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$5m in 10 years part 3: finance

Planning stages

Before setting yourself an aim of $5 million worth of property, it is critical to understand your current and future financial position. Planning in the early stages can save investors a lot of heartache down the track.

In particular, Empower Wealth director Ben Kingsley believes cash flow modelling is “absolutely paramount”. These predictions must include current salary, assets and liabilities, and any outstanding debts, he suggests.

When putting together a projection, Mr Kingsley encourages investors to anticipate future changes in their circumstances. This might include raising a family, taking time off work to study and any other major shifts in incomes or expenses.

“For our clients, we spend time unpacking their cash flows for the next 40 years,” he says.

Philippe Brach from Multifocus Properties & Finance also believes investors need to plan for circumstances changing in the wider economy. While the portfolio may be affordable in the current environment, investors need to consider what would happen if rates rise or the economy takes a dive.

Heroly Chour, an investor with over 15 properties in his portfolio, started his journey with a thorough analysis of his finances and lifestyle.

“The first part when I was building up my portfolio was to really understand my personal circumstances – like what’s the minimum cash flow that I can live on comfortably? My wife and I also tried to figure out where we wanted to be in five years, whether we [would] have kids and what our financial position [would] be,” he says.

Current and future income levels also need to be considered. According to Mr Brach, an investor’s income can be the biggest road block to their long-term property goals.

“If your salary only allows you to do so much, let's get to the maximum you can do and then work on your job, on your savings plan and on investing with your partner or family,” he says.

This approach, he says, may allow you to side-step some of the limitations your income can initially present.

While it may seem pre-emptive, Mr Kingsley also advises investors to work out an exit strategy for when they reach their goal. With a highly leveraged portfolio, investors need a plan to pay down their debts.

“It might be great that you have a $5 million property portfolio in 10 years, but if you've still got $4.8 million in debt, it's not necessarily a great result,” he says.

Once you get closer to your borrowing capacity, you go to banks that are easier on serviceability.

Structuring your portfolio

The financial structures underpinning your portfolio are like the structure of a house – get it wrong and the entire thing could collapse.

One issue is whether investors intend to use equity from an existing property or whether they have savings available for the deposit. For investors who only have a limited amount of cash upfront, Mr Brach advises buying small and giving it time.

“The only way to do it with a $50,000 deposit is you buy one property and then you just have to be patient,” he says.

Mitchell Burge is an investor who took $40,000 and turned it into $440,000 worth of equity in 17 months. He believes buying wisely and under market value helped grow his wealth tenfold in a short period of time.

For investors who already have a home loan, Mr Kingsley suggests liquidating equity and moving it to an offset account or line of credit facility, where funds can be withdrawn as necessary.

Part of this liquefied equity can be used as a deposit for the next investment, Mr Brach adds. In addition, the line of credit can be used to collect rent, pay bills and deal with any other expenses that arise.

Mr Kingsley also recommends designating part of the fund as an emergency “buffer”.

“We always like to work on holding at least a year of surplus cash flows,” he says.

While purchases can be funded by extracting equity from existing loans, Helen Collier-Kogtevs from Real Wealth Australia warns investors to avoid “cross-securitisation”. This means offering the lender two or more properties against a single loan, she explains.

Some investors may find cross-securitisation appealing because all their properties can be held within a single loan facility. However, Mr Kingsley warns this will rob investors of the flexibility to grow their holdings faster. He gives the example of an investor with six properties, where two have seen strong growth and the other four have held steady.

“If you're cross-securitised and want to access equity in the high-growth properties, the bank would want to value every property and that would impact on the amount of equity you're able to release,” he says.

In addition, Ms Collier-Kogtevs warns the banks may also calculate the loan-to-value ratios (LVR) on the portfolio as a whole rather than each individual property, which may leave investors substantially out-of-pocket. To avoid cross-securitisation, investors need to specify that they want their properties to remain separated in their loan documents, Mr Kingsley suggests.

“In your loan application, it's important to clearly instruct that you're going to take a portion of equity out of that existing property and that is going to be the funds you use to purchase this property over here, but you don't want those crossed,” he says.

Mr Chour has been careful to keep cross-collateralisation out of his portfolio, which is now worth around $4.5 million.

“Cross-collateralisation gives the bank more power – if something goes belly up, it gives them the power to strip you of all your properties,” he says.

I would strongly urge you to create a dream team to help guide your journey.

Maximising borrowing capacity

At some point, an investor building an extensive portfolio may reach the bank’s maximum lending limits. Ms Collier-Kogtevs says investors can try to stay off the bank’s radar by focusing on balance and diversification.

“By balance I mean you should aim to have a mix of cash flow properties and negatively-geared properties, so that your personal discretionary income isn’t too impacted by your property investments,” she says.

Eventually a bank may refuse to extend any more loans to a heavily-leveraged borrower. In this case, investors may be able to push past these limitations by moving to a less strict lender, Mr Brach suggests.

“If you start out knowing you have a $2 million borrowing capacity, you go to a more conservative bank for the first two or three properties. Once you get closer to your borrowing capacity, you go to banks that are easier on serviceability,” he says.

At the same time, investors should keep in mind that banks are likely to provide discounts for clients with multiple loans, Mr Brach says.

Mr Kingsley believes spreading your loans among lenders helps mitigate risk in your portfolio, as well as allowing you to grow your holdings more aggressively.

However, he warns investors will almost certainly need the assistance of a broker to navigate each bank’s policies.

“Most investors would be well-served by establishing a relationship with a quality broker who specialises in investment property to unpack that strategy,” he says.

The financial structures underpinning your portfolio are like the structure of a house – get it wrong and the entire thing could collapse.

Tax time

When looking at the tax implications of a $5 million portfolio, a key consideration is whether you plan to buy through your own name or a separate entity. For investors with an ambitious goal, Ms Collier-Kogtevs believes a more complex structure may be the way to go.

“You may want to use a trust structure for asset protection, for instance – or if you plan to make buying and trading in real estate your career, then you may need advice on setting up a company structure to eventually manage your investments,” she says.

As each structure attracts a different tax scale, Mr Kingsley recommends investors sit down with an accountant.

“The main structure that an accountant or a tax adviser is going to look at is a discretionary trust. Some might also look at a hybrid trust, which is a combination of discretionary and unit trust, and some are going to look at a company,” he says.

“They're all legitimate strategies and your accountant is going to know, based on what your plans are and your current position, ways in which you can legally minimise tax.”

Mr Kingsley cautions investors against setting up a dummy structure purely for tax-minimisation purposes.

“Setting up a structure purely for a tax benefit – investors should avoid that at all costs. That's illegal,” he says.

Mr Burge holds two properties in his own name, a further two in his self-managed super fund and the rest in a variety of company structures. He believes security is the major advantage of diversifying his investments across different entities.

Mr Chour, on the other hand, currently holds all his properties in his own name but is considering a more complex approach.

“Now, we’re at the stage where our accountant is saying we need to buy properties within trust structures to mitigate risks and to maximise tax advantages,” he says.

Aside from income tax, investors also need to consider state-based taxes like land tax and stamp duty, Mr Kingsley says. Spreading your portfolio across multiple state markets may cut down on your tax bill in some circumstances.

On a federal level, investors should start thinking about capital gains tax (CGT), which will be payable when they sell properties in their portfolio, Mr Kingsley suggests.

“When you look at your exit strategy, you have to ask yourself ‘if I have to do a sell-down, then do I have a provision for CGT?’. That CGT is a calculation on the income, which in this case is profit that's earned during that financial year,” he says.

On the flipside, taking advantage of tax deductions can take the pressure off an investor’s cash flow. Mr Brach says depreciation can play a huge role in boosting an investor’s cash flow, especially on new properties.

Mr Burge calls depreciation a “game changer” while Mr Chour gets a schedule done for every property, even those over 30 years old. He has found that renovations in particular can result in excellent depreciation write-offs.

While negative gearing may come into play in a large portfolio, Mr Kingsley suggests cash flow would need to be carefully managed. In addition, Ms Collier-Kogtevs warns negative gearing write-offs may not be available to investors who buy through a trust or company structure.

Ultimately, the best finance and tax strategy is one that incorporates the investor’s personal circumstances and ambitions. As such, qualified advice is essential.

“For any investor who is contemplating investing in property in a serious way – as in, more than one or two investments – I would strongly urge you to create a dream team to help guide your journey,” Ms Collier-Kogtevs says.

“A qualified and experienced mortgage broker, mentor or coach and accountant can be the difference between a mediocre property portfolio and an asset portfolio that delivers long and lasting wealth.”

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