Making your equity work for you

Editor's Notes

• #3: NotesAt some time in our lives we all make a conscious or sub-conscious decision to follow one of two paths. We either decide to do nothing and rely on an age pension (if there still is one) in our retirement or we can become financially independent by doing something about it. The aim of this presentation is to explain why people need to take steps now to avoid the path of a welfare-dependent retirement and to explain why investment property can provide the fastest, surest and safest pathway to financial independence.The following presentation is based on independent information contained in the latest book by Jan Somers, More Wealth from Residential Property. It is important that people know that the book was written by a fellow investor (albeit a very successful one), who has no vested interest in any specific finance or property group.Apart from the advantages of having an independent third party establish the urgency of investment action and endorse property as the most effective vehicle, the book also provides answers to most of the questions you are likely to encounter and should supplement the message you are trying to deliver. It is available through major book stores ($29.95 ea, incl GST) or in bulk at a discount price directly from Somerset Financial Services Pty Ltd.ReferencesSomers, J. (2002). More Wealth from Residential Property.
• #4: NotesThe purpose of this slide is to give people a graphical image of the two paths discussed in the first slide. Most people go through life earning and spending which contrasts with the alternative of earning, saving and investing.Most people live for today, with little regard for their retirement years – until it is too late to do anything about it. They earn then spend, spend, spend. The best they can look forward to is a retirement dependent on welfare (the age pension).Alternatively, the other pathway involves saving, then investing. The advantages are to retire wealthier and earlier, or at least have the option of doing so, with complete financial freedom.Reassure your audience that there is nothing wrong with aspiring to wealth. It is far better to choose to be wealthy and pay taxes than to choose to do nothing and be dependent on welfare paid for from the taxes that others pay. ReferencesMore Wealth from Residential Property, pp 19-20.
• #5: NotesThis slide shows the distribution of annual incomes for couples who are currently retired. (Note, for individuals, these incomes need to be halved). You can go through the graph step by step if you like. The first bar shows that 62% of couples retire on less than $20,000 per year, mostly reliant on an age pension. The second bar shows that 22.1% of couples retire on between $20,000 and $30,000 per year. Only 4.7% retire on $50,000 or more, the income that most couples indicate that they will need in retirement. But even then, we are not talking about people with billions. . It reinforces the fact that most retirees depend on the age pension for the bulk of their retirement income. In fact, the median retirement income for couples is just $18,500 per year. Point out what living on the age pension for couples of $17,000 per year means compared to the average income for families of $67,000 per year. It means that the income is limited to buying essentials, with no extra for even the little luxuries in life: no nice holidays or presents for the grandchildren. For beer drinkers, it means being able to afford about 4 stubbies a week (or just two at the pub!).ReferencesMore Wealth from Residential Property, pp 24-25.
• #6: NotesPose the question “If you choose the pathway to financial freedom, how much do you think you will need?” $100,000, $200,000 or possibly more?Also point out that the amount is in Today’s dollars and over and above the value of the family home.Having posed the question, twist it around by saying that instead of guessing how much you will need in total, it is easier to guestimate how much annual income you will need in today’s dollars for a comfortable retirement. Then we can use a simple formula to convert annual income into total income producing the assets needed.Most couples think that they will need a retirement income of at least $50,000 per year (before tax). Higher-income earners think they will need even more. ReferencesMore Wealth from Residential Property, p 23-28.
• #7: NotesA conservative estimate is to multiply the income needed by a factor of 20. For $30,000 they would need $600,000. For $40,000 they would need $800,000. And so on... The factor ‘20’ is based on the assumption that an asset yields sufficient to remain indexed to inflation and still produce about 5% in income. Whatever the amount calculated it is bound to wipe the smile off most faces. But point out that this presentation will show average investors how to achieve these large amounts without doing double overtime or having to work at three jobs. We will be showing them how to make their money work harder, not them.Remind your audience that only 4.7% currently retire on an income of $50,000 or more and its not by accident - they invested their money.ReferencesMore Wealth from Residential Property, pp 26-28.
• #8: NotesOnce people decide to invest, they are then faced with another decision. Pose the question “ Do you want to pay someone else to do it all for you, or do it yourself?” What most people don’t realise is that in going to a financial advisor, they have unwittingly already made a decision to have someone else do it all for them by investing their money into a managed fund. Funds are then “creamed off” (commissions, management and administrative fees, etc.) along the way, but end up in one of the three investment types (cash, shares or property). Because most financial advisors only sell managed investment products, which does not include residential property, it is not possible to go to an advisor with the proposition: “I want to invest directly into property. Will you show me how and can you help me do it?” Direct investment in property not only means greater control over your investment dollar (you can see and touch your investment, you decide when to renovate, sell, etc.), but you do not have the expense of all the middlemen.However, point out that “do it yourself” does not mean “do it all yourself”. Property managers are paid a percentage of the rent, not a percentage of the asset value, as is the case with managed funds. It is the aim of the remainder of this presentation to show why property, and in particular residential property, is best suited for building wealth.ReferencesMore Wealth from Residential Property, pp 39-44, 55-57.
• #9: NotesThis slide provides a road map of where the seminar is heading. Each one of these will be talked about in turn so that at the end of the session, people will understand the reasons why property is better than cash or shares (Why?), exactly what type of residential property (Which?), the best location (Where?), the recipe for building a property portfolio (How?), the timing of the purchase of the investment (When?) and last but not least, the questions and objections that pop into peoples’ minds (What if?).
• #10: NotesPoint out that it would be foolish to look at just one attribute when comparing investment alternatives. Although it is important to look at all the attributes of a good investment, at the end of the day, the investor is really only interested in four points. An investment destined to provide financial freedom must provide a good return with low risk. It must also be able to be safely and highly geared (by borrowing money) to allow wealth to be created safely and quickly. Over the next few slides we look at the returns and risks associated with cash, shares and property. ReferencesMore Wealth from Residential Property, pp 61-72
• #11: NotesMost people feel secure with cash in the bank however it is important to point out that the after-tax, after-inflation return from investing money in the bank are actually negative. There is not much point in investing in something with no risk if there is also no return. The blue line represents the interest rate, or the gross return, on 2yr term deposits. The red line shows the real rate of return after allowing for tax and inflation. For most of the time, this line is below the zero axis line indicating that the real after-tax return from cash is negative. In other words, investing money in the bank will eventually send you broke! Not only no risk, but no returns, no gearing and no wealth.ReferencesMore Wealth from Residential Property, pp 61-62
• #12: NotesIt is important to take your time over the next few slides because herein lies the most important difference between shares and residential property. The aim is to show that while the return from both shares and property is good, there is a much greater risk of losing capital by investing in shares. Make the statement. “If you invested $1,000 in a Sydney unit in 1960, what would it be worth now?” Answer $100,000. Make another statement. “Instead of buying property, how much would you have made by investing your $1,000 in 1960 in Westfield shares?” Answer $109,000,000!!! Everyone likes to back a financial winner like Westfield, but few, if any, of us have achieved such results or ever will. There are no flashing neon signs that signal future share market winners — so you either need the foresight of Nostradamus, a source of inside information, or a lot of luck. For instance, in 1960, had you invested in a company such as Centralian Minerals, your shares would now be worthless: the company liquidated in 1962. Is there any residential property in Sydney that is worthless now? Trading in shares - especially on the internet - can be exciting. What’s even more appealing is that, like a ticket in Lotto, you have a small chance - a very, very small chance - of making a fortune with the next Westfield. How exciting is that? But at what risk to your own money? ReferencesMore Wealth from Residential Property, pp 63-64.
• #13: NotesSuppose you decide to try to eliminate some of the risk by investing only in the “best” shares - supposedly those in the All Ords Index. Let me explain. In 1980, there were 1,029 companies listed on the stock exchange, but only 265 companies were deemed to have been worthy (because of their size and turnover) of being listed as part of the All Ords Index. However, by 1990 only 124 of these 1,029 remained and by 2000, only 109 remained. The rest had either dropped out of the index or had been eliminated from the stock exchange altogether. Maybe, you could stick with just the top ten companies. But there are only two out of 10 remaining since 1980. The point is that whilst investing in shares is risky (see page 66), investing in shares that are part of the All Ords Index can also be risky, as the companies in the that Index are constantly changing. ReferencesMore Wealth from Residential Property, pp 63-65.
• #14: NotesLooking at growth and yield data from both shares and property over a twenty year period, we must compare the returns on a level playing field. The most accepted measure for shares uses the All Ords Index supplied by the Australian Stock Exchange and for residential property, the Residential Investment Property Index supplied by Graeme Newell for the REIA.For shares to achieve exactly the same returns as the All Ords Index, it would be necessary to buy and sell shares, sometimes every few days. According to Professor Terry Walter from the Faculty of Economics at the University of Sydney, such transactions cost between 2% and 3% of the asset value of the shares annually , excluding Capital Gains Tax (CGT). Hence, the overall returns for shares is 11.5%.For property, 20% of rent was allowed for expenses giving an overall returns of 14.0% per year.ReferencesMore Wealth from Residential Property, pp 64-65, 241-248
• #16: NotesWe have seen that in order to retire financially independent, we need assets of around $1,000,000 in today’s dollars and over and above the value of our own home. As it is not possible for the average person to simply save this amount of money from weekly wages, we need some kind of lever to crank up the returns on the small amount we have invested. The great thing about property is that the already good returns can be safely increased through tax advantages and the leverage effect of gearing. Gearing, or borrowing money not only magnifies the returns, but it makes investing in property extremely affordable as we will see in the next slide. It is important to point out here that we are talking about “good debt” not “bad debt”, the difference being that with “good debt”, you borrow to buy things that increase in value - such as property - rather than something that decreases in value - such as cars.It is also timely to point out that gearing is something that an investor must feel comfortable with and that any level of gearing, no matter how small is still better than just saving money. ReferencesMore Wealth from Residential Property, pp 49-50,67-69
• #17: NotesGearing not only provides leverage but makes property extremely affordable. Let’s see how a $360,000 property can cost less than $16 a dayNote that the following example has been worked out using the example property described on page 127 of More Wealth from Residential Property, and for someone with a taxable income of $65,000 per year.If the full amount is borrowed (using the family home as security, the total loan including purchase and borrowing costs would be $376 729. With and interest rate of 7%, the interest payments in the first year would be $26 371. If the expenses (such as rates, insurances etc) for the property were $5674, then the total expenses for this property would be $32 045.Already the “cost” of the property has come down from $360,000 to $32 045 in the first year. If someone lived in this property as their own home, the cost would be the entire amount of $32 045. However, for an investors with a tenant in the property, the cost is cheaper still. Let’s see how.ReferencesMore Wealth from Residential Property, pp 193-195
• #18: NotesWhy does a $360,000 property cost you so little with the annual cost of $5,768.10 being about $111 per week? Because two other people are contributing to the major portion of the loan interest payments and expenses of $32,045! Firstly, the tenant pays $18,265 in annual rent and then the taxman gives you a $8,011 tax refund. What’s even better is that you don’t have to wait until the end of the year for that tax refund. It can be claimed back each week as a reduction in tax taken from your pay as allowed under Section 15-15 of the Tax Act. Then you the investor is left to make up the deficit of just $5,768 or 18% of the total expenses. ($32,045 - $18,265 - $8,011 = $5,768). This equates to just $111 per week - less than $16 a day. And this is only in the first year. As time goes on, the cost to the investor decreases as rents increase.ReferencesMore Wealth from Residential Property, pp 193-195, p 200.
• #19: NotesOne of the greatest difference in how investments work is the way they can be geared so that greater amounts of capital are working for you.Lets suppose you invest this same $5,768 in other areas of investment.For cash, all you can do is put your $5,768 in the bank. That’s it. No more. In super, you might have a bit more of say $7,000 if your employer puts in a bit as well. But you cannot borrow to add to you own money in a super fund.For shares, you could borrow a reasonable amount of say $200,000 (60% of the value of shares), which might cost you $5,768 taking into account a dividend yield and tax refund However, we have just seen how $5,768 per year will allow you to invest in a $360,000 rental property by borrowing the full amount using your home as additional equity. Let’s then look at the effect of say 10% capital growth (10% is simply to make the calculations easy) on the assets you now have working for you. For cash, you’d make about $400, taking into account taxes. For super you might make $600, with a few tax concessions, for shares, it might be $20,000, but for property, where gearing has allowed you to invest in more assets, the 10% would produce $36,000. ReferencesMore Wealth from Residential Property, pp 58-59, p72
• #20: NotesAt this stage you might like to recap on why residential property is the best vehicle for the average investor.Good returns over the longer termLow risk of losing capitalEasily geared giving even better returns and making it very affordable.Good returns coupled with low risk and high gearing ability make it a great vehicle for creating wealth.
• #21: NotesOK, its got to be median-priced residential property, but before we expand on this, you should point out why commercial property and land are not ideal. Briefly, commercial property is too risky and is prone to wild fluctuations in both values and rents, while it is not possible to claim tax deducions on land, making it less affordable.Let’s look at a specific example in an imaginary place called Middletown. The graph represents the values of all properties sold in the past year. A total of 980 prices were sold with prices ranging from $50,000 to $500,000. In this case the median value is $180,000, the price at which half (490) the properties sold for more and half (490) sold for less. Let’s use a scale of 1 to 10 instead of dollar signs, where 1 represents the pits and 10 the palaces. Notice that median priced property falls within the range of 3 to 5. So don’t think of a property in terms of price, but where it fits on the scale of properties in the area in which you are looking.ReferencesMore Wealth from Residential Property, pp 74-78, 80-81.
• #22: NotesLet’s now take away the dollar values and replace them with completely different property values from a more upmarket area. Notice that the graph still looks the same but the range of 3 to 5 around the median value now gives values of $350,000 to $450,000. In this case the median value is $380,000.The point of the exercise is to show that investors shouldn’t be thinking in terms of “Should I buy one property at $400,000, two at $200,000 each or four at $100,000 each.” They should think in terms of a scale of 1 to 10, no matter what the value. Why median value? Properties scaled at number 1 are generally akin to dog boxes which no one wants to rent, and properties at number 10 akin to a palace are too expensive for investors to buy and too expensive for tenants to rent, unless there is a drastic drop in rent, giving a very low yield. Properties scaled between 3 and 5 usually fit the bill perfectly. They are highly desirable properties that suit the average person as either a first home or an investment. So they are easier to buy and sell if people need to. Also, these properties appeal to, and can be afforded by, a greater number of tenants.ReferencesMore Wealth from Residential Property, pp 80-81.
• #23: NotesRecap on the road map to let people know that we have now looked at why and which property but it’s time to look at exactly where is the best location.
• #24: NotesMost major cities and provincial towns where there is a stable economy are suitable for investment in residential property. The aim of this slide is to point out the differences that occur between investing close in to the CBD as opposed to further out in the fringe suburbs.Close in to the CBD, capital growth tends to be higher and further out in the suburbs, it is lower.Conversely, close in to the CBD, the yield is usually low compared to out in the suburbs where it is relatively higher. (Yield is the relationship between the rent received and the value of a property.)So we experience the phenomenon of higher growth coupled with lower yield or lower growth coupled with higher yield. Which is better?Neither. They are just different. It’s a bit like asking which kind of dog is best. One with short brown hair or one with long white hair. Different breeds of dogs are suitable for different situations and so it is with property. It is important to point out that for most investors, a combination of growth and yield is desirable.ReferencesMore Wealth from Residential Property, pp 93-99.
• #25: NotesJust another road map to let people know we are past the half way mark. Also. It’s timely to point out that the next few slides are the crux of the strategy of how to build more wealth from residential property
• #26: NotesThis slide shows the recipe in graphical form. The first slide in the sequence shows how we start with one property. We all have to start somewhere by using a deposit to borrow and buy that first one. It can be pointed out at this stage that the first property may be the person’s own home or it may be an investment property. This first property is the stepping stone to a portfolio of properties. ReferencesMore Wealth from Residential Property, pp 121-133
• #27: Notes First, you must build up equity in the first property, usually your own home. This can be done by paying off the loan ASAP, or by capital growth, or both. Then, the increased equity in this first property can be used as collateral to borrow to buy another property. Note how the debt is increasing on the left hand line. It is also useful to point out that it is not necessary to have paid off the first home before purchasing the second. Neither is there any rule for the amount of equity needed. Buying the second property is more dependent on the person’s cash flow than anything else.Point out that buying the second property is so much easier than buying your own home because a tenant and taxman contribute to the major portion of the costs. Whereas the poor old home owner has to foot the entire bill. ReferencesMore Wealth from Residential Property, pp 121-133.
• #28: NotesGradually buy more investment property as increasing equity and cash flows allow. Equity increases with rising property values and decreasing loans, while cash flows increase with rising rents and wages.Point out that the properties increase in value but the debt for each particular property remains constant.In this way, a portfolio of properties can be collected over a period of time, the earlier properties helping to finance the later acquisitions through use of both the equity in them and the positive cash flow that should result over a period of time.ReferencesMore Wealth from Residential Property, pp 121-133.
• #29: NotesAfter a period of ten to fifteen years, the point can be reached when the investor can then make several choices with respect to retirement. The aim is to reduce debt levels and have a collection of properties where the rent is greater than the interest. This may be achieved by selling a few properties (not the best method but the most obvious), winding down to work part-time instead of full time (allowing more time for rents to increase in relation to interest payments), paying principal and interest for the last few years, using any lump sum superannuation to reduce the debt etc. There are a number of ways to wind down into retirement and page 208 discusses various ways of minimising the Capital Gains Tax. ReferencesMore Wealth from Residential Property, pp 121-133, p 208
• #30: NotesOne of the most often asked questions is “How much money can I borrow?” Two factors primarily determine this. Firstly, a financial institution requires some form of security, preferably a residential property, to advance a loan. A measure of the level of security is called the LVR or Loan to Value Ratio.Secondly, the lender must be convinced that the investor can comfortably make the repayments on the loan. A measure of this level of serviceability is called the DSR or Debt Service Ratio.ReferencesMore Wealth from Residential Property, pp 147-156.
• #31: NotesHow do lenders measure LVR and DSR? Point out that there is no need for investors to get bogged down in detail.Simply point out the formula for each of them.The LVR is measured by the relationship between the total loans to the total value of the security offered, usually a combination of the family home and investment properties, including the one being purchased. And the DSR is measured as the relationship between the total loan payments (including home loan payments and car loans etc) and the sum of roughly 30% of incomes plus 80% of the rent, though this may vary with lenders.It’s probably a good time to suggest that either your PIA software will calculate this for them or a lender can assess their borrowing capacity for them.ReferencesMore Wealth from Residential Property, pp 147-156
• #32: NotesWith a short time frame of just a few months in which a property is bought and sold, timing is critical. Consequently, for property traders and speculators, buying and selling at the right time can make or brake the deal. However, for long term investors, timing is less important. Many financial commentators try to predict the best time to buy property but it is all too easy to sit back and do nothing and then miss the boat altogether. It is best to get in at any time and hold on for the long term. The best time to buy a property is not when you judge the time to be right - because this is crystal ball stuff - but when you can afford to.ReferencesMore Wealth from Residential Property, pp 101-108
• #33: NotesTiming should have more to do with an individual’s finances than the economic clock. An investor should be buying an investment property when he can afford the $52 (on average) that it costs to buy it. This is the average cost when the investor uses the equity in their own home instead of a deposit. The tax benefits and rent then help pay for the investment property. This slide should be a good lead-in to informing investors that you, the agent, can show them how this is possible. The PIA software can be used to produce a detailed report showing investors how affordable an investment property really is. You can point out that the property might be $100,000 and the cost only $6 per week or $300,000 and the cost $80 per week. But no matter which way you look at it, the cost of buying an investment property is cheap.If buying an investment property is so cheap, then why can’t everyone afford to? ReferencesMore Wealth from Residential Property, pp 194-195, PIA software
• #34: NotesAlthough buying an investment property is relatively cheap, the reason why most people cannot afford to buy today is not because they have a high mortgage on their own property, not because interest rates are high, but because they have other priorities. These in themselves do not cost much, but together consume most of the available spare money.The costs highlighted in this slide are the hire purchase/lease costs of the typical consumer items. Most people will identify with at least one of these. The next slide shows the alternative to spending all this spare money on consumables. ReferencesMore Wealth from Residential Property, pp 225-226.
• #35: NotesIn this slide we present an alternative to spending all the spare money on consumables. It really drives home the fact that buying an investment property is no more expensive than buying a lounge or a car but it is the cost of consumer debt that prevents most people from buying an investment property.It should also be pointed out that after buying an investment property, the joys in life still continue. It is not a case of giving up everything nice, but a case of setting a priority. Yes you can have a four wheel drive now, but the boat may have to wait. Yes you can have the new kitchen now, but you have to do without the “you-beaut” leather lounge. People can afford to buy an investment property when they set a priority system in place. Invest first - spend later. ReferencesMore Wealth from Residential Property, pp 225-226
• #36: Notes At this stage, you may wish to recap on some of the things you have already said before you come to the final point of “what if”. ReferencesMore Wealth from Residential Property
• #37: NotesHaving covered the how, which, where and why of property, most investors will begin to ask “but what if?” Jan’s new book answers a series of questions relating to many of the what if’s that people ask. Over the next few slides, we will look at some of the more important what if’s.ReferencesMore Wealth from Residential Property, pp 211-240 .
• #38: NotesThis slide is a good one to make it known to investors that any problems that do arise, mostly do so because they, the investor, were unprepared for the inevitable hiccup which is a non-event if they are prepared. For example: If investors are afraid of rising interest rates - fix the rate for at least 5 years. If they are worried about high vacancies - buying a reasonable property and setting a reasonable rent usually avoids this problem arising in the first place. Keeping cash on hand avoids the problem of having to scratch around at the last minute for money - banks love to lend you money when you don’t need it - but try getting it from them when you do.Setting up credit lines well before any problems arise may save the need for keeping too much cash on hand.ReferencesMore Wealth from Residential Property, pp 211-220.
• #39: NotesTo help reassure potential property investors that indeed there is a large pool of tenants, remind them that there is a 95% chance that they themselves had rented at some stage in their life; it may have been when they were single, or while they were having a house built, or when they went on holidays. Suggest therefore, that tenants should not to be thought of as second-class citizens; a large proportion of them will be just like those to whom you speak!About 30% of the population rent now! In Australia, this proportion has actually being growing slightly (from 26% in 1978 to 30% in 1991 to 32% in 1997). In European countries, renting is actually the norm. It is anticipated that in the next few decades, the number of renters will climb from 30% to 40%.ReferencesMore Wealth from Residential Property, pp 223-224.
• #40: NotesAs well as being concerned about a shortage of tenants, investors often believe that if too many people get in on the act of buying investment property, then vacancies will increase because there will be too many rental properties. The fact is that very few people actually invest in property other than their own home. Of the 70% of people who buy their own home, 63.5% buy just the one property, while a mere 6.5% take the next step of buying more property. Of this 6.5%, 5% buy just one more property (usually they are accidental investors who have inherited a property or who have upgraded into another home and kept their old home for rental), 1% buy two more, and only .5% buy three rental properties or more. Obviously not everyone is “doing it” and there should be no fear of there being too many investors. ReferencesMore Wealth from Residential Property, pp 225-227.
• #41: NotesWe’ve now looked at most of the why’s, how’s and what if’s in relation to property. But before we conclude, there is one more very important “what if” that we need to cover.
• #42: NotesWhat if you don’t??? What lies in store for you when you retire if you don’t start a wealth building plan today? Let’s recap on some of the alternatives so you can see that the answer to ‘What if you don’t?’ is not a pleasant one.If you do nothing, you run the risk that there’ll be no age pension. What about the SGC? The reality is that the money generated by the SGC will be totally inadequate, and at best will provide an income equivalent to the age pension, except that you will have paid for it.What if you pay someone else to do it all for you by investing in a managed fund? I suppose it will be better than doing nothing, but your returns will be significantly reduced by the fees you pay. You could invest in shares, but their volatility increases the risk and decreases your capacity to borrow, curtailing your wealth building strategy. Ultimately, we believe that the best way for the average person to build wealth is through residential property. Do you fancy being one of the 95.3% of couples who never achieve the income they want in retirement? Or will you be one of the 4.7% who retire with more that $50,000 a year?ReferencesMore Wealth from Residential Property, p 240.