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Suspicion around living off equity

Discussion in 'Real Estate' started by shasta, 24th Aug, 2007.

  1. shasta

    shasta Member

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    Hi there

    I just found this forum yesterday - looks interesting. I have just finished reading the extensive articles by Steve Navra around 'Living off Equity'. As i am about to purchase my first IP, my wife and I are thinking about how to access passive income etc in the medium term. We have many of the usual questions/issues that you've heard before. So the articles were thought provoking.

    However, the articles suggest that you can redraw, say 65% of equity growth to live off, allowing for the interest costs associated with the redraw. But the article doesn't seem to pick up that these interest costs are cumulative - ie with $100K equity growth pa and a redraw of $65K, you would increase your interest costs (at 8%) by $5200 per year in year one. In year two you pay another $5200 on year one's redraw, plus around another $5200 for year two's redraw. That's $10400 in additional cost in year two. (i'm ignoring tax deductions etc, but you get my drift).

    As you can see, it seems that over the years your interest costs accumulate, and could easily spiral out of control. Therefore, isnt the additional interest cost that you can withstand each year constrained by the additional income generated by rental rises in that year (irrespective of if you are cashflow neg, neutral or positive).

    So, if you earn an additional $40 per week on two IPs in year 2, thats (40x2x52) $4160 in additional income. That means you can cover a maximum of additional $4160 in interest costs on a redraw, implying your max redraw for year two is (4160/0.08) $52000??

    What are your thoughts?
    Shasta
     
  2. voigtstr

    voigtstr Well-Known Member

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    I think you would have to factor in the return from manged funds in meeting the interest payments from Lines Of Credit.

    One plan of attack is to have enough money invested in the funds so that the quarterly distributions pay
    1. rental shortfalls
    2. interest on the equity thats been drawn (eg by Line Of Credit)
    3. margin loan interest

    For safety, most people assume a 10% pa return from Navra retail fund. It would be wise to keep a buffer capable of paying the above costs if Navra returned less than 2.5% per quarter. When Navra does pay more, you could add it to your money to live off, or pay it off the LOCs.
     
  3. shasta

    shasta Member

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    Hi Voigtstr

    Thanks for the reply. I'm still learning, but is there a trick to getting that much in managed funds?, ie do we use some of the equity in our house/IPs?

    If we use equity from our house/IPs, we pay interest on that borrowing too - so the costs keep rising. Also what happens when the funds have a negative return (the stockmarket is volatile, as evidence by the last couple of weeks). That means the whole thing hits the skids, doesn't it? A bit confused.

    Have you done all this? Can anyone supply a spreadsheet (deidentified) that shows a long history of all the financial flows for this sort of thing?

    Shasta
     
  4. Simon Hampel

    Simon Hampel Co-founder Staff Member

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    The trick is that your investments need to compound at a rate greater than the compounding interest costs - otherwise you go backwards.

    For those periods where the market goes backwards (or simly doesn't faster than your debt), you need to have good buffers to cover your cashflow shortfall.
     
  5. voigtstr

    voigtstr Well-Known Member

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    Moving money from equity to funds is one way. For me I'll be simply using money from salary and putting them into the managed funds.

    The spreadsheet is fairly specifc to my needs, but it does show how I've factored in a buffer to meet costs (at O26) if the fund doesnt return enough to pay the costs.

    In my case I'll be aiming to use equity, plus dipping into the fund slightly to fund the purchase costs on the next property.

    (in the spreadsheet, make sure you to turn on, or allow cyclical calculations)
     

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  6. shasta

    shasta Member

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    Wow thanks so much - i didnt actually expect anyone to post a spread sheet! I'll take the time to investigate how it works. If i have any q's i know where to go!

    Thanks also to Sim.
     
  7. seaview

    seaview Well-Known Member

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    Interest which compounds on debt used for living is not a worry if your asset base is big enough, because your asset value is growing faster than your debt. Of course this assumes that you have assets that will enjoy good capital growth and that you keep your debt LVR to a manageable level. If assets don't have good growth, then you could compensate I guess by having lots of them. Even slow growth of lots of assets would help offset growth in debt.
    Cheers
    Seaview
     
  8. voigtstr

    voigtstr Well-Known Member

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    In my case I wont be capitalising my interest (and thereby compounding it), I'll pay it fortnight by fortnight.