The goal for most of the property investors I deal with is to grow their asset base (rather than grow their income).
A large asset base gives you options.
Say you initially purchased 5 x $1M = $5M investment properties, and you borrowed $800,000 for each property ($800k x 5 = $4M debt).
Then over time say the investment properties double in value, so you now have the original $4M lending against $10M property, and $6M equity.
Here are some examples in terms of what you could do with the $6M equity…
Using the equity to further grow your portfolio
You could borrow a further $3M (moving to $7M total lending, or 70% Loan to Value Ratio, a level most banks tend to be comfortable with), and then grow your wealth further either by purchasing additional investments or by adding value to your existing properties via renovation or development.
You could even just borrow the $3M and then place those funds into a linked ‘offset’ account… this way you wouldn’t incur any additional interest (the new loan would be fully offset), however the additional cash could be available to you either as a ‘cash buffer’, or to buy other assets when the opportunities arise.
Cash buffers prevent investors from having to sell assets prematurely, for example when markets turn or when they run into harder times personally. Most real estate fortunes have been made via compounding returns over very long periods of time, so the commodity of time is often very valuable.
Using equity to live…
You might wish to do nothing with the $6M equity, and simply live off the positive cash flow an equity position of this size generates.
For example if the investment portfolio was generating 3.0% net income after running costs, and the interest rate on the debt was also 3.0%, then that’s $180,000 in pre-tax income. ($10M x 3.0% – $4M x 3.0% = $180,000).
As an alternative, you may attempt to borrow further, not to pursue further investments, but to fund other things like larger one off purchases or even additional living expenses.
This strategy sounds high risk on face value, however even with conservative capital growth and rental income your wealth position can still grow more than the higher cost of debt, thus enabling you to work less while still growing your wealth position.
For example 5% capital growth alone on a $10M property portfolio is $500,000, so spending $100,000 of borrowed funds – which incurs say $3,000 interest, but is tax free incidentally because it’s not income – is unlikely to cause financial ruin.
Many sophisticated investors tend not to worry about how much debt they’ve got or how much it costs, so long as they:
- Have financial buffers in place; and
- Own appreciating assets which allow them to constantly be growing their wealth position.
Establishing the right finance structures is critical in terms of maximising the benefits of real estate as an asset class.
What happens when you can’t borrow any more?
In the current market the banks are quite strict and won’t allow people to borrow indefinitely, even if they have large investment portfolios with strong equity positions.
It may be that in the future different lending rules apply, and releasing equity or borrowing in general becomes easier, but at the time of writing anyone who already has $4M in lending is going to require much more than $180,000 pre-tax net rental income to leverage further.
When clients start edging towards the upper limits of their borrowing capacity, I often look at second or third tier lenders who tend to have more lenient credit policies than the major banks.
It’s one of the beauties of being a mortgage broker… not being restricted to one bank, with one set of rules, and hence having more options available to assist clients.
But when thinking about property investment strategies for eventual retirement, one naturally gets to the point where they consider ‘selling assets’.
So how much cash do property investors receive when they sell…?
The benefit of having clear Titles (and not giving the banks more security than they need)
Chris Gray from Your Empire wrote a good article about this recently and it caught my attention having just fulfilled a near identical request for a client of ours.
Remember in the example above each $1M investment property started with $800,000 debt (80% leverage), and then the property doubled to $2M in value while the debt balance remained the same.
If you were to sell one of the $2M properties, then you would clear c $1.2M (e.g. $2M – $800,000), less capital gains tax, and less other selling costs like agent commissions, marketing costs and the like.
However, there’s an argument that to hold the $4M of original lending, the bank should only need $5M in security property (80% Loan to Value ratio), not the $10M in security it now has (40% Loan to Value ratio).
So we could go to the bank and attempt to release say two of your $2M properties. This is not always possible, but having good bank contacts and knowing how to position such requests certainly helps.
The bank would still be left with $6M property as security, and 67% loan ratio ($4M debt / $6M property = 67%), however the benefit would be that you would now have $4M in unencumbered assets.
If you were to sell either of the $2M unencumbered properties, instead of then only clearing the $1.2M explained above, you would clear $2M (less the same capital gains tax and other selling costs), since there is no debt which the bank requires you to repay.
This is some $800,000 more cash in your pocket than in the scenario where the bank required you to repay the original/ related loan.
Even if you had no intention of selling, you can still see the advantage of the having clear property Titles and more security. It gives you more control.
Options are king
I started this article by explaining how having equity in a portfolio gives you options around refinancing and retirement.
I touched on the concept of cash buffers, and explained how these can help investors hold onto their assets for longer periods of time.
I ended by explaining that clients who hold clear Titles can realise more net sale proceeds should they ever end up selling any of their properties.
Knowing how to work the banking system is key because these options are the types of things which allow clients to fully benefit from their investments in real estate.
Your finance strategies are often as important, if not more important, than the properties themselves.
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This article provides general information only and has been prepared without taking into account your objectives, financial situation or needs. We recommend that you consider whether it is appropriate for your circumstances and your full financial situation will need to be reviewed prior to acceptance of any offer or product. Nothing here constitutes legal, tax or financial advice and you should always seek professional advice in relation to your individual circumstances.
