$5m in 10 years part 4: exit strategies
While $5 million worth of property might be your ultimate goal, it’s important to break down the figures to establish exactly what you need at the end of your purchasing phase.
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“How much passive income do you want and what's the capital base you require to achieve that?” Brendan Kelly from RESULTS Mentoring asks.
Keeping this figure in mind will help you identify how far you have come and what you still have left to do.
Starting a new phase
The road to wealth takes you through several stages. In the first part, you accumulate as many properties as possible, aiming for quantity over equity, according to Philippe Brach from Multifocus Properties & Finance.
“You have the accumulation phase where you buy, buy, buy until you reach your target. Every time you get a bit of equity in the property, you release that to buy the next property,” Mr Brach says.
When you reach your goal of $5 million worth of assets, you will have very little equity, Mr Brach warns, but the journey is far from over. The next challenge is to pay down the outstanding mortgages, according to Mr Kelly.
“Having $5 million of property and $5 million of equity is a very different thing. Having $5 million of property can mean you have $4.5 million worth of debt,” he says.
In these circumstances, if investors were to sell up immediately, they may walk away with as little as $300,000 cash in hand, he warns.
“You're not ready to leave yet. You have to keep going. If you've got $5 million worth of property and a high debt against them, you're not ready to stop,” he says.
At this point, investors enter the second phase of their property journey, which Mr Brach calls “the transition”. During this period, which could last until retirement, investors let equity accumulate.
One option is to sit back and let capital growth do the heavy lifting.
“You actually do nothing. You keep your loans on interest only so your debt doesn't change. But all the time, capital growth goes up and you start building up equity in your portfolio,” Mr Brach says.
For investors with cash flow positive properties, the rental income may be sufficient to begin paying down debts, according to Helen Collier-Kogtevs from Real Wealth Australia.
“For example, one of my investments pays me a positive cash flow of several hundred dollars per week. That gives me around $12,000 annually that I can use to decrease the principal owing on that mortgage,” she says.
Another technique may be to be buy, renovate and sell. Mr Kelly advocates this as the fastest way to supercharge your equity growth.
As an example, an investor might sell a poorly performing property, take the profit and use it to renovate an old house in a high growth area. They can then sell that and use the profits to either pay off a debt, or undertake another, even more profitable, renovation project.
Over the period of a decade or more, the market might go through flat periods or even declines but Mr Brach urges investors to ride out these difficult times.
“You just have to be patient, wait for the economy to do its magic and for your property prices go up,” he says.
“I say 10 to 15 years because cycles tend to be between 7 and 10 years long. You might have a flat market or a slow market and then a boom. You have to give it time to go from one boom to another,” he says.
Having $5 million of property and $5 million of equity is a very different thing.
Challenges to holding your portfolio
Although acquiring properties is the most difficult stage, investors who hold extensive portfolios are still at risk before their debts are paid down.
“The three big risks are marriage breakdown, loss of job and health issues,” Mr Kelly says.
In most cases where investors lose their job, the situation can be resolved within a few months, Mr Brach says. While illness can be longer-lasting, the appropriate insurance can make up for shortfalls in income.
However, divorce can be especially problematic. Mr Brach warns that assets are often split 50/50, meaning the portfolio will need to be sold off.
“You might have lots of equity but you probably won’t have much cash. So you have to share that with someone you're splitting with,” he says.
Mr Kelly recommends trying to anticipate this scenario and planning for it, even in the happiest of relationships. If one party is more interested in investing, for example, he recommends all investments are held in their name while personal properties go in their partner’s name.
Issues can also arise with the investor’s portfolio. Ms Collier-Kogtevs points to unexpected property maintenance issues or extended vacancies as scenarios that could be crippling.
“With a portfolio this large, you're bound to have at least one or two fairly decent, unexpected bills every few years,” she says.
In any of these situations, having access to liquid cash is crucial for your portfolio’s survival. Mr Kelly suggests a line of credit can help investors keep afloat until the crisis has passed.
“You can draw down on the line of credit until you've found another job or replaced your income. It will cost you equity but sometimes a little reduction in equity for the purposes of reassuring financial cash flow is a good thing,” he says.
Ms Collier-Kogtevs is an advocate for buffer accounts large enough to cover any emergency situation. Whatever the crisis, she encourages investors to avoid selling at all costs.
“Ultimately, there is no right time to sell, but there is a wrong time to sell: when you're under pressure financially due to a stressful situation in your life, such as illness, divorce or job loss,” she says.
Congratulations! You have reached your goal amount in equity and you’re ready to take the next step – maybe travelling the world or starting that business you always dreamed about. At this point, investors have a range of possibilities. The way forward will depend on their current circumstances and future needs.
Often, investors may choose to sell some or all of their properties in exchange for a lump sum of cash, according to Ms Collier-Kogtevs.
“Your exit strategy will likely involve selling some of your assets at some point, as you'll want to realise the full capital gain of those investments,” she says.
Investors who take this approach will also be liable for capital gains tax, Mr Brach says. On such a large portfolio, this could result in a hefty bill.
“Let's say you have $3 million worth of equity in your $5 million portfolio. If sell the entire lot, you make capital gains of $3 million. You probably pay about $1 million worth of taxes on that so you 're left with $2 million,” he says.
Investors who put this cash into a high-interest bank account could receive a healthy income. The major drawcard is that this approach is the safest and most secure, according to Mr Brach.
However, Mr Kelly warns this strategy will net lower returns than an investment in a high-yielding property. As a general rule, the highest possible interest from a bank account is unlikely to exceed five per cent, he suggests.
“On the premise you have a lump sum amount of cash, you then need to invest for a higher rate of return. If you want to be more conservative, you need more equity,” he says.
Sell half of your portfolio so you can pay off the debt on the remainder or pay down enough to get you an income stream.
Live off rental income
An alternative is to hold the portfolio and live off the rental income being generated. Ideally, the properties will be unencumbered by retirement age, Mr Brach says.
“Early on during the transition phase, when you've stopped buying and you've got your portfolio in place, you can start paying down your debt. By the time you retire, you might not actually have to sell anything because the cash flow provided by the property might actually be enough to cover your needs,” he says.
If the investor does still carry debt, they could sell one or two of their high-value properties to pay down the ones with the best returns, Ms Collier-Kogtevs says.
“If you own a $5 million portfolio but you owe $2 million in mortgages, then you might decide to sell a few properties so you can eliminate all of your mortgages, and enjoy living off the rental income,” she says.
“This will leave you with a small debt against a multimillion-dollar investment portfolio, and a strong ongoing cash flow.”
In this scenario, investors will continue to benefit from capital appreciation while receiving their income, Mr Brach suggests.
“Sell half of your portfolio so you can pay off the debt on the remainder or pay down enough to get an income stream that you like. Then you're still exposed to capital growth on the remainder of your portfolio,” he says.
Reinvest in high-yield properties
A less orthodox option, proposed by Mr Kelly, is to sell the portfolio and reinvest the funds in high-yielding properties. He suggests those dwellings with good capital gains do not necessarily deliver the best returns.
“In your phase of accumulating equity, you're going for high growth. The yield on those properties are in the range of three to five per cent, and you might need eight per cent to achieve your passive income dream,” he says.
One option may be buying into volatile mining towns, although this approach comes with an element of danger.
“You can get 10 or 12 per cent in an active mining town but the viability there is risky. If the mine shuts down, your asset base has eroded significantly and so has your income,” he says.
In his view, a safer option may be commercial properties. Offices, for example, attract yields in the order of seven to nine per cent while warehouses can get as high as 13 per cent.
However, these options are not risk-free. Offices have a higher turnover but lower vacancy rates; warehouse leases tend to be 10 to 15 years, but vacancies can also stretch out to years, Mr Kelly says.
Planning for the future
Ultimately, an investor’s strategy will depend on their circumstances decades in the future. As such, it is impossible to completely plan for, Mr Brach says.
However, he emphasises the importance of thinking about the future and taking action to secure your financial security.
“If you're looking at building wealth, it's usually for your retirement. You've got hopefully 20 years ahead of you. You want this thing to be steady, safe and deliver the results,” he says.
Mr Kelly says having a large portfolio allows you the freedom to pursue your own agenda. Among investors who retire early, most go on to other projects or pursue new goals.
“What they're doing then is starting to live the dream,” Mr Kelly says.
Case study: “I want to retire before 40”
Number of properties: 15
Estimated portfolio value: $4.34 million
First investment purchase: February 2007
“My end goal is to have a passive income so I can retire – I'm about halfway there now. I am aiming for $100,000 per year in gross income.
Currently, I’m working 9am to 10pm in the corporate world. After a decade or more, you grow weary of it. You just think there's more to life than working every day.
I want to buy time to spend with my family and see the world. I just want to live life and not be tied down. That's what everyone wants but I am actively working towards making it happen.
Currently, the properties are giving me $300,000 in gross income. What I'm doing now is trying to retire the existing debt and the loans. That could involve buying another 10 properties and selling them off to pay down the loan.
I'm currently renovating a property that will generate potentially $60,000 worth of capital after the sale. We're also looking for more opportunities like that.
Once you own your portfolio outright, it doesn't matter if interest rates go up. I own it and no one can take it away from me.
At that point, I just plan to hold on to the unencumbered properties. That will be my foundation, the bread and butter portfolio giving me passive income. If anything were to happen to me, so I couldn't work, I would still be fairly comfortable.
Personally, I think once I hit my goals, the world will be my oyster.”