Almost every investor I help with an investment strategy will ask me how they actually make money out of property. I found that the most effective way to crystalise the subject is to explain how strategic planning works from the very beginning to the end of the process, when the investor actually exits his/her investments all together.
There are essentially 4 phases in any investor’s strategy:
1. The planning phase
This is when an investor (usually with the help of a professional) works out key numbers, such as borrowing capacity, how much equity or cash is available, in other words the current boundaries of the strategy. This will “frame” an action plan, which is then developed based on the investor’s profile, objectives as well as less tangible factors such as conservatism, attitude to risk, etc… The plan must also include a risk management strategy such as making sure there are “buffers” in place, insurance, diversification, research, etc…
The planning phase also looks at deductible expenses (including interest on loans) versus non deductible expenses and how to manage them both.
2. The accumulation phase
This is the phase when the investor acquires a property portfolio using savings or equity in existing properties. It may includes using say equity in property 1 bought five years ago to acquire property 4. During this phase the investor does not really build any serious equity in the portfolio as available equity is being used to acquire the more properties. Also all loans would be interest only to conserve as much cash as possible.
3. The transition phase
This is when the investor has reached the final number of properties set out in the plan. Most of the time this is dictated by servicing or available equity becoming low, but it can also be because the investor has reached a number that he/she feels is enough. Once the transition phase starts, the investor stops investing and just manages the existing portfolio. Time will then work for the investor as equity will grow in the portfolio whilst debt remains constant (or decreasing – see below).
4. The drawdown phase
This is what all the hard work is about: collecting the rewards from years of investments. They are various options available and I will outline the main 3:
a) Sell the whole portfolio
This is a safe strategy and is common among the risk averse, especially retirees. The investor will have to accept the fact that capital gains tax will need to be paid upon the sale of the properties. Currently the maximum tax payable is 22.5% (based on properties own in own name and more than 1 year). Proceeds are then invested in a savings account and ongoing taxes will have to be paid on the interest. But this still can work nicely. If an investor has capital gains of $1million say, he will still have $775K after tax.
b) Sell half and keep half
This is an exit strategy whereby the investor sells some properties and uses the proceeds to pay down some (or all) debt of the remaining properties. This will make sure there is an income stream from the remaining properties and also keep exposure to capital growth. The questions of how many properties need to be sold is all about numbers at the time. How much income stream does the investor want, how much proceed will he have etc…?
c) Reduce debt during transition phase
Once the investor reaches the transition phase, focus can be given to making extra repayment on investment loans (assuming all non deductible debt have been paid first). This is the most satisfying option as it allows to increase the income stream of the whole portfolio during the transition phase and prepare the whole portfolio for the drawdown phase without having to sell properties. Of course this assumes that the investor has comfortable surplus income to repay debt during the transition phase.
In conclusion there is no hard and fast rule around which strategy will work, for instance, a high net worth investor will have no difficulties implementing the third strategy, while an investor on 55K a year will probably opt for the first strategy.
It’s all a question of numbers and careful planning!