Wealth Power of Property

Chapter 6:
Become a property multi-millionaire in 15 years

ESCALATING GROWTH BY LEVERAGE

Do you want to increase your financial worth by more than one million dollars, over the next ten to fifteen years? Let us say you do, and seriously intend to pursue that objective. Let us look at the process that you might undertake to achieve it. You have decided that residential property is an appropriate means to achieve that end. One of the main principles in accumulating a substantial portfolio of property is by means of leverage. Leverage being the ability to own more property, and therefore receive more growth in property values by carefully planning to use other people’s money, by borrowing on existing resources.

That means using the right kind of borrowings wisely. There are two kinds of other people’s money. Let us make a real distinction by using the word debt for one kind, and the word borrowings for another. Debt describes money that we use to buy products or services that do not have lasting value, or fall in value. When you use personal loans to buy cars, or use hire purchase to buy furnishings, or you use a credit card to go on a holiday, that is debt. You are not acquiring something that has lasting value, or increases in value. It is in fact going to fall in value, or straight after the holiday, have no value at all, other than memories. Whilst holidays are important, they do not secure our financial future.

We use the word borrowings when we use other people’s money to buy something that does have lasting value, or will increase in value. That is a very real distinction. The word debt is a negative word, and not too many people wake up in the morning and say "I'm going to enter into some debt today", and feel really good about it. Borrowings sounds much more positive.

With that in mind, how do you apply these principles to add more than one million dollars to your net worth over the next fifteen years without putting yourself at undue risk, or doing anything that will cause you to lay awake at night worrying?
HOW ONE COUPLE CREATED A MULTI-MILLION DOLLAR ESTATE - CONSERVATIVELY

A CASE STUDY

James and Susan purchased their first home in Sydney around twelve years ago, in June 1987. The home they purchased was a modest cottage, worth close to the median value for houses in Sydney at the time. In this case study, James and Susan are a fictitious couple we will use to show how, by safe and conservative planning, modest beginnings can be escalated into substantial wealth and security. They paid $83,000 to purchase the property, with a cash deposit of $21,000, part of which was used to pay stamp duty and legal costs, and a home loan from their bank of $66,000.

ORIGINAL HOME PURCHASE (TEN YEARS AGO)

Purchase Price $83,000

Purchase Costs $4,000

Total Cost $87,000

Cash deposit $21,000

Mortgage $66,000

Total Funds $87,000

Today, after living in that home for more than ten years, and in line with the actual growth in Sydney values over that period, their home has now increased in value to $220,000. They have reduced some of their home loan from $66,000 to $50,000. As it is a principal and interest loan, it has not reduced quickly. The payments on the loan in those early years have mainly been interest. Today they have equity, which is the value of the property less the amount they owe the bank, or anyone else, of $170,000.

HOME POSITION TODAY

Value $220,000

Less Mortgage $50,000

Present Equity $170,000

The actual result they have achieved in financial terms, is that equity has grown from $21,000 when they purchased the property ten years ago, to $170,000 today. An excellent result, but of course, all they own is the same home at its increased value.

GROWTH IN HOME EQUITY

Original Equity $21,000

Asset Growth (and loan reduction) $149,000

Present Equity $170,000

THE NEXT TEN YEARS

If we project their position today ten years into the future, and increase the value of their home at say 8% per annum, it will increase to $475,000. It will then be just over twenty years since they originally purchased their home, and they would have paid off the home loan. They would have equity in their home of $475,000, most of which, other than the loan of $66,000 which they paid off over the period, was achieved by natural market growth. No major renovations, or rezoning or change of land use. Just the inevitable increase in value over time. In this example we have used an 8% growth rate, rather than the historically higher 10% growth. At 10% their home would increase in ten years to $570,500, but let us remain conservative with the 8% example.

HOME EQUITY IN TEN YEARS FROM NOW

Value of Home Today $220,000

Projected Growth @ 8% per annum compound $225,000

Projected Value in Ten years From Now $475,000

Mortgage in Ten Years NIL

Projected Equity in Ten Years From Now $475,000

In ten years, with a property value of $475,000, they could sell and buy a cheaper home and bank the difference, but as their home is in the median price range, that would mean settling for significantly inferior accommodation. They may even have to rent in order to have a reasonable nest egg if they were to retire at that time.

ADDING TO GROWTH POTENTIAL

Alternatively they could do something now to add to their growth potential over the next ten years by using their property as collateral and borrowing to acquire additional property, which could be rented as an investment, with tax benefits, and most importantly, would also grow in value.

James and Susan decide on the latter plan and approach their bank manager for a loan to purchase investment property. But what are the risks? The first rule of investment is to protect existing capital. The bank would look at James and Susan’s position and should be happy to lend them up to 90% of their homes value of $220,000. At this level of borrowings they would have to pay for mortgage insurance which protects the bank’s position. But they want to remain fairly conservative, especially as a first time investment, and decide to borrow only 75% of their homes present value. Banks do not usually require mortgage insurance at this level of borrowing, as they perceive minimal risk, especially on investment in residential property.

AVOIDING BLUE SKY

If protecting our capital is our number one rule, then avoiding either "blue sky" optimism, or taking too "gung-ho" an approach to investment are important points to keep in mind.

The bank agreed to lend them 75% of the value of their home today, a $165,000 loan. But they still have a balance of $50,000, owing on their existing mortgage. If that $50,000 is deducted it leaves a borrowable amount of $115,000 which could be used as a deposit for a further investment property. The bank manager then has to establish that they can afford to service the total loan out of their income including the rent from the new investment property and the potential tax savings which would result from investment ownership. Providing those tests are met, the bank would lend them $115,000 "for any worthwhile purpose", to use a bank expression, in this case, as the deposit for another property purchase.

If James and Susan also borrow 75% of the value of the new investment property they intend to acquire, that would give them a total borrowing power of $385,000, which could be used to purchase properties worth $365,000 after allowing for acquisition costs such as stamp duty and legal fees. The next week they could go shopping for a property or properties up to $365,000 in total value.

BORROWING FOR INVESTMENT PURPOSES

Current Value of Home $220,000

Increase Borrowings to 75% of Present Value $165,000

Less Current Borrowings ($50,000)

Further Borrowings Obtainable on Existing Home $115,000

Plus Loan on New Properties at 75% of Purchase Price $270,000

Total Borrowing Power $385,000

Funds Available for Further Purchases After Purchase Costs
$365,000

You can see in the following figures with their new mortgage of $385,000 for investment property, with a value of $365,000 after allowing for stamp duty, legal fees and borrowing costs, which equate to around 5% of the purchase price of a median priced property, plus their home and existing mortgage, their total property holdings have increased to $585,000 with borrowing's of $435,000.

POSITION WITH NEW PROPERTIES

Home Investment Properties TOTAL

Value $220,000 $365,000 $585,000

Borrowings $50,000 $385,000 $435,000

Equity $170,000 ($20,000) $150,000

What they have done is increase their assets and liabilities, giving them greater exposure to future increases in values. Now they will receive capital growth on property worth $585,000.

THE FIRST FIVE YEARS

If they then do nothing for the next five years, what would their situation be? Applying the same principles and assuming values have increased at an average 8% per annum, their home would have increased to $323,000. We can assume that they have continued repayments on their home loan as they have done in the past, increasing their equity and reducing the mortgage.

POSITION IN FIVE YEARS FROM NOW

Home Investment Properties TOTAL

Value $323,000 $536,000 $859,000

Borrowings $24,000 $385,000 $409,000

Equity $299,000 $151,000 $450,000

The investment properties have increased at 8% per annum to $536,000. They still have the loan they took out to buy the properties at $385,000. If it were a principal and interest loan it would have reduced a little increasing the equity. We will assume that they borrowed interest only for investment purposes, so their total property holdings have increased to $859,000 with loans of $409,000 which is under 50% of the value of their properties. Looking at the total picture, this is a conservative level of borrowings. Their equity has increased to $450,000.

They have virtually achieved in five years what would have taken ten, if they had just continued paying off their home and left their equity passively non-productive. By putting that equity to work within fairly conservative limits, they have substantially improved their net worth. This could be achieved at relatively low ongoing cost, which is covered in detail in the next chapter. The actual ongoing cost to James and Susan works out to be less than leasing the average family car worth say $28,000 and which will fall in value, compared to owning $365,000 in additional property which will rise in value. There is no comparison - it is chalk and cheese.

After that first five year period, James and Susan are very satisfied with the results of their first property investment. They go back to the bank to show their manager what they have achieved, and seek to borrow for further investment.

AFTER THE FIRST FIVE YEARS

They have property worth $859,000. If they again increase or "top-up" their borrowings to 75% of that higher value, they could borrow an additional $235,000. If that $235,000 again becomes the released equity from current properties to act as deposit to buy more property on which they borrow 75% of value, they would have a purchasing power, after acquisition costs, of $785,000.

THE NEXT FIVE YEARS BORROWING FOR FURTHER INVESTMENT

Current Value of Property $859,000

Increase Borrowings to 75% of Present Value $644,000

Less Current Borrowings ($409,000)

Further Borrowings Obtainable on Existing Home $235,000

Plus Loan on New Properties at 75% of Purchase Price $550,000

Funds Available for Further Purchases After Purchase Costs
$785,000

James and Susan now buy another three properties at around $250,000 each, or any combination up to $745,000 after allowing for costs. Remember property values have increased generally by that time. That brings their new overall position to property holdings of $1,604,000 with borrowings of $1,194,000 and equity of $410,000.

YEAR FIVE - WITH NEW PROPERTIES ACQUIRED

Home Investment Properties TOTAL

Value $323,000 $1,280,000 $1,640,000

Borrowings $24,000 $1,170,000 $1,194,000

Equity $299,000 $300,000 $410,000

AFTER TEN YEARS OF ESCALATING

If they do nothing for another five years and then reassess the situation, their home has increased to $475,000 as we first calculated it would over the ten year period. They have now paid out the balance of their home loan, which five years ago was down to $24,000. The investment properties have increased to $1.88 million, the loans are unchanged at $1.17 million. The total value of the properties they are holding is $2.355 million, with borrowings of $1.194 million. Their equity has increased to $1.161 million.

POSITION AFTER TEN YEARS

Home Investment Properties TOTAL

Value $475,000 $1,880,000 $2,355,000

Borrowings NIL $1,194,000 $1,194,000

Equity $475,000 $686,000 $1,161,000

If they had kept their home, made no investment at all and paid off their mortgage, the equity would have been only $475,000 not $1,161,000, as the case study demonstrates. They have increased their net worth by $1 million within ten years.

They then review the situation again. With a total property value of $2.35 million, they bring borrowings back up to 75% or $1.76 million, less the current loans of $1.194 million. They can then borrow another $572,000, as long as it can be serviced. It becomes another feasible step without high risk. That would give them a total purchasing power of $1.906 million. This time James and Susan can acquire a whole building of new apartments for that sum. With those purchases and another five years, a total of fifteen years from now, growth on James and Susan’s property portfolio has been substantial.

A MULTI-MILLIONAIRE AFTER FIFTEEN YEARS - A REALITY

POSITION AFTER FIFTEEN YEARS

Home Investment Properties TOTAL

Value $698,000 $5,563,000 $6,260,000

Borrowings NIL $3,100,000 $3,100,000

Equity $698,000 $2,463,000 $3,161,000

By keeping borrowings to a level that any professional investor, or any financial adviser would regard as reasonably conservative, that is topping up to no more than 75%, and by projecting values at 8% per annum, which is less than the average over the last thirty years, they have managed to enhance their lifestyle, wealth, and security, far beyond that achievable from income and savings.

SLOWING THE PACE TO RETIREMENT

James and Susan could continue to add to their portfolio and probably will. Now retirement is in sight and even though they are now only in their mid fifties, they are starting to think about retirement income. They will probably continue to buy more property, possibly even encourage and assist their children to invest in property, but at a slower pace than before. This will allow overall borrowings to progressively fall as a proportion of value, and allow the portfolio to start generating net income in their hands. If they wanted to speed up that process, they could sell a number of properties and use the net sale proceeds to reduce borrowings on the remaining properties. This would allow more net income to flow to them.

Not everybody wants borrowings of more than $3,000,000, or even need a net worth of almost $3,200,000, but a lot of people have achieved those results. This is one of the most common ways that people build wealth. Creating or earning a large income does not necessarily build wealth, accumulating assets does.

THE KEY PRINCIPLES

In this study, James and Susan have been relatively conservative. They have patiently created a large portfolio of property over time. The properties were properly financed for investment purposes, and throughout this example we have assumed less growth in property values than has been the case in the past.

Our example has seen them review and invest every five years, for ease of example. In practice they may have reviewed their situation more frequently and acquired property sooner than this case study provides, which would in turn enhance the result they were able to achieve.

We also use a constant growth rate of 8% per annum compound and, as this book reveals, market cycles do not always provide a constant level of growth. At times values will increase at higher or lower rates, so increasing the investors opportunities to buy at the best time in the cycle to enhance growth. James and Susan will also vary their purchasing programme depending on changes to their income, prevailing interest rates and rent levels, hastening or slowing their purchases as circumstances permit. A more thorough examination of these factors is covered elsewhere.

There are some who would do more than James and Susan. Keeping what we do with our investments to a level that we are comfortable with, so that we can sleep at night, is just as important as any other consideration. We could do more, or certainly do less, according to our individual objectives, resources, lifestyle and comfort zone.

GETTING STARTED FROM NOTHING

The prospects for James and Susan becoming property multi-millionaires in this case study depends on their having purchased their first home ten years previously with a present build up of equity to launch them into an asset building program.

MONEY MANAGEMENT

Not everyone is in that fortunate position. With family responsibilities or a newly acquired mortgage and twenty years of mortgage payments ahead, the task to acquire a first investment property may seem a formidable one. There have been many good books written on the subject of money management. Paul Clitheroe’s "Money" and "Making Money", and Noel Whittaker’s "More Money" and "Making Money Made Simple" are good examples. Daryl Pike has recently written a book called "The Apprentice Millionaire", which we commend to the under 30’s who wish to apply themselves to money management and planned asset accumulation.

Each of these books deals with the problem of making a start in gathering together the means to your first property purchase. It would be better for you to read one or all of them than have the principles repeated here. A disciplined approach to acquiring your first property is essential. Jan Somers book "Building Wealth In Changing Times" also covers this subject in Chapter Twelve "The Human Factor".

For most, the first purchase will be the family home, and for the majority, that will be the right course to follow, but not necessarily so. We point out that it is possible to borrow more money on rental investment property than owner occupied homes. The rental adds to income and the tax breaks from property increase after tax net income, so increasing affordability in the eyes of the lender. This makes for better access into the market. Often for singles or double income couples, an investment property may be the best first purchase.

This applies particularly if one’s occupation forces a different geographical domicile than a more appropriate investment location. A warning at this point, it can be a dangerous decision to try and combine the two. Refer to the Chapter "But Could I Live In It?"

A FOOT IN THE MARKET

Gathering together a deposit for the first home still remains first and foremost for the beginner. You have to get a foot in the market or it will pass you by. Sometimes the struggle can be difficult, but struggle you must. That can mean sacrifices, hard work, or going without. It is a simple choice.

Once you are on the first rung , acquiring your second property will be the next goal. Sure it may also seem tough, but the rewards are worth the struggle.

If moving from home ownership to property investor proves onerous, you still have the same option that James and Susan had. It took them ten years to make their first investment. So, instead of becoming a multi-millionaire in fifteen years, it may take twenty five years.

Youth should be on your side. James and Susan took ten years to use the accumulated equity in their home to set them on the path to riches. They could have achieved it in maybe five years less. Twenty years will pass quickly if you do not think about it too much. Just focus on the goal, security and an improved lifestyle.

This raises a common question which is "How do we know when to invest? Do we pay off the home loan entirely, wait until it is significantly reduced, or is there a magic formula?" Whilst there is not a hard and fast rule, you might consider this.

There is no doubt home loans should be reduced as quickly as reasonably possible. The payments are not tax deductible and therefore the cost is high, but only to a point.

If you adopt the view that the interest on your home loan represents the cost to you of providing a roof over your head, then there is a way to work out at what point you might invest in additional property.

If the interest is equal to, or less than, the rental value of your home, then you have reduced your home loan to less than its "roof cost" value and you could consider investment.

If the interest is above the amount you would have to pay to rent your home, then continuing to use disposable income to reduce your loan until it does reach that point is probably the best course of action.

It is not hard to establish the rental value of your home. You could have a local real estate agent assess it for you. It is a normal part of the service they offer.

The interest on your loan should include just that, interest only, not the total payments you make which would normally include a repayment of principal component.

When James and Susan first set out on the property investment path they applied this test as follows:

Home Current Market Value $220,000

Home Loan Balance $ 50,000

Interest at say 10% $ 5,000

Rental Value at $250 per week $13,000

Their interest component was well under the rental value of their house and indicated they could probably have invested for the first time much sooner than they did.

By waiting, the built-up equity in their home remains passive for longer when it could be leveraging them into ownership of additional property on which they will receive capital growth. The benefit of more growth would far outweigh the non-deductability of interest on their already less than "roof cost" home loan.

There are other procedures and principles you will read in this book, that may speed the property accumulation process. Buying at the right time, in the right place, with the right funding, and the right tax breaks, could reduce the time factor substantially. Even from a standing start, wealth and security are still attainable within a relatively short time span. In the words of that well known Aussie song, written by Charlie Drake and Max Diamond and performed by Charlie Drake, "If you want your boomerang to come back, first you’ve got to throw it".

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