How to Retire at 40

Christina and Ricky have a property portfolio worth $1.7m and nearly $1m in equity. Where should they invest next?

Vital statistics:

Ages: 33 (Ricky) and 29 (Christina)
Occupations: Electrical engineer and pharmacist
Combined salaries pre-tax: $265,000 (excluding rental income)
Combined savings: $0
Equity available: $985,000
Super fund: $100,000

Just over seven years ago, Perth resident Christina had bought her first property and met her future husband, Ricky. Little did she know that those events would lead them to a property portfolio worth $1.7m and net wealth of $1m. The couple aren’t finished yet, either: they’re on the lookout for their net purchase and are seeking advice.

Property one: Morley

The story begins just after Christina now 29, graduated from university. She was employed on an annual salary of just $25,000 – but she was intent on investing in property.

“I’ve been interested in property my whole life” says Christina. “I saw my auntie become extremely wealthy through property and I remember following my father around property inspections every weekend as a child. However, he always looked but never bought – I was certain that I wanted to take action.”

To that end, Christina lined up her first property – a $200,000 four bedroom house in Morley near her parents’ home. However, she hit a hurdle straight away: her salary limited her borrowing capacity to a maximum of $140,000. Even with her $10,000 savings as a deposit and the First Home Owners Grant, she was stuck. Luckily her property-mad father came to the rescue.

“Dad used the equity in his property to gift me $50,000 to supplement my deposit – although I took out a loan to pay him out a year later, once my salary increased,” she says.

That property has done Christina well over the years: she lived in it for the first 12 months, then moved back to her parents’ house and rented it out. In that time, its value has more than doubled.

Property two: Bentley

Christina’s love of property also influenced Ricky, now 33, to get on the ladder.

“Ricky wasn’t too bothered about buying property when we first met,” she says. “However, by the end of our first year together he’d bought his own place.”

Ricky’s property was a $230,000 two-bedroom townhouse in Bentley. The plan was for Ricky to use this as a principal place of residence (PPOR), and later to rent it out to students as it is situated close to Curtin University.

As Ricky came here as an international student, he didn’t have a savings history. Ricky’s mum sent him $10,000 to help him along the way and this enabled Ricky to complete the purchase.

This property has also shown impressive growth – it’s now worth around $410,000 and the couple were able to maximise the rental income by a simple bit of canny DIYing. “As well as the existing bedrooms, the property also had a second-floor attic that could theoretically be used as a bedroom – it was only missing a door,” explains Christina. “So, we installed one! It’s the only bit of reno work we’ve ever done!

Property three: East Perth

The couple took a different tack for their third purchase in 2007, choosing a $207,000 studio apartment in blue chip East Perth. This may have been a mis-step, admits Christina.

“The property is tiny – only 30 square metres,” she says. “Some banks refuse to do loans for properties that small. We suspect that the only reason we got it was due to having a lot of equity. We also made the mistake of fixing the interest rate on the mortgage at 7.6%: a year later, interest rates were plummeting. Now, just as they’re coming back up again, we’re about to come out of the fixed-rate period.”

This has meant that the property has remained negatively-geared through their ownership, despite high rental yields. At one stage, the couple had a tenant paying $320 a week – a yield of well over 7%. However, due to the size of the apartment, and the fact that that it has no car space, Christina and Ricky have found it hard to keep tenants for more than a few months. Capital growth has also been disappointing, with values falling to around $250,000 last year.

“It’s not really costing us anything to keep it, but it’s not really making us very much either,” says Christina. “On the other side, it’s not really the best time to sell it, expecially as there’s a lot of development going on nearby. We’d really like some advice on what to do with this property.”

Property four: Redcliffe

Christina and Ricky’s most recent purchase was their current principal place of residence, a $510,000 three bedroom home in Redcliffe in September 2008. However, even this has undergone a stint as an investment property. “The previous owners were building a new property, and were looking to rent for a while: for us it was convenient for them to do this, as we were about to get married and weren’t planning on moving in straight away,” she says. “They ended up staying there for eight months, which was a little longer than planned; in fact, we ended up living with the tenants in the Bentley property for a couple of weeks!”

The couple have given their all to paying down the mortgage on the Redcliffe property, reducing it to $140,000 in just over two years thanks to the couple diverting all their leftover income to extra payments and Christina transferring $200,000 in savings into the loan. This, along with the equity growth they’ve seen in this and the other properties, means they’ve got a significiant amount of equity to play with.

“We’ve got nearly $1m in equity,” says Christina. “We’ve got relatively high salaries too, so serviceability isn’t a problem either. Our problem now is working out what we need to do to help us reach our ultimate goal – to be able to retire by the age of 40.”

Indeed, the pair are somewhat spoilt for choice: they could effectively enter any market in Australia and are willing to consider pretty much anything. They’ve seen friends be successful in eastern capitals like Melbourne, so are interested in buying interstate; they’re also willing to consider mining hot spots like South Headland. Buying a vacant block and developing it is even on the cards.

Structuring is also a big question for them: properties this far have been bought haphazardly, with Christina owning one in her own name, Ricky two in his name and only their PPOR being joint-owned. They’ve also cross-collateralised part of their portfolio, and are concerned this could be an impediment going forward. What should they do in terms of ownership in future? Is it worth setting up a trust?

The couple are also planning to start a family in a few years and perhaps purchase a bigger home. How will this factor into their strategy plans? It’s time to find out the answers.

The state of the play

After discussing Christina and Ricky’s plans and priorities with them, Philippe draws up a strategy review based on their current situation.

He agrees that they’re in a very strong position financially. The interest rates on their current loans are at an average of 7.11%, with minimum ongoing charges.

“From an economic point of view, they’re doing fine,” he says. “There are cheaper loans out there, at just under 7%, which could save them about $900 per annum excluding the cost of refinancing. However, over the long term lenders will take turns at being the cheapest, so their rates are competitive in today’s market.”

One loan that Philippe suggests the couple could look at is the fixed-rate loan on the East Perth studio, which may be worth refinancing depending on the break costs.

An issue that Philippe highlights – not now, but certainly for the future – is cross-collaterisation.

“Currently, their ING loans are cross-collaterised with two of the properties (Morley and Redcliffe). Their two St George loans are also cross-collaterised with the other two properties. This will almost certainly become a problem in the future,: explains Philippe. “Banks love cross-collaterisation because it makes you, in their jargon, a ‘sticky customer’, and it’s harder for you to go elsewhere.

“An example of a potential problem is if they want to sell one of the properties. ING will want to value the remaining property beforehand, and make sure that its value is still adequate to secure the remaining debt,” he continues. “If the remaining property has dropped in value, they may be stuck and not be able to sell, or the bank may keep more of the proceeds to reduce the remaining loan and ensure LVR (loan to value ratio) remains the same. Conversely, if they want to release equity, ING will want to value each property, potentially costing them more in valuation fees. The same comments apply to the St George loans.”

Philippe also applauds the couple’s efforts to reduce their home loan, but suggests the should rethink how they do this.

“Christina and Ricky contribute all surplus cash towards repaying their PPOR, which is not tax deductible. This is great in principle; however, in their case their current PPOR – which was an investment property before – may become an investment property again in the future when they acquire their next PPOR, maybe when they decide to start a family. If this occurs and there is no debt left, it will make their Redcliffe property substantially cash-flow positive and will increase their taxable income. Worse, they will need to borrow 100% to buy their next PPOR and this will not be tax deductible.”

Instead, Philippe recommends setting up their PPOR as interest only and linking a savings account (called a loan offset account) to it. This would allow them to offset any money in the saving account against their home loan. For instance, if their home loan balance was $300,000 and they had $20,000 in the offset savings account, they would only pay interest on $280,000.

“So, the loan balance does not change but as they save in their offset account it has exactly the same effect as repaying the loan,” he adds. “The major difference is that when they buy their next PPOR, they just transfer the balance in their offset account to their new PPOR offset account. As a result, the Redcliffe loan becomes tax deductable again, but the new PPOR loan will be reduced by the amount in the offset.”

Existing portfolio

Philippe notes that Christina and Ricky bought their Morley and Bentley properties at just the right time, before Perth property values took off in 2003 and 2004. The East Perth studio, however, is more problematic.

“The East Perth property is quite small, and most banks are reluctant to finance these properties as a standard loan. This is because these types of properties are not mainstream and therefore resale value is uncertain. St George was happy to finance it as it cross-collaterised the property with their other property. It doesn’t rely on the subject property itself for security. I personally acquired such a property in Queensland. It provides a good cash flow, but very little capital growth, so it isn’t going to make me rich!”

Philippe suggests that Christina and Ricky may wish to rethink keeping this property in the long term, although there is no urgency or pressing need to sell it to increase their borrowing capacity for other investments.

Borrowing capacity

Based on the above, the couple’s current borrowing capacity is $2.5m – including an assumed proposed rental income for their investment property purchases of 4% gross yield, which is well below average.

“Assuming an average investment of $400,000 per property, this represents another five properties,” says Philippe. “Combined with available equity in their portfolio of $630,000, this places Christina and Ricky in an enviable position. Most investors have borrowing capacity but little cash/equity, or vice versa. As you need to satisfy both factors to invest, this limits most investors’ ability to build a sizeable portfolio. However, in Ricky and Christina’s case there is little stopping them acquiring several further properties

As they may start a family in the near future and Christina might only be working part-time thereafter – so her income will drop from $85,000 down to perhaps, $40,000 – this would reducer their borrowing capacity from $2.5m to $2.1m. This would also reduce the number of potential property purchases, assuming $400,000 per property.

The couple could mitigate some of this by reducing their credit card limits, which they pay off in full each month, but Philipps doesn't think this would make a significant difference.

Ownership

In terms of how to structure the portfolio ownership, Philippe reckons that the current ownership structure is “Okay for today”.

“I would certainly recommend that in future Ricky should be acquiring properties in his own name or as tenants in common – say 90% Ricky, 10% Christina,” he says. “In the longer term, if Christina drops her income, most of the tax will be paid by Ricky. As they grown their portfolio, they may need to adjust the mix of ownership.”

The Plan of attack

Financing

As Christina and Ricky have ploughed all their spare cash into repaying the loan on their PPOR, they have little cash savings. Therefore, they will need to ‘unlock’ equity in their existing portfolio.

As the couple have two properties cross-collaterised with ING, he recommends setting up a line of credit (LOC) of $539,000, secured by these two properties.

“At a later stage, if needed, we can also set up a second LOC with St George for $102,000, secured by the other two properties,” he adds.

The new set-up would look like this:

The LOC would act as the couple’s current account for everything relating to their investments: all rent would go into this account and all expenses would also come out of it. They would also pay for the deposits on any properties they wish to buy from this account. As a rule of thumb, investing in a $400,000 property and borrowing 80% against it would result in them needing about $100,000 from their LOC. Keeping all loans below 80%LVR would also mean that there are no LMI considerations.

“On this basis, Christina and Ricky could fund five properties out of their $539,000 LOC,” says Philippe.

“However, there would be little ‘buffer’ left. Keeping a margin in their facility is always a good idea, just in case. So, I suggest starting with two or three properties, and then reassessing the situation. Remember, they will also have the potential to set up a LOC of $102,000 with St George, secured by their Bentley and East Perth properties.

The properties

Location-wise, Philippe recommends that Christina and Ricky look to the eastern seaboard to diversify their investments away from resources-driven areas.

“Any investment strategy contains a degree of risk, and risk needs to be mitigated by having a risk management plan,” he says. “In Christina and Ricky’s case, all their properties are in Perth, within a few kilometres of each other. Although they did extremely well by purchasing two of their properties just before the last boom, it would be prudent for them to look elsewhere for their next acquisition. If the current resources boom comes to an end or if for some other economic reasons the Perth property market is adversely affected, their entire portfolio will suffer.

Philippe therefore recommends that Christina and Ricky acquire their next properties outside Western Australia in areas not dominated by the resources sector, to mitigate the risks associated with their existing portfolio.

“Sydney or Brisbane would be the place to invest: an apartment in an inner-city location in each of these capitals would be a good move, and maybe a four-bedroom house in the satellite economic centres – Ipswich in south-east Queensland, for instance,” he says. “To help with cash flow, they could consider an investment under NRAS (the National Rent Affordability Scheme). I would also be looking at large regional centres such as Townsville.”

In terms of property type, Philippe thinks that, due to their busy lifestyles, development might not be the best plan for the couple at this point. Instead, he suggest buying new or near-new properties – because of the general lack of hassle, as well as maximising depreciation. This can be in the form of recently completed houses, apartments, house and land packages or even off-the-plan in certain, well researched locations. The type of property will really depend on the market they invest in. An investment in inner Sydney would certainly be an apartment because dwelling density and population behaviour (25% of dwellings in Sydney are occupied by one person). Conversely a property in Townsville would usually be a four-bedroom house because of the demand from young families from the military contingent, education sector, government postings, and so on.

Philippe suggests two projects as examples; a recently completed apartment development in Sydney’s upper north shore, and a house and land package in Townsville.

Playing On

Christina and Ricky’s conversations with Philippe have helped them crystallise the aims of their strategy – certainly financially.

“Philippe’s assessment of our borrowing power was much higher than what we thought it was,” says Christina. “He’s also really cleared up the structure questions: we’ll definitely be looking to set up the line of credit option he recommends so that we’re ready to go when we find our next investment. It’ll also mean we’ll have a deposit ready to go if and when we choose to purchase, which will be a real bonus in this market – and it won’t cost us anything until we buy something.”

They’re also willing to consider the offset strategy Philippe suggests.

“That really depends on the decision we make with the PPOR – whether we end up renting it out or not. We’ll be talking this over in more detail with our accountant,” she says.

However, the couple are unsure about the property recommendations.

“The Sydney example seems like a good suburb, but we were a little concerned about the size of some of the apartments – some of the one-bedders were still quite small, and we don’t want to repeat the experience we’ve had with our studio apartment. We’re also very keen on having a sizeable land component, so we're not sure about an apartment in general,” says Christina. “However, we haven’t even considered Sydney before, as we didn’t think we would be able to get into that market.

“Many thanks to Philippe for his time and advice: we certainly will be buying this year – at least two properties – and more in the years to come! It’s nice to know we can comfortably achieve this without giving up on our overseas holidays, cars, restaurants and quality of life in general!”

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