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Best use of equity.

Discussion in 'General Investing Discussion' started by coopranos, 7th Nov, 2007.

  1. coopranos

    coopranos Well-Known Member

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    Thought an exercise might be an idea to generate some interesting discussion:
    Lets forget for a moment how a guy got to a certain point, whether he would have been better off going all shares or all property or whatever. He finds himself in a situation many of us have.
    On the asset side he has his own PPOR, 2 IPs, and a portfolio of managed funds.
    On the Liability side he has a loan for his properties, a line of credit he pulled out to start his MF portfolio, and a margin loan on the portfolio.
    PPOR $100,000
    IP1 $100,000
    IP2 $100,000
    MF portfolio $50,000


    Margin Loan $30,000 (60% LVR)
    Line of Credit $20,000
    PPOR Loan $80,000
    IP1 Loan $70,000
    IP2 Loan $70,000

    The guy is comfortable sticking with 80% LVR for property, and 60% LVR for managed funds. Now the guy has a choice. He can get another $100,000 property, but has to come up with a 20% deposit (or he isnt comfortable with the LVR). His options going forward are either leave things as they are, or sell his managed funds and use the $20k balance (from the LOC) as a deposit on IP3.
    He expects his managed funds to grow by 15% per annum (no yield), and his property to grow at 8% per annum with a 4% yield. He expects his average property interest rate to be 8% and his average margin loan interest rate to be 9%.
    What is the best way forward for this guy? Why?
    (Sorry, some goals might help: guy wants to retire as soon as is safely possible on the $25,000 per year - he doesnt care, LOE, divs, rent, whatever as long as it is $25k a year, indexed for inflation of 3%).
     
  2. crc_error

    crc_error The Rule of 72

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    Can he afford to service a 3rd IP? IP's work out better if you can gear them at 90%.. gearing them at 80% compared to MF at 60% works out in the favor of the 60% on MF.

    IE using your figures. I have $100,000 to invest. that will buy him a $400,000 IP (20% deposit and 20k in costs). net return will be (8+4-(1% costs) = 11%) so he will make $44,000 growth & rent return in a year. Now we less $25600 (8%PA) in interest = $18400 net return on his $100,000 initial investment.. First year he makes nothing as the $18k goes towards paying back the initial $20k in stamp duty and other buying costs. Second year he will make about 18% on his money.

    Take the same $100,000 and invest it into a managed investment scheme at 60% LVR as you suggested. at 60%LVR he has $250,000 to invest right from the start. (no lost funds in costs to setup) His managed investment will grow at $37,500 (15%PA as you suggested)in the first year. Less margin interest $13500 (9%). = $24,000 net return.

    So at the end of year 2, the property will yield him 18k (remember we had to recover the 20k in costs to buy the IP), whereas the managed funds will yield him $48000 net.

    This is going with your assumptions.. I haven't considered the benefits of deprecation and negative gearing on the IP, so that would improve the IP result by a small amount depending on your 'guys' tax rate.
     
  3. coopranos

    coopranos Well-Known Member

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    CRC: thanks for the reply.
    So you are saying that unless he is prepared to leverage higher on property than 80%, he is better off just plowing his money back into his managed funds, continually topping them up to his 60% comfort level, and carrying on like that?
    your point re tax/depreciation etc is valid. Lets assume he is average joe on 30% marginal. His managed funds are only growth, so maybe 2% income. He obviously also gets a deduction on his interest bill for his managed funds.
    I guess other things that can be considered are if he has a family and gets family tax benefits/rent assistance/etc negatively gearing on property gets added back, but not on shares/managed funds.
     
  4. crc_error

    crc_error The Rule of 72

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    he also has 2 IP's already, so he will be using up some of his tax benefits on his wage, so you need to work out how much wage he has left in the 30% bracket after deductions of the current 2.

    If you go by just your figures, the MF's will be better.. but you need to also consider diversification, time he plans to work, etc as the IP's will keep on costing him money to keep. If he wants to retire soon, then there is no point in getting another negatively geared investment.

    with funds he can easily sell down portions to fund his life style, or support the current IP's.. Selling a IP is a costly exercise.

    I have done the figures on a spread sheet and found that gearing IP at 90% usually gets a simular result to gearing MF's at 60%.. however if your in a high tax bracket, say 40%, then the property will work out better..

    but all is speculation, as you don't know what a MF will return, or how much growth you will get out of a IP, or future interest rates!!

    Due to the lower LVR of the managed funds, interest rate rises will affect your end result allot less.. however due to the high LVR of the IP, slight interest rate rises will erode your result much more.. I would bet interest rates are going up in the near future!
     
  5. crc_error

    crc_error The Rule of 72

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    I also think classing 'depreciation' as a benefit is a little deceptive. Deprecation of a item is when its losing value. You might deprecate a kitchen over 7 years.. at the end of the 7 years you need to buy a new one and update it..

    Same with a hot water unit, it has a life of say 10 years before you need to fork out in the future for a new one, which will be a cost in the future which your considering its cost pro-rata..
     
  6. MiddleClassMonkey

    MiddleClassMonkey Well-Known Member

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    Hi crc, can I ask what assumptions you made in your comparisons? I'd be keen to find out more not only on your results but how you came about them.
     
  7. Dr Lobster

    Dr Lobster Well-Known Member

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    I disagree.

    Depreciation improves cashflow. This may mean the difference between holding an asset or not, whether its the property or managed funds or even using it for lifestyle.

    Replace the item when its kaput, who cares ? Your assets will hopefully have gone up in value and it won't be a drama.

    The new item can be depreciated as well.

    I absolutely add back my non cash items when budgeting my cashflow, why wouldn't I, they are real, they help my position throughout the year.
     
  8. crc_error

    crc_error The Rule of 72

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    what do you mean? the OP put the assumptions in his original post.. so I used his figures.
     
  9. crc_error

    crc_error The Rule of 72

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    yes it does.. however you will be forced to pay back the money once the item comes to the end of its life, hence costing you in the future.

    It may help with cash flow now, but it will be a cash flow killer once you need to renovate/replace again.. it needs to come out of your bottom line eventually...

    I'm just stating the facts.. its up to the investor to decide the benefits.
     
  10. Dr Lobster

    Dr Lobster Well-Known Member

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    1. You don't pay back depreciation once the asset comes to the end of its life.

    2. If you need to replace the depreciated asset it does not necessarily have to come from your cashflow. Further, whether you depreciate the asset or not will not determine whether something needs replacing.
     
  11. crc_error

    crc_error The Rule of 72

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    I don't think you understand what I'm saying. What I'm saying is you depricate a item which is losing value. Once it becomes of nil value you need to update it, which will cost you money.

    If I buy a PC, it will have a 4 year life span, sure I get deprecation over 4 years, but then after 4 years I need to spend the money and replace the item. it doesn't matter where you get the money from, you still need to fork out the cash. wether its drawing down equity, or from your cash flow.

    Its still a expense, not a freebie.
     
  12. Dr Lobster

    Dr Lobster Well-Known Member

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    Rubbish.

    Whether an asset is fully depreciated under the provisions of the tax law does not mean you must replace it.

    You also used the term "cashflow Killer" in an above post. Its not a "cashflow killer" if you draw down on equity.

    Replacing the item is also not classed as an expense, the expense is the depreciation.

    I have understood what you said, I also knew what you meant, which were two different things.

    This is taking the thread off topic.