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Silly question about multiple investments

Discussion in 'General Investing Discussion' started by Thudd, 16th Jul, 2008.

  1. Thudd

    Thudd Well-Known Member

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    This is something that has been bugging me for a while and I can't quite get my head around it. Yet there's clearly an answer because many people do it; or at least, seem to do. So if this seems like a silly question with an obvious answer I apologise in advance, but as the saying goes, the only silly questions are the ones not asked. Feel free to chime in at any point if I've made incorrect assumptions or just plain made a mistake.

    I'll use a simplistic property scenario to illustrate.

    Let's say you decide to buy some investment properties. You find a suitable place for $350000. You borrow 80% of the value, which means you have to come up with a 20% deposit of $70000. Maybe that $70k comes from savings, maybe it's borrowed against your existing PPOR, it doesn't matter, you still have to get it from somewhere.
    Interest on the $280000 loan (80% of 350k) @ 9.5% comes to $26660pa.

    You then get rent at $400pw. That gives you a yearly rental return of $20800. Net loss for the year = -$5860.

    Assume an income of $100k. Net on that is $72900, take off the loss from the IP and you end up with a net income of $69384. So the property has cost you $3516. That's $3516 that you have to find out of your own pocket, right?

    Obviously you're hoping for long-term capital growth to counter the losses you incur along the way, but you still have to be able to afford those losses along that way in the first place. Which is kind of where I'm heading.

    Now let's say you want to purchase a second IP, and for this exercise it's identical to the first: $350k purchase, $400pw rental return. And this is where I start to run into the mental brick wall. To whit:

    You need another $70k deposit to purchase the 2nd property. That means you either need another $70k cash lying about, which I suspect is unlikely, or you borrow against something else to get it, which now means you're not only looking at the yearly loss but maintaining a now $140k loan just for the deposits.

    Additionally, your income has now, with the yearly loss from the 2nd property, dropped to $65868, or a $7000 hole in your pocket if you like. For your average person burning $7000 a year is not something you take lightly, and for this example I've been quite optimistic with a high rental return on a lower priced property.

    So after all that preamble to show you what my understanding of the situation is, my question is this: how do people actually afford multiple investments? It could be borrowing for shares or for property, it doesn't matter, I just used property for this example. But somehow you still have to find the money to support the loan and the ongoing losses before you can claim the capital growth pot of gold at the end. And it doesn't take long before my calculations show that your ability to do this becomes severely eroded. Yet people clearly do own multiple investment properties and/or large geared margin loans and they're not inordinately wealthy themselves. So how do they do it? Are they living on the bones of their butt to support their investments or is my understanding fundamentally flawed?

    Sorry for the waffle! :) I'm just trying to get my head around it all.
     
  2. TryHard

    TryHard Well-Known Member

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    Hi Thudd

    At face value, I would say getting a return of $400 pw on a property that cost $350K would be doing pretty well in the current market, at least where I'm used to.

    In my experience the people who can afford multiple properties have accumulated them over time and many bought before or during the recent rapid catch-up in house values in most markets. Not many recent property investments I am aware of are cash positive, unless maybe in mining towns (where you might sacrifice capital growth for income).

    Based on your examples I would suggest no one could afford multiple properties unless they have the income to prop them up till the growth in capital and rent, and maybe a drop in interest rates, made things balance out. Depending on what you buy, you can help accelerate the filling of the gap - either by depreciation allowances, renovate and add value etc.

    Cheers
    Carl
     
  3. JustB

    JustB Well-Known Member

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    Hi Thudd,

    There are many factors that can enable holding multiple investments, but I'll throw up 2 scenarios that first come to mind for you to consider:

    1) Taking your example, what if hypothetically the 1st property was purchased 4 years ago for $250k with interest rates locked in @ 6%pa, and is now returning $400pw rent. Would that make it feasible to buy another property now?

    2) Investing involves sacrifice at times, and nothing comes for free. If someone is only capable of setting aside <5% of their gross salary to invest, then multiple properties / large share portfolio isn't going to be feasible. I'm sure most investors on this site (in the early stages, at least) would be allocating significantly more than 5% of their salary towards their investments. Investing 10%, 15%, 20%, 30%, 50% of one's salary would be quite common, depending on individual circumstances of course.

    Cheers,

    JustB
     
  4. Billv

    Billv Getting there

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    Thudd

    If you want to build up a significant property portfolio in a short period of time then market timing is very important.

    If you missed the recent market openings, you can start small and when your first property becomes cash flow neutral either by development/improvements, by loan reduction or by the gradual increases in rent you can then go out and buy your next property and so on.

    Time is working in your favour.
    Over time rents will be increasing while your loan size will be reducing and/or will be losing it's value due to inflation.

    What seems like a huge loan today will look like a small loan in 10 years time.

    Cheers
     
  5. Chris C

    Chris C Well-Known Member

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    Here is an example that might explain how it works...

    IP # 1:
    Home Value: $500k
    Deposit: $100k
    IO Loan: $400k
    Interest Rate: 9%
    Rent: $500/week
    Rental Growth Rate: 5%pa
    Property Growth Rate: 10%pa

    So for the first year our property earns you $26000 in rental income but costs you $36000 in interest. That's a net loss of $10,000 in the first year that you will need to be able to service out of your own pocket, but you will be able to write it off against tax.

    However after that first year you have your home revalued and have a new rental appraisal, and because you property went up by 10% it is now worth 550k, and you also upped your rent to $525/week.

    Home Value: $550k
    IO Loan: $400k
    Interest Rate: 9%
    Rent: $525/week

    So during your second year you earned $27300 in rent and paid $36000 in interest, but you house went up in value again and is now worth $605,000 and you upped your rent to $550/week.

    Home Value: $605k
    IO Loan: $400k
    Interest Rate: 9%
    Rent: $550/week

    So during your third year you will have earned $28600 in rental income and paid $36000 in interest leaving you a shortfall of $6400 that you will still need to service but are still able to write off against tax.

    Now after three years you decide you want to buy a second property so you go to the bank and you say you want to buy another IP that is going to cost $600k, they say we want 20% deposit (120k), you say "I have built up 165k equity in my other investment property that I'd like to borrow against". They say "sweet as, can you service the loan", you go "yep my gross income is $100,000 plus $28600 current rental income, plus I'll rent this place out for $600/week, plus my employer who has been paying $100,000 for the last three years promised me I'd get a pay rise!"

    Now you have:


    Total Home Values: $665k + $600k
    IO Loan: $1000k
    Interest Rate: 9%
    Rent: $580/week + $600/week

    :p

    Then after one year with both those properties you'll have made $61300 rent but paid out $90000 in interest repayments, and assuming you can service the $28700 shortfall that should leave you with this:

    Total Home Values: $730k + $660k
    IO Loan: $1000k
    Interest Rate: 9%
    Rent: $610/week + $630/week

    And the cycle continues... and that's how people afford multiple IPs.
     
  6. Billv

    Billv Getting there

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    Chris,

    Great post but I should add a couple of points.

    This above example assumes that property prices will keep on increasing.
    What if we have already exceeded reasonable affordability levels and property prices won't go anywhere but sideways and/or down for the next 5 years or so?

    I say this because the property market just like the share market is cyclical.
    In some areas we've had double digit increases for quite a long time
    and at some stage the market will turn just like it did with shares.

    Will the market turn tomorrow?
    I wouldn't know but investors should tread with caution just in case it does.
    IMHO

    Cheers
     
  7. Chris C

    Chris C Well-Known Member

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    I completely agree BV - obviously my example isn't an accurate one, just an ballpark example with rounded figures to get the principle across.

    I suppose at this point I should probably mention that the reality is yearly growth in both property price and rental yield is completely based on a market system which in the past has been driven by the assumption that demand is always outstripping supply and people fight for the finite resource of places to live to invest in.
     
  8. Thudd

    Thudd Well-Known Member

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    Ok... one question has been answered. Revalue the IP and use that increase in value (if indeed it actually has increased) as security for the deposit. I assume you could use a similar approach for share loans: "I have $X equity in shares, I'll use that to borrow against to purchase more."

    That's the killer. I see or read about the property 'miianaires' and think "fine, the purchase of each property is propped up by the previous one, but unless they've managed to neutrally/positively gear all of them how do people on average incomes service that shortfall?" Or is that my answer, their gearing on some or all of the properties is +ive so the shortfall is serviceable.

    This is all prompted by one of the units in the complex I'm living in being put up for sale; out of curiousity I did some basic sums and thought "how do people on typical incomes like myself afford these portfolios?"
     
  9. Simon Hampel

    Simon Hampel Co-founder Staff Member

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    There are two basic approaches: 1) increase your income, 2) decrease the holding costs.

    There are lots of ways you can do each of these:

    Increase income:
    1a. get a better job
    1b. get a second (or third) job
    1c. start a business
    1d. buy a business
    1e. generate cashflow from trading (shares and/or property)
    1f. use equity to fund cashflow
    etc

    Decrease holding costs:
    2a. negotiate hard to increase rental yields
    2b. add value to increase rents
    2c. subdivide
    2d. multi-let
    etc

    If you are relying solely on your PAYG income alone, then you will hit a wall sooner or later.
     
  10. Chris C

    Chris C Well-Known Member

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    You can always just not leverage yourself as hard. So rather than having a LVR (Loan to Value Ratio) of 80% you could look to have a LVR of 70% as the difference between rental income and interest payments is significantly smaller.

    In the current market (with interest rates at 9%) I'd imagine that the majority of properties start to become positively geared somewhere between 50% and 65% LVR.

    Though the trade off with going with a smaller LVR is that assuming that the rate of property growth and rental yield growth combined is higher than the interest rates (which they have been over the last 4 - 5 years) you are missing out on the opportunity of making money on other people's money (ie the banks) but you are obviously reducing your risk and are also able sustain your lifestyle.

    At the end of the day I think the core premise behind high yield investing is making money on other people's money. As in you borrow money at X rate and invest that money so you get X plus an extra few percent return.

    Though with that said in the current climate you'd be a pretty brave man to back yourself to definitely be getting a better ROI than 9-10% pa.
     
  11. Simon Hampel

    Simon Hampel Co-founder Staff Member

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    Actually it's not quite that easy ... you haven't really given consideration to the extra capital required to purchase at lower LVRs.

    If we assume a 5% rental yield, 9% interest (IO) and look at upfront capital required + holding costs over a 5 year period, we get the following total cost (as a percentage of purchase price):

    80% LVR: 31%
    70% LVR: 36.5%
    60% LVR: 42%
    50% LVR: 47.5%

    ... etc

    It actually gets more expensive the lower the LVR is!
     
  12. troy81

    troy81 New Member

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    What about depreciation of the property. This would also decrease your holding costs by enabling you to save more tax
     
  13. troy81

    troy81 New Member

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    You can also apply to the ATO to have less tax taken out of your pay during the year if you predict to be losing money on your investment.