Join our investing community

Optimal Leverage

Discussion in 'Real Estate' started by Norak Bastiat, 30th Sep, 2007.

  1. Norak Bastiat

    Norak Bastiat Well-Known Member

    Joined:
    16th Sep, 2007
    Posts:
    66
    Location:
    Melbourne
    The gist of the Living of Equity idea involves taking out a loan, buying residential property, using that equity to buy more and more investment property, and so on. This infinite leveraging has the capacity to amplify gains, but doesn't this plan rely on the assumption that the assets will definitely go up in value? Isn't there risk that property will go down in value and stay down for a long time? The more you borrow to invest, the more reliable the asset appreciation needs to be to cover the costs of borrowing.
     
  2. crc_error

    crc_error The Rule of 72

    Joined:
    1st May, 2007
    Posts:
    1,367
    Location:
    Melbourne, VIC
    You raise a very valid point. Due to the high leverage pyramid your building, you need your property to grow. A few years of no growth or even negative growth can make you go backwards very quickly. Remember your margin between interest paid and NET of expenses growth is very narrow, so one bad year can take years to 'recover' your loss. Remember in the 80's, we had 7 years of no growth.

    At least with managed funds, they average 12-14%PA and a margin loan is 9% PA, so you have 5% up your sleeve to move around with.. with IP interest is 8% and growth usually sits at 8-10% PA NET so you can imagine if you have 1 bad year, it could take 5 years to recover your loss.
     
  3. willy1111

    willy1111 Well-Known Member

    Joined:
    5th Jul, 2006
    Posts:
    54
    Location:
    Melbourne
    crc - are you forgetting rent of 3-6%?.

    I would think the managed fund return of 12-14% would be Capital Growth + Income.
     
  4. crc_error

    crc_error The Rule of 72

    Joined:
    1st May, 2007
    Posts:
    1,367
    Location:
    Melbourne, VIC
    no, but you have forgotten to take off costs. managed funds dont slug you with rates, repairs, agent fees etc out of the yield you get.
     
  5. DaveA

    DaveA Well-Known Member

    Joined:
    19th Feb, 2007
    Posts:
    617
    Location:
    Sydney, NSW
    No just high auditor fees, extremily high responsible entity fees, (in the case of property managed funds) HUGE tenant incentives (ie $10m for a tenant to move in) etc.... You loss control and this will always lead to money in other peoples pockets...

    The problem is your distrubtion from a fund, all these are taken out before you get it so its a bit "out of site out of mind", however doesnt mean its anymore value to you...
     
  6. shake-the-disease

    shake-the-disease Well-Known Member

    Joined:
    9th Jun, 2006
    Posts:
    61
    Location:
    Melbourne
    those costs are no where near 3-6%, more like 0.5 to 2 %.
     
  7. crc_error

    crc_error The Rule of 72

    Joined:
    1st May, 2007
    Posts:
    1,367
    Location:
    Melbourne, VIC
    I think your not following my calculation.

    The question was that I forgot to calculate the rent and only the capital growth. I explained that although you get a growth of say 9-10%PA, you still need to deduct expenses out of that, so your real growth will be 7-8%PA NET.

    With Managed funds, the end result published is NET of fee's and costs.. so what you see quoted on domain.com from property as long term growth, doesn't deduct costs, whereas figures quoted in managed funds are net of fees.
     
  8. crc_error

    crc_error The Rule of 72

    Joined:
    1st May, 2007
    Posts:
    1,367
    Location:
    Melbourne, VIC
    Annual Costs:

    Rates: $1200
    House Insurance $600
    Tenant Insurance $350
    Agent Management 7% $910 PA
    Advertising $500
    Vacency 2-3 weeks a year $750
    Tenant placement fee 1.5 weeks $375

    Now thats already $4685 PA in costs.

    Add to that $8000 in Interest which isn't covered by the rent ($20,000 PA interest less $12000PA in rent)

    Plus any repairs you do and Land tax you may pay.

    Those are estimates on a $300,000 property getting $250 a week rent.

    Do the math, and you will see thats 4% in costs PA.

    So I don't see how you arrive at 0.5%
     
  9. coopranos

    coopranos Well-Known Member

    Joined:
    11th Oct, 2006
    Posts:
    498
    Location:
    Perth
    I love how crc allows himself to use averages like 12-14% average for managed funds, but says "imagine if you have 1 bad year it could take 5 years to recover". So managed funds cannot have bad years??
    I would suggest that in a bad year you will still have a tenant paying rent, whereas it is entirely possible your managed fund wont distribute. Add to that your higher interest rates and margin calls, and I think in a bad patch property would be a whole lot better off.
    Also as far as holding costs go, managed funds arent much more attractive. With higher interest rates and distributions around 7%, your managed funds are probably better off by about 0.5%. Bring non-cash deductions into the picture and they are probably about on par.
    Now add in the control you have in property, the ability to increase rent through property improvement, property development potential, main residence exemptions, first homeowners grants, etc and property looks really really good.
    I am definitely not saying that shares/managed funds dont have their place, but perhaps you should at least start taking the whole picture into your arguments instead of conveniently only including numbers that support whatever argument you happen to be making at the time.

    As for the original post, a well thought out and planned LOE strategy (regardless of what vehicle you use, property or equities) does rely on average growth over the long term. Kindly let me know any investment strategy/retirement that does not rely on assets increasing in value (besides a short selling trading strategy!). People make a massive deal about that, but at the end of the day if you werent expecting increasing asset values, why bother investing in the first place?!
    A LOE strategy could potentially allow you to "retire" earlier than a more conventional strategy, and is potentially a more efficent use of your assets. Of course you will want to have a good buffer in there to ensure that if your assets do hit a rough patch you have plenty of years in the tank before your equity basket runs dry.
     
  10. crc_error

    crc_error The Rule of 72

    Joined:
    1st May, 2007
    Posts:
    1,367
    Location:
    Melbourne, VIC
    Prehaps you missed my point. House interest rates 8% NET capital growth/yield 8-10%. Means at BEST you have 2% buffer.. so if your property has one flat year of 0% capital growth, how many 2% profit years do you need to make that 8-10% back?

    Managed Funds - Margin loan interest 9% return 12-14% NET that gives us a 5% buffer of profit. If we have a bad year with nil growth, how many 5% profit years do we need to make back the interest? Only 2. What happens when rates go up again? This margin will only get eaten up more.

    Property runs at a very tight margin.. and if you don't get your timing right, it can take years to recoup the interest and costs you paid out.

    Managed funds don't need to distribute, as interest capatilizes, however if you have a carefully balanced fund with several sectors amongst your funds, you will get growth happening somewhere in your portfolio..

    Both statergies require a long term approach, however with property, due to its high upfrount costs and high leverage, you need a longer time frame than with property to make sure you recoup those costs.

    I can buy shares today and sell them tomorrow, with potentially only losing on brokerage... with property, you would lose the stamp duty, mortgage insurance, agent selling fee of 3% and bank penalty fee for breaking the loan in the first 5 years, titles transfer, conveyancer etc .. You don't have these large costs with funds/shares.

    I read somewhere you need to hold property for 7 years to break even on its costs, if you sell before, you loose out.
     
  11. Mark Laszczuk

    Mark Laszczuk Well-Known Member

    Joined:
    16th Aug, 2005
    Posts:
    793
    Location:
    Brisbane
    I've already done this a million times before, but hey, one more time won't hurt. crc_error, gonna use your figures here, okay? Also, I'm gonna keep costs out of this for ease of example - will use your net percentages anyway.

    Person has 50K to invest. They are fairly conservative, so they are willing to borrow to 80% on a property and 50% margin loan. So here is what they have:

    - property worth 250K
    - shares worth 100K

    According to your first post in this thread you said "At least with managed funds, they average 12-14%PA" and "with IP growth usually sits at 8-10% PA NET" (remember we are keeping costs out for now - you made the claim that property achieves this NET growth).

    At end of year one, at 8% growth property is worth $270,000 - a gain of $20,000. At 10% it is worth $275,000 - a gain of $25,000.

    At end of year one, at 12% growth shares are worth $112,000 - a gain of $12,000. At 14% they are worth $114,000.

    As the years go on, the gap just gets wider. Both are valid investment vehicles, I just personally don't understand why people choose one over the other.

    Mark
     
    Last edited by a moderator: 2nd Oct, 2007
  12. crc_error

    crc_error The Rule of 72

    Joined:
    1st May, 2007
    Posts:
    1,367
    Location:
    Melbourne, VIC
    Mark, both are valid investments.. You can never make a accurate model of either, as the outcome greatly depends on interest rates, and your capital growth and yield of both.

    Last 5 years the sharemarket returned 20%PA. Yet property did only about 5% in the last couple years... seems to be picking up recently..

    Plus with property you will reach a point where you cant service them, so you wont be able to gear at 80-90% forever.

    I agree people should have SOME property in their portifilo, a mix of BOTH is good.

    With funds, once you gear at 60%, you will see your math will come closer together.

    Anyway all this discussion has been fun!
     
  13. shake-the-disease

    shake-the-disease Well-Known Member

    Joined:
    9th Jun, 2006
    Posts:
    61
    Location:
    Melbourne
    I don't understand your methodology. You include interest costs for property but not shares? Why?

    Even with your grossly inflated costs above that's around 1.5% not 4%.

    I'd suggest the best comparison is cap growth + net yield. For property that's around 9% + (4.5%-1.5%) = 12%.
     
  14. shake-the-disease

    shake-the-disease Well-Known Member

    Joined:
    9th Jun, 2006
    Posts:
    61
    Location:
    Melbourne
    Quite true
    In and out costs are ~9% (6 or 7% entry, 2 or 3 exit), so no you don't need 7 years.
     
  15. AsxBroker

    AsxBroker Well-Known Member

    Joined:
    8th Sep, 2007
    Posts:
    1,448
    Location:
    Sydney, NSW
    He internally gears the managed funds.

    I must agree, with Mark, it doesn't really matter how you make money as long as you make money :D Though, I prefer shares as I've worked in stocks since highschool, some people like property because you can see it, walk in it, etc. But at the end of the day it doesn't matter which asset you use to increase your wealth as long as it makes your wealthier!

    CRC, our licensee suggests 8.5% pa returns since 1970 for a 100% growth portfolio. Naturally, if you gear you could probably squeeze it a bit more, regardless of the asset being invested.

    I don't think anyone in the US is thinking about 10% plus returns right now in many asset classes. Maybe only Halliburton which is a defence contractor in Iraq (The irony of Defence in Iraq...shouldn't it be defend in US??? Slightly off track ;) ).

    Cheers,

    Dan
     
  16. crc_error

    crc_error The Rule of 72

    Joined:
    1st May, 2007
    Posts:
    1,367
    Location:
    Melbourne, VIC
    Which costs are grossly inflated? Tenants insurance?

    I could add more to the list like body corp for those who buy units.. That can be anything up to $3000 a year in some cases.

    I have counted margin interest in all my comparisons.. Property LVR of 90% and shares 60% LVR.

    Anyway you can argue all you want, and choose to ignore the large holding/acquisition costs of IP.. But the facts remain, a managed fund performs better than a IP. Even in a geared environment.

    Managed fund returns: Growth and yield 13.5% ROI
    Colonial First State Wholesale Industrial Share Fund

    A property in Melbourne Suburb of South Yarra: Growth 8.2% + 3.5% yield - 1.5% costs = 10.2% ROI
    http://www.domain.com.au/public/suburbprofile.aspx?searchTerm=south+yarra&mode=research#mapanchor

    I have $48,000 to invest:

    I can buy a $300,000 house (10% deposit and $15k stamp duty and $3k mortgage insurance)

    Or $120,000 into managed funds 60% LVR. No costs to enter. (even get rebates with investsmart.com in trailing fees but lets not get pedantic)

    House will make $30600 PA 10.2% NET ex interest
    Fund will make $16200 PA 13.5% NET ex interest

    Less interest:
    House $21600 PA (90% LVR $270k loan @ 8%PA)
    Managed fund $6480 (60% LVR $72k @ 9%PA)

    Total NET return:
    House $9000
    Managed Fund $9720

    With the Managed fund we would get a 8% BETTER result, and WITHOUT the hassle of owning a property. Not to mention the $18,000 we loose straight away when buying a house in stamp duty and mortgage insurance. And when we sell, we loose another 3% to the agent. I haven't counted this in my model.

    Anyway I believe 1.5% PA COSTS is been very optimistic. I owned houses and units and we always had body corp levy, house repairs etc.. but lets stick to your assumption of 1.5%

    Problem with property investors, is they ignore the additional transaction and holding costs of IP, none of which are paid by the end investor of a managed fund from their returns.

    Mark also likes to bend his assumptions to suit his push for IP. Even in his example above, he mentioned with $50,000 he could buy a $250k property with 20% deposit.. what he forgot to calculate is the $15,000 stamp duty payable.. so he would not be buying a $250k property @ 80% LVR. I wonder how he explains to his clients that they have to cough up another $15k after they spent the $50k on a 20% deposit lol..
     
  17. crc_error

    crc_error The Rule of 72

    Joined:
    1st May, 2007
    Posts:
    1,367
    Location:
    Melbourne, VIC
    check this out.. property in QLD:

    Council Rates $2000 PA
    Body Corp $2340 PA

    $4340 each year out of the pocket of the investor.. my goodness.. looks like my estimates were conservative..

    lol..
     

    Attached Files:

  18. Mark Laszczuk

    Mark Laszczuk Well-Known Member

    Joined:
    16th Aug, 2005
    Posts:
    793
    Location:
    Brisbane
    crc_error,

    Who do you think you are? Okay, you wanna play dirty, let's go!

    Let's use your latest figures.

    I have $48,000 to invest:

    I can buy a $300,000 house (10% deposit and $15k stamp duty and $3k mortgage insurance)

    Or $120,000 into managed funds 60% LVR. No costs to enter. (even get rebates with investsmart.com in trailing fees but lets not get pedantic)

    House will make $30600 PA 10.2% NET ex interest
    Fund will make $16200 PA 13.5% NET ex interest

    Less interest:
    House $21600 PA (90% LVR $270k loan @ 8%PA)
    Managed fund $6480 (60% LVR $72k @ 9%PA)

    Total NET return:
    House $9000
    Managed Fund $9720

    Once again you've conveniently left rent out of the equation. Now, astute investors will take rent into account when calculating returns, so using this, the property investor gets a rent of $15,000 based on a 5% yield. So using your figures and adding the $15,000 on top, the house makes $24,000 before expenses (management fees, repairs etc) - let's say that's 15% of the rent, so subtract $2,250 to get a total return of $21,750 for the property and the managed fund makes $9,720.

    So using total returns, the managed fund makes 45% of what the property does, using your figures. Even after you take into account property purchase costs the property still makes more than double what the fund does.

    Do you want to keep going crc_error? Keep in mind that I do this stuff ALL DAY, EVERY DAY for both property and shares. I can (and have) run rings around this argument plenty of times before, so if you wish to go toe to toe, I'm more than happy to do so.

    I normally don't get so heated, but when someone makes snide remarks and insinuates that I have an agenda, then that's when I get really upset. It's pretty easy to sit behind a computer screen and post under an anonymous name, isn't it.

    As far as I'm concerned, you no longer exist and will not be replying to any of your posts on this or any other matter.

    Mark
     
  19. Mark Laszczuk

    Mark Laszczuk Well-Known Member

    Joined:
    16th Aug, 2005
    Posts:
    793
    Location:
    Brisbane
    Wasn't going to reply, but couldn't resist this as this is like shooting fish in a barrel, it really is. So in your post you use a $300,000 unit (I say unit because you've put body corps in the equation) yet in the above post you use as your example property a house that will sell for minimum $588,000. I asked a friend of mine who has been working in real estate for 15 years how much a person could reasonably expect to pay in rates and body corp for a unit worth 300K.

    He told me:
    Council Rates $1,400 PA
    Body Corp $1,280 PA

    So let's adjust the figures I used in my example to reflect this. So that $2,680, let's add another $1,320 for unexpected stuff. So total $4,000. So now it's a total return on the property of $20,000 ($24,000 - $4,000). Managed fund makes $9720.

    Congratulations crc_error, your managed fund now makes 46.35% of what the property does.

    Mark
     
  20. coopranos

    coopranos Well-Known Member

    Joined:
    11th Oct, 2006
    Posts:
    498
    Location:
    Perth
    He included rent in his 10.2% figure, as it was growth + rent.
    His completely contrived figures again adequately prove his point.

    Mark, I think the key to this whole discussion is if you argue with an idiot, now you have 2 idiots.
    it is a pity, because I am sure crc has much to offer in terms of his share/managed fund experience, unfortunately he seems intent on pushing his anti-property agenda. I honestly dont have a problem with debate or people stating their preference for particular vehicles, I for one have a lot to learn from it. However I do have a problem with people making up numbers to "prove" a point. Like you, I think the best course of action is to ignore him.