# How much Equity needed in IPs for share income 150k?

Discussion in 'Investing Strategies' started by Tulip, 25th Oct, 2007.

1. ### TulipMember

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I am trying to calculate our ideal end goal so I can model the impact of changing the parameters, and would appreciate some help with the numbers I should use to get me started. Our current strategy is to accumulate IPs for growth using leverage, then extract the equity and possibly sell down a couple and buy a spread of income producing shares.

1) How much available equity is required to produce a net income of 150k without selling anything down?

2) And if we sold a couple of IPs to limit the share gearing so we had say 300k to 500k, how much extra equity in IPs would be needed then?

I guess the process would be extract the equity via a standard loan (or LOC?), set up an offset account for 75% but use a maximum of 50%. Shares would probably be purchased in our trust, so I would assume a maximum tax rate 30%. I am not sure of what other variable values I should use.

We are a little off doing the share part yet, but are going to purchase another couple of IPs once finance comes through, so I would like to understand this before buying.

Thanks very much to anyone who can assist.

2. ### MichaelWhyteWell-Known Member

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Hi,

It all depends on your assumptions, but I'll have a stab at it for you given some reasonable assumptions which others will no doubt want to tweak.

Lets assume the following:

Managed fund generates 10% pa income
LOC interest cost is 7.5% pa
ML interest cost is 8.5% pa
LVR on margin loan max is 50%

So, you want \$150K net. I mocked up a quick excel sheet and used goal seek to get the following:

\$3.75M equity
\$3.75M margin loan
Total investment \$7.5M
Income from investment at 10% = \$750K
Cost of LOC borrowing at 7.5% = \$281,250
Cost of ML borrowing at 8.5% = \$318,750
Total cost of borrowings \$600K
Therefore, net income is \$750K income less \$600K interest costs = \$150K net.

So, you need a lazy \$3.75M equity on the above assumptions.

Mind you, if your income return jumps to 15% from 10% as assumed, then you need a touch over \$1M in equity all other things being equal...

Its all about the spread (the difference between what you earn and what you pay). At a ML cost of 8.5% your spread with a return of 10% is only 1.5% pa. But if that return goes to 11.5% pa from 10.0% pa then you have doubled your net return from 1.5% to 3.0%. That's why those incremental 1% or so make such a big difference. Incidentally, that is also why I am so focussed on relative returns of funds versus the index and maximising my return. Every 1% pa makes a world of difference to my spreads at the moment in this rising interest rate environment. And if the RBA goes up 0.25% in November then another 0.25% in Feb, then wipe another half a percent off your spread.

With a 0.5% interest rate hike applied to both the LOC rate and the ML rate, then using the original assumptions above, you won't need \$3.75M equity, you'll need \$5M for a total investment of \$10M!

\$10M at risk for a net return of \$150K (a 1.5% spread) would take some big kahunas. That's a lot of risk for a minimal return.

By the way, this is also the exact dilemma I am facing right now. My ML cost is 8.6% pa and on the news last night I hear rates might hike another half a percent by February. So, it could reach 9.1% real soon. I also invest in a fund that works on an annual return expectation of 10%. So, do I really want to put \$500K on the line via my ML for the potential return of \$5K. Particularly given the sub-prime issue in the US and everything else going on. The ASX looks hot, and there's US recession fears. We're at high PEs and almost everything is starting to look expensive. Boils down to: Do I risk \$500K in this environment to make \$5K? I think I'm rapidly formulating an answer to that question.

Cheers,
Michael.

PS Sorry about the long winded response

3. ### TulipMember

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Michael,

Thanks for such a detailed response, it really helps me understand how it all works. Details are much better for me!

So the higher the interest rates, the less effective drawing down equity is. I could see interest rates potentially getting to 12%, unlikely, but possible and I think I should consider it in my model.

I guess the reason for potentially selling down some IPs is to give us a more reliable income and room to breath should interest rates increase significantly, especially in the early years before growth improves.

It seems one would have to obain a significant amount of cash from the sale of IPs in order to have some confidence to maintain the 150k income. That would require some advance planning so that only one property was sold every year to limit capital gains.

Time of course in the key though, within a robust model.

4. ### AlanWell-Known Member

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Hi Michael.

A number of interesting points.

In fairness, if you are referring to Navra Returns, I think the often quoted minimum return expectations are 10% Income and 3% Growth. If the Growth Component does indeed allow you to capitalise the ML Interest Component and maintain your LVR, the figures do look much improved. As you say, 1% increase can make quite a difference.

5. ### MichaelWhyteWell-Known Member

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But the numbers in my original post all still stack-up as an example. In reality, to personalise it to my situation I should work on a 13% expectation and not 10% and see what the spread looks like then.

Cheers,
Michael.

6. ### Nigel WardTeam InvestEd

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Great post Michael.

Working the spread is key. I think the point to remember too is that when you have a good year and the return is 13%-20%+ you've got to put that aside to provision for leaner times...

If the arbitrage is 1-3%pa on average you can almost bet that in some years it will be more but in other years it will be less .

Cheers
N.

7. ### handyandyWell-Known Member

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As I have mentioned before if my income from the Navra fund (being the difference between the distribution and cost of funds) was <5% then I would no longer be in the Navra fund.%

It simply comes down to risk/reward and in the instance that my derived income is <5% then the potential for nil or worse negative income would be to real and possible (at least for this little black duck).

Cheers

8. ### MichaelWhyteWell-Known Member

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Hi HandyAndy,

So does this mean you've now exited the fund? Or do you look at the reported annual returns to make that decision and not the single most recent distribution (which is what I would advocate you do). If I were to just use the last distribution (Aus Retail) it would look like this:

Last Distribution: 2.8c (2.41% on 1.1630 pre-distribution unit price)
Annualised distribution rate based on 2.41% per quarter: 9.64%
Required margin over cost of capital: 5% stated
Therefore, maximum cost of capital: 4.64%

Now, I know you're on a good rate with your ML, but I reckon its not 4.64%...

Cheers,
Michael.

PS I know I haven't added the retained growth to the calcs, but HandyAndy did say "derived income < 5%" not "absolute return < 5%" above cost of capital.

Last edited by a moderator: 25th Oct, 2007
9. ### handyandyWell-Known Member

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Absolutely right, I am not on 4.64% but my average is less than the going rate as there is a cash component involved. In regard to any cash component I deem this to have a cost of 7%, the going rate for simply having cash in the bank.

I was in this situation previously and I would be looking at a number of 1/4's returns.

Take last year. If the last 1/4 hadn't been what it was I really don't think I would have been invested now. Remember that there was a fair bit of gain already in the unit price and I determined that a fair proportion was going to be distributed.

Obviously saying 'I wouldn't be invested' and actually achieving this in the cold hard light of day are two different things. But you do need to be tough about it.

Cheers

10. ### Simon HampelCo-founderStaff Member

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Michael - I've called you on this before, and I feel I need to do so once again.

Projecting annualised figures forward using a period of anything less than a year is misleading, and in my opinion, a dangerous practice.

I might forgive a 3rd quarter projection into the 4th quarter, but not a 1st quarter projection to the 4th !!!

Look back at the history of the fund distributions, consider the degree of discretion the fund manager retains for holding back distributions through the first three quarters, and consider that the performance of the markets itself is somewhat cyclical (the old "sell in May" syndrome becoming self fulfilling is one example).

Any suggestion on the annual performance of any fund (Navra or otherwise) based on a single quarter of returns is completely unreasonable.

Let's look at the financial-year-to-date of the Navra AUS W/S fund versus the CFS W/S Geared Share fund ... 4.8% vs 3.7%

I have no doubt that the geared share fund will vastly outperform Navra by the end of the year (assuming we don't finish on a strongly down note), but right now you'd pick the Navra fund as the better fund based on current performance ???

11. ### AlanWell-Known Member

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Personally I think in the first instance I would use the actual previous four Quarters, not an annualised single Quarter. Especially not the first Quarter when it's likely some will be retained to smooth out Distribution Returns. Similarly, I certainly wouldn't 'annualise' based on the final Quarter which may typically be larger due to all profits needing to be paid out.

12. ### MichaelWhyteWell-Known Member

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Sim,

I know this, as does everyone else reading this no doubt. That's why I posted the above intro to my review and did the whole thing a bit tongue in cheek (note the smilie). That's why I said "If I were to use the last distribution", note the "if" in that statement. In reality I wouldn't advocate doing that, but it did make for a fun exercise.

One distribution does not an annual return make...

Cheers,
Michael.

13. ### Simon HampelCo-founderStaff Member

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Actually I wouldn't assume this ... which is why I continue to make such a big deal about it!

Regardless of whether you mean to make it tongue-in-cheek, it is still something that many of the newer members may take too literally, so caution is required.

It annoys the heck out of me when I see the media doing it too ... so it's not just you MW

14. ### GlebeWell-Known Member

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That was a great post Mike, Invested is fortunate to have posters who go the extra mile.

I'm gonna have to find this goal seek tool in Excel, it looks handy..

15. ### Simon HampelCo-founderStaff Member

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I do apologise actually for being too harsh on you MW ... I didn't read your post fully - just looked at the numbers (which is why I still justify making a big deal about it - if I glossed over your comments and missed your sarcasm, other people might too). Still - I was too harsh, so ... sorry!

16. ### MJKWell-Known Member

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This is why it is very hard to create income from equity. Because of the interest burden. It would be better to spend the equity ala LOE rather than try to create net income.

I prefer to sell a property or two and invest unencumbered cash into the MF @ 10%. Then you only need 1.5M cash!!!

Still is a lot of cash but is easier to achieve than the 3.75m equity.

What about \$500k in cash/ capital gains with some margined income & growth funds coupled with capitalised interest and highish rental incomes on remaining propeties all thrown in to create a more modest income of 100K pa?

MJK

17. ### LeandroWell-Known Member

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Actually i have to commend Sim for pointing this out. I know when i whip through some of the threads which i read, i don't pay enough attention to the detail, and can be misled.

Not taking away from your post Michael, i appreciate your input to. ;-)

18. ### MichaelWhyteWell-Known Member

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No problem at all mate, no offence taken.

Its hard to convey tone on the internet and despite using smilies to indicate the tone it still sometimes gets misconstrued. I'll try and be explicit using caveats such as "I don't advocate using a single distribution to measure performance". In fact, I just edited that post to add the "(which is what I would advocate you do)" caveat for clarity.

But that post was intended to be tongue in cheek, hence the initial smilie and the roll-eyes at the end...

Cheers,
Michael.

19. ### MJKWell-Known Member

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I have done just this over the years. I have never sold more than one property a year and still hold more property than I have ever sold.

You would have to say with Australias generous CGT laws, rising interest rates, lowering tax rates and lack of firm direction in the Stock market a case for selling some property can be made.

I just like to keep some property so as I have access to the capital growth when it comes around.

MJK

Last edited by a moderator: 25th Oct, 2007
20. ### AlanWell-Known Member

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Yes.......I thought you may have been 'taking the p***' a little Michael.

Still I think Sim was right to make his comments in this case. When we talk about 'annualising' the price of bananas or even inflation, that's fairly general. When we talk about annualising the potential returns of a specific company, a bit of extra care may be appropriate. Note: This is probably where I need to make my Declaration. "I'm a tiny and totally uninfluential NavraInvest Shareholder who in all likelyhood will only be able to choose a slightly better pizza topping in the event of a significant dividend improvement."