Following on from last week’s article called “The Long Term Impact Of Negative Vs. Positive Geared Property”, today I want to explain “How The Wealthy Create Money From Thin Air”. The exciting part is that you don’t have to be rich to follow in their footsteps when you get started.

Hopefully last week’s article demonstrated practically the benefits of capital growth over rental yield. If you look at it as a sliding scale with all growth at one end and all rental return at the other; the best place for you and me to be placed will vary from individual to individual, based on our uniquely differing overall situations.

Again, in writing this I am attempting to help you to better understand how the process works, always with the intention of arming you to make your own fully informed decisions. Responsible financial advice cannot be given on mass, nor do my qualifications allow me to offer advice… except in a one on one situation.

When speaking with clients about starting or adding to their investment portfolio, the first thing we do is run them through our Three Safety Check Points.

Three Safety Check Points

1. Borrowing Capacity – How much would a bank be prepared to loan you
2. Holding Capacity – What are the holding costs and how would you manage them
3. Mental Toughness Capacity – Could you do this and still sleep at night

Assuming a person “passes” the above, I would always prefer to see them go into a property that is likely to see faster capital growth.

mrd offers a mix of investment property opportunities as individually we are all a different position on the sliding scale (as mentioned above).  At different times we often move up and down the scale ourselves; for example… when you are ready to look for your next investment property you may be at a stage in life where you have more equity than available cashflow, or vice versa.

Even the person who can afford what I would consider the better returning investment, they may only be comfortable with a property that offers a lesser entry level with fewer holding costs. Perhaps they are not so concerned if their investment were to average an 8 year doubling cycle when another would have been 7. That’s where they find comfort and peace of mind.

Regardless of the investment mix chosen, in many instances people are passively growing their wealth without taking cashflow from their family budget.

How The Wealthy Create Money From Thin Air

Assumptions

• Purchasing a $300,000 investment property
• Borrowing 105% (or $315,000) so as to have enough to cover Stamp Duty and settlement costs
• Have set up a ‘line of credit’ type loan or redraw facility against the unused equity in the family home
• Interest only loans
• Interest rate of 5.25%
• Initial rent of $300 a week
• Bank valuations come in at contract price. NB: They often don’t, especially in the current climate. Don’t be ‘tricked’ by the term VALUATION, however… see it as a “Bank’s Risk Assessment Figure”

• Rental income doubles over the same timeframe (a real estate doubling cycle) as do values. Rents and values generally rise at different times but roughly both double concurrently

How To

• Leverage off the unused equity in your home that is perhaps just sitting there “doing nothing” anyway
• Borrow 105% of the purchase price of a new investment property. The additional 5% is to cover Stamp Duty and settlement costs
• $240,000 from the Bank financing your new purchase, if borrowing 80%. NB: This may be with the nab, yet your home loan is with St George, for example
• The $75,000 shortfall to come from your line of credit set up against your own home… or perhaps from personal savings
• Another option is to allow your bank to cross collateralise the new purchase with your existing home. For many reasons I do not believe this is in an investor’s best interest; even though it is in your bank’s
• If you were to borrow 90% of the new property’s value, and pay a mortgage insurance premium, you could borrow $270,000 against the new asset and then only have to use other equity (or after tax cash) for the remaining $45,000
• Whether borrowed from one lender or two, the interest on the whole $315,000 becomes a tax deductible expense; please check with your accountant to ensure you are entitled to the maximum deduction from the ATO
• If you borrowed the 105%, your weekly interest bill would be $318.03 a week and fully tax deductible; please check with your accountant
• If you borrowed 80% (or $240,000) and used personal after tax cash for the remainder… your tax deductible weekly interest amount would be $242.31 a week
• Similarly, borrowing 90% (or $270,000) and using personal after tax cash for the remainder… your tax deductible weekly interest amount would be $272.60 a week
• Borrowings over 80% on a full doc loan attracts a once off Mortgage Insurance premium
• NB: The rules governing low doc loans have changed somewhat recently… and the rules differ from lender to lender. Some will only loan up to 60% on a low doc loan
• Your once off Mortgage Insurance premium can be claimed in the tax year that the expense was incurred… but again please confirm this with your accountant
• Many people look to avoid the COST of mortgage insurance, only borrowing up to whatever level they can before it kicks in, when financing a new purchase. They will then top up 100% of the shortfall from existing equity in another property (or use after tax cash savings)
• I prefer to avoid the OPPORTUNITY COST of having to use the additional $30,000 equity (in our above example), as preserving it allows me to buy more property sooner
• Doing this would allow you to generate more wealth over time… and the additional wealth will outstrip the once off tax deductible cost of the mortgage insurance premium
• If the mortgage insurance premium was $3,000, for example, and you took it from borrowings, it would equate to just an extra $3.03 a week in interest payments; again tax deductible (but check with your accountant)
• $3.03 is, in my opinion, a very small price to pay to preserve $30,000 in capital/equity that you can use elsewhere to secure another asset (after passing the Three Safety Check Points, of course)

Initial Results

• New Asset in portfolio valued at $300,000
• New Productive Debt of $315,000
• Negative equity of $15,000 (you borrowed $315,000 to purchase a $300,000 asset)
• Loan to Value Ratio (LVR) of 105%
• A negatively geared property with probable negative cashflow (it varies depending on a person’s tax rate)

• $300 a week gross rental income

Results After First Real Estate (Doubling) Cycle

• Positive equity (or WEALTH) of $285,000 (you still owe $315,000 but the asset is now worth $600,000)
• What commenced as a loan with 105% LVR is now down to just 52.5% LVR ($315000 divided by $600,000… expressed as a percentage)
• A positively geared property
• $600 a week gross rental income
• Both equity and cashflow have been created “out of thin air”; using the bank’s money… NOT YOUR’S!!!
• Positive cashflow pushes your taxable income higher. It’s like a pay rise without working overtime

What I have tried to do here today is simply step out the process I take to build my property portfolio. Given my borrowing capacity is measured by both income (they call this my serviceability) and equity (necessary to secure the shortfall between the 60%, 80% or 90% borrowings, for example)… the above shows how each additional asset I secure, over time, increases my ability to leverage and buy more.

This is why the rich get richer. The good news is, however, that anybody can do this… you don’t have to be rich; yet!

Let me qualify…

• You need to be working, earning an income and paying taxes
• You need to be over 18 years of age
• You need to be assessed by the lenders and have them loan you the required money
• You need to “bring something to the table” over and above the asset you are looking to purchase; they will not ever lend you 100% of the value of the new asset without additional security
• NB: What you would normally bring to the table, when you first get going, i.e. you do not own a property as yet, is cash
• You need (in our opinion, anyway) to have the mental toughness… or sleep at night factor too – or it is not “Set ‘n’ Forget” TM

Where cash is used… it may be a gift from a parent perhaps. Alternatively, it may borrowed, but secured using the equity available in mum & dads home. By that I mean that you borrow the money, in your name, and you make the interest payments, but the security offered to the banks over and above the new property you are purchasing is someone else’s asset.

Personal Example

Katrina and I did this six years ago using the spare equity my brother had in a Sydney property. Once our new purchase had grown in value so that the total borrowings represented less than 80% of the new asset’s increased value (this took about 12 months in a growing market) we were able to have the Sydney property released and our new investment property stood on its own. We have since borrowed against that property again and bought more. This is exactly How The Wealthy Create Money From Thin Air!

[Read our story... click here]

I cannot overemphasise the importance of not taking what I have said as financial advice. It is imperative that you have your own situation thoroughly and carefully looked at before making any investment decision. I encourage you to run past your accountant or financial advisor what I have said and take counsel before acting on ‘a blog’ (mine or anybody’s).

Of course as part of our Customer Care Program we are more than happy to prepare a complete (and complimentary) Financial Structure And Cash Flow Health Check, so as to help you gather the necessary insight required ahead of making any decision – whether that decision is to do something or do nothing. Understand that either may be against your best long term interests!

To request a complimentary Financial Health Check… Click here

To view last week’s article: “The Long Term Impact Of Negative Vs. Positive Geared Property”… click here

Happy Investing,

Nick Lockhart
mrd Customer Care Program… because investing is personal

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