BUILDING A PROPERTY INVESTMENT STRATEGY

Residential property is a powerful tool for creating wealth. But to effectively harness it, we need to understand how it operates as an investment vehicle, and how it will interact with our personal financial situation and goals. This what we call a property investment strategy, and it’s our plan for creating sustainable wealth over the long-term with the least possible risk.

What Makes Residential Property a Good Investment?

There are three factors which have made residential property a reliable and resilient asset class:

  • Consistent demand

  • Expensive to supply

  • Proven historical performance

Because almost everybody needs a place to live, there is always demand for property, either to buy or rent. And because the elements needed to create new property - land, labour and materials - are scarce, it’s expensive to supply. This has led to a consistency in performance over the past century that is unmatched: the average price of Australian residential property has increased in value over a five year period for the last 100 years, except for during the Second World War. Other than making lots of people rich over that time, the fundamentals underpinning this growth allows banks to lend against property at up to 80% (even higher with lenders mortgage insurance). This is the highest level of leverage you can obtain from a lender for any asset class, and it is the power of this leverage that elevates residential property into such an investment machine. By using this leverage, we can achieve five times the level of growth that we would have achieved if we hadn’t borrowed against the asset.

This does come at a cost, however. While leverage dramatically accelerates our capital growth, it usually comes at a cost in cashflow. Residential property isn’t the strongest cashflow asset to start with: after costs most properties will only generate a yield of somewhere between 2-4% of their total value, or $20,000-$40,000 per year for a $1,000,000 property owned outright. Once you throw significant borrowings into the equation, this will often push cashflow into the negative, particularly when interest rates are higher. So our investment strategy needs to take into account that leveraged residential property is a powerful capital growth asset, but a poor cashflow asset.

This is further shaped by tax. Any rental income produced by property is taxed at your marginal rate, which can take anywhere from 20-50% of the return away from you, a big consideration if you are a higher income earner (which property investors usually are). Capital gains are treated more generously by the taxman, with a 50% discount for any asset sold that has been owned for longer than 12 months. Better still, any money that you borrow against the equity of a property you own is tax-free. This doesn’t mean that the income generated by a property is unimportant - it is very important - but it does mean that it’s not going to be our primary means of making a return.

Residential property is usually much stronger in producing capital growth than cashflow, which shapes how we develop our investment strategy

What Do You Need For a Successful Investment Strategy

So now that we understand how residential property works as an investment, we can now relate it to your personal circumstances and build an investment strategy that is aligned to your unique situation and goals. Some the key elements of your personal situation we’ll need to consider are:

  • Your Age

  • Your Cashflow

  • Your Savings

  • Your Existing Assets

Unlike a lot of what you might see or hear in the property investment space, there’s no such thing as a free lunch. A successful investment strategy will require, time, patience, hard work and some degree of sacrifice. It is also hardest at the start, before getting easier as time goes on. It’s definitely true that if you start with more income, savings and assets, your strategy will be easier to implement and will make you more money. But it doesn’t matter what you start with, you can develop a property investment strategy that will make a meaningful return for you over the long-term. For it to work you’ll need the following four ingredients:

Surplus Cashflow

If you want to lose weight, you need to consume less calories than you burn. It’s much the same with cashflow. If you want to make money, then you need to start by spending less than you earn. By generating surplus cashflow, you can save for a deposit, apply for a loan, build up a cash buffer and repay debt when the bank asks you to. So we recommend getting match-fit and getting your cashflow house in order before anything else.

Savings

Building up savings is a critical step for any successful investor. Savings will provide you with your first deposit for a property if you don’t already have an existing property with equity you can draw upon. It will go some of the way to providing a deposit for your second property. Once your portfolio expands, savings provide you with a buffer to ride out events, like rising interest rates or unexpected maintenance. It’s your peace of mind, and no serious investor in property should be flying by the seat of their pants without a chunk of savings in their offset account.

Assets

If cashflow is your calories in and out, then assets are the muscles you build as a result of your discipline. As long as you select them well and can fuel them with cashflow, assets will do the heavy lifting required to replace your working income. Short of winning the lottery, or having very wealthy parents, owning assets is the only way to achieve financial independence.

Time

While you can make good money from it in the short-term, property isn’t a get-rich quick scheme. The true power of property investment comes from its compounding nature over time, as return builds on return. So you’ll need time for your strategy to come to fruition. How long? The longer the better, but at least a decade to be confident of enjoying decent returns.

Here’s an example of the returns a property will generate over a thirty year period. Let’s take a relatively standard property purchased for $800,000 at a Loan to Valuation Ratio (LVR) of 80%, yielding 4.25% in rent per annum.

Years 1-10: $336,243

Years 11-20: $1,186,707.06

Years 21-30: $3,110,432.56

The power of compounding growth is breath-taking. And the sooner you start, the better off you’ll be.

Climbing Out of The Income Trap - The Stages of a Property Investment Strategy

Property investment generally starts hard and gets progressively easier, particularly if you’re starting without a significant base of assets or savings. This is because our financial system is weighted against people who earn income and towards people who own assets. We need to climb out of this trap, and convert our hard-earned and heavily-taxed income into lightly-taxed assets that start doing the work for us. It’s not fair, but it’s the way life is.

So how we get out of the trap? Through the discipline of spending less than we earn, methodically building up savings, using these to acquire assets and then paying down debt on our portfolio. Our system of surplus cashflow, savings and a growing portfolio of assets works together beautifully to build a strong and compounding financial machine, while smoothing out the inevitable volatility that comes with investment.

This will broadly unfold in three stages:

The Climb - This is where you use your surplus cashflow, savings and any equity you can build to acquire the assets that will make up your portfolio. This period requires the greatest focus and discipline from you, as the the tax system makes it difficult to convert income into savings, and you'll only be receiving a limited benefit from your assets.

The Acceleration - Having acquired the cornerstone assets in your portfolio, you start to build momentum as rising values and incomes and falling debt combine to create a tailwind of compounding benefits. Surplus income is used to repay principal and build further savings, quickly reducing your LVR and creating a generous cash buffer.

The Glide - This is the stage you reach when your portfolio becomes self-sustaining. The value of your properties continues to compound while paying down their own principal, and as the LVR continues to decline you can drip-feed tax-free equity releases from your portfolio.

How long does this take to execute? Obviously, it will depend on your starting position, the size of your portfolio as well as its performance. For most people though, a period of 10-15 years is enough to get them to the glide phase.

What stage of the property investment journey are you at? Just starting out? Wanting to leverage the good foundations you’ve already created? Or looking to supercharge your retirement? Book in a free consult to discuss your specific goals, stage of life and strategy.