this option is that you’ll be paying capital gains tax on any profit you make. But the main concern is that while this may seem like a logical short-term fix, it could leave you with an ever-shrinking income as years go by and you eat up the equity you released.
Many investors might think that offloading property is the easiest way to go when they need to make some money. Living off increasing equity can seem too confusing to contemplate. Really though, it doesn’t need to be so hard.
Yardney explains, “The concept of living off equity is one that very few people adopt because it’s foreign to what they’ve been taught. What you have to do to live off equity is to live off increased borrowings.
“The principle is: I’ve got $2 million worth of properties in good locations across capital cities so therefore every year I’m worth $200,000 more. If I live on $100,000 of that I’m still going to be worth another $100,000 every year, so even if I’m eating away $100,000 capital, at the end of the first year I’ll be worth $2.1 million, at the end of the next year I’ll be worth $2.2 million and so on.”
He does caution though, “You really can’t count on that 10 per cent increase each and every year because we know property doesn’t achieve that rate of growth consistently, so every year you have to leave yourself a ‘safety buffer’.
“You probably shouldn’t be using up any more than 50 per cent of what you think your increasing equity will be. You have to leave 20 per cent of it for the bank anyway and the rest as your cash flow buffer, because you’ll have good and bad years as well as some unforeseen expenses.”
He continues, “Your income should come from two sources – partly from rent and partly from capital growth. Make sure you’ve got more than enough to cover what you want, plus some because you’ll always have a couple of lean years.”
Lomas isn’t so keen on the idea of refinancing and drawing on increasing equity to generate income. For her, the more capital you own outright, the less you have to pay back and therefore, the greater your share of the income derived purely from rental returns will be.
Lomas’ calculations of what an investor can expect to get back from their portfolio as income goes something like this: “the portion of the portfolio you own, multiplied by whatever the rent return is considered to be, is your share of the income it makes – the rest of it goes to the bank and expenses. So if I owned $2 million worth of property but I owed $1 million on it, it’s feasible to say I would generate about a $40,000 to $50,000 income per year (based on $1 million x 4 to 5 per cent rent return).”
Wakelin also considers rent returns a good solid means for retirees to replace the weekly wage they enjoyed when working full time. She feels investors should take a more proactive stance with their portfolio though and use their increasing equity to not only retire any debt, but also invest in other means of wealth creation.
She explains, “If you’ve been smart you’ve amassed a bit of superannuation, you’ve got some good shares and you’ve got four or five properties, so you sit down with your financial adviser and say, ‘I need to minimise my income tax and I have all these assets that I need to generate a retirement income from so I can live in a reasonable fashion.
“At this point, you move from increasing your store of equity to maintaining good levels of equity and using that equity to generate income.”
“That doesn’t mean that you go out and sell all of your assets and buy high-yield properties that generate large rents, because the fact that they won’t hold their value will over time diminish the income they generate. You have to maintain your high-growth properties because they actually generate more dollars in terms of income than their high-yield, low-growth counterparts.
“So hold onto your good-quality properties and retire your debt by whatever means possible, whether that’s using your super or selling one of your properties, then basically live on the rental income and other income you have from super, shares or whatever else.”
Don’t sell yourself short
Armstrong says one of the biggest mistakes people make is to sell down their entire portfolio purely to generate income, without giving any thought to their future.
He describes a concept known as the “headless fish”, whereby retirees put all of their equity into an annuity stream (or complying annuity), and in doing so, offload their entire investment portfolio.
The problem being, as Armstrong clarifies, that “your equity is reducing in value every year as you draw more income out of it and you have compound growth working against you.”
He adds, “That’s fine, as long as people are still holding property that’s compounding in growth. They need to have a balance, they need to take out some equity to generate income, but they also need to have a portfolio that’s still growing. The reality is that our cost of living is always compounding, so you must have assets into retirement that are compounding as well.”
In this way, when your cash flow begins to dry up from that initial amount of equity you drew on to use as income, you’ve still retained a portion of your portfolio that’s been growing and growing to give you a kick along and allow you to continue living comfortably.
As Armstrong puts it, “So that when you hit 75, you can sell that compounding asset again and flip the profit over into a cash flow-driven strategy to give you another 10 or 15 years of retirement money.”
This article was first published in Australian Property Investor Magazine and is copyright and reproduced with their permission.
