Our Adventures with Leveraged Property

Leveraged Property

Recently, I’ve been sharing my story with more people.

And it seems as soon as I mention property, there’s sometimes an assumption that we got rich off the east coast property boom.

Admittedly, I’ve been lucky in many other ways, which I wrote about recently.

And while I would love to say we made a lazy few million from holding real estate in Sydney and Melbourne which enabled our early retirement, that’s just not the case.

Now, we did make money from property as it was our investment of choice in the beginning.  But the properties themselves didn’t actually boost our wealth as much as you might expect.

Yes, I know that sounds strange.  There’s a few reasons for this.  Let me explain…

 

Location

Since we’re Perth based, we bought our first few properties in our home city, as most people do.

Having held these properties for 6-8 years now, the results have been poor.  The Perth economy has struggled since the mining downturn from 2011-12, and the property market has followed suit.

On average, these properties have increased by about 5%, in total, over that time.  Not each year.  In total!

While this is disappointing, it’s not uncommon for a city to experience zero price growth for many years at a time.

Of course, there’s no guarantee, but I do expect the next 8 years to be better than the last.  And most economic data is suggesting that the Perth economy is now steadily improving.

“Ok, I hear you, Perth didn’t do so well.  But what about your other properties?”

So, luckily we decided to buy the next few properties in the eastern states.  Two in Melbourne, one in Sydney and one in Brisbane.

We’ve made some better returns on these properties, but again, not as much as you might expect.

Because of the shorter time-frame involved with these properties (under 5 years) the gains have been partly diluted by…

 

Transaction Costs

Because we bought these properties from interstate, we used buyers agents.  And while they did a good job, they weren’t free!

So, the transaction costs on a typical $600k investment property in Melbourne, for example, look something like this…

Stamp Duty – $32,500  (roughly 5% of the property value)
Buyers Agent – $15,000  (roughly 2.5% of the property value)
Settlement Costs – $2,500  (basically admin and bank fees)
Total = $50,000

This is a cost we need to recoup before we start making any money.

 

Negative Cashflow

Also, remember rental yields aren’t exactly generous in the capital cities of Australia.

Yields for units tend to be around 4%, and houses even lower.  After expenses and maintenance, which usually hoovers up at least a third of the rent, we end up with around 2-2.5% net yield.

I underestimated the costs myself in the early days.  Surely, I thought, it can’t be that much?

Well it can.  Sometimes we have a good run.  But eventually, the costs somehow have a way of reaching 35-40% of the rent.

Even the staunchest of property investors can’t argue much with this point.  The truth is, capital city residential property is a very expensive asset class to own, shown by transaction costs, low yields and large ongoing expenses.

With mortgage rates around 4.5%, it means we’re out of pocket about 2-2.5% per year, unless we put in a large deposit.  Or, probably around 1.5% after tax benefits.

On a $600k property, this is around $9k per year.

As long as the property grows more than that on average per year (which is very likely), happy days.  A well located property is likely to increase at least in line with household incomes.  If it’s in a supply-constrained area with continual high demand from wealthy residents, it’s likely to do better.

These figures are fairly typical across our portfolio and from what I’ve seen, many other investors too.

 

The Result

So we have a scenario where the investment property is roughly $50k in the red from the start.  And then, almost $10k per year out-of-pocket to hold.

Clearly, it doesn’t take much imagination to see that the first few years of price growth is just to break even.

After this, the gains are adding to your net worth.  And they’re yours to keep.  Well, unless you sell that is.  Then, you’ll be up for more agents fees and some Capital Gains Tax.

We experienced strong rates of growth on a couple of our properties, which helped to boost returns overall, resulting in moderate growth for the portfolio.

Because of the way our loans were structured, and the price gains, we ended up with two properties with large equity in them.  These are the ones we decided to sell off, so we could use that equity for dividend investing, creating a strong income stream.

Now I’ll agree, this is a somewhat unusual scenario and course of events.  But it’s what played out for us.

Initially, we were only interested in property, because that’s all our comfort level would allow.  The truth is, we just didn’t know a thing about the sharemarket and saw only scary headlines, like most people.

Then, with some experience in both asset classes and seeing the pro’s and con’s of each, we decided we should switch to shares for income and gain our financial independence.

(Side note – ideally, you’d hold any asset for a much longer period to see a better result, which we could have done, but as I explained in this article, our goal was early retirement as soon as possible.  Therefore, we changed course when we realised it would shortcut our journey)

 

The Secret Sauce

So if we didn’t make a ton of money from property investing, where the hell did it come from?  Bitcoin?

How about saving!  Yes.  That boring, old-fashioned technique that never seems to be cool (only among the strange underground FI community).

The last answer people want to hear, when they ask how it’s possible to retire early.

As I’ve written before, our savings rate was comfortably over 60% on average.  Actually, with our tax rate heading to zero because of our negatively geared properties, it was higher.  This meant even if our investments did just ok, the outcome was still a strongly rising net worth.

Remember, the truth is, to reach financial independence in 10 years or less, it’s all about saving.  Compound interest takes a while to kick in, even though it’s powerful.

For folks like us, who want to generate freedom quickly – hardcore saving and investing for income will get the job done with little fuss.

Instead, all our savings went into deposits for properties, along with plenty of debt of course.  The rest of our spare cashflow from our jobs was used to pay the shortfall along the way, while the portfolio steadily grew in value.

 

Notes on Forecasting

Some people may question why we bought in Perth at all.  While it might be obvious to some (in hindsight), that Perth was a poor place to invest, it simply didn’t look that way at the time.

Perth’s economy was quite strong.  Vacancy rates for rentals were low.  Wages were growing at a decent rate.  Population growth was high.  And the property market was improving after a flat few years, catching it’s breath after the massive boom that ended in 2007.  Even many research firms and experts were predicting growth for Perth property.

This is a good point to note.  Asset prices of any kind, are not as easy to predict as some people claim.  Many folks say they ‘knew’ what was going to happen.  But did they?  Anyone can make the right call once or twice.  How many times does anyone call it correctly again and again?

That number is somewhere between none and not many!

However, I’m not saying that forecasts are a waste of time.  Essentially, when we’re investing, we’re making a calculated bet on the future.  So we do need to take some sort of a view.

But it’s important to think of a range of scenarios and then make our own judgement, on what we deem as the most likely outcome.

 

What Can We Learn?

  • We learned that to reach your financial independence goals quickly, don’t rely on your investments.  By that I mean, don’t sit and wait for your investments to do all the hard work.  Pull your finger out and do some serious saving!

 

  • Focusing on saving is a double win.  As you lower your expenses, you boost your savings rate.  But you also lower the amount you need to reach FI instantly!

 

  • If your early retirement time-frame is 10 years or less, I would really question whether it’s best to load up on property.  In our scenario it wasn’t the best idea.  After all costs and making conservative calculations for capital growth, the numbers don’t look all that appealing.  But for us, we simply didn’t know it was possible to retire so quickly, and without being multi-millionaire rich.

 

  • Sometimes, property cycles don’t play out like you expect.  And you could be forking out for years for a small or negative return.

 

  • Simple and boring investing is under-appreciated.  Yes, the returns look small compared to leveraging up.  But leverage doesn’t always work in your favour.  Obviously, if we have a large property boom in another city and you manage to catch the wave nicely, then it can definitely work for you, even with a short time-frame.  However, I would caution against being too optimistic or using historic price growth as a guide.

 

  • When looking at leveraged returns, be sure to calculate returns after costs.  All costs!
    Don’t get caught up in the glitzy magazine articles and the big numbers involved.  I wouldn’t say we fell prey to this ourselves.  Perhaps just under-appreciated some aspects of it, such as all the costs involved and the end game – actually retiring on property.  But talking to others who have just started in, or are looking at using leveraged property, the excitement and lack of in-depth analysis is quite scary.

 

  • Equity needs to be turned to cashflow to retire.  One of the best cashflow generators in Australia is dividend-paying shares, due to strong yields and franking credits.  Put another way, to retire on your residential properties, you’re going to need a far higher net worth than if that equity is invested in diversified Aussie shares like LICs.

 

Bottom Line

It boils down to this…

Some of our properties performed poorly.  Then there is massive transaction costs.  And don’t forget the ongoing negative cashflow.

Add it up and we get a situation where our 9 years of strong saving generated a return that was just ok.

It’s an odd story perhaps.  This isn’t the sort of quick-wealth property story you’ll read on the news websites.  We’ve likely been slow learners and made a few mistakes.  But because of our heavy focus on saving, things worked out great overall, so no complaints!

I’ve come to realise that having a steady stream of cash going out the door for property expenses, is not really an enjoyable way to invest, even if they’re increasing in value.

While dividend investing on the other hand provides constant positive reinforcement, with cash hitting the bank account effortlessly every 6 months or so, and none of the headaches and large expenses associated with property.

Irrational?  Maybe.  But very satisfying!

 

Closing Thoughts

As of a couple of years ago, we’ve decided that an investment strategy based on rising income suits us much better than a strategy based on rising asset prices.

Basically, it’s just a different approach.  And I believe, one that makes your financial independence plans much simpler and predictable.

With our desire to be financially independent as soon as possible, it’s clear why we became so attracted to Aussie shares.  Our early retirement would simply not be possible had we stayed firmly in property.

Interestingly though, it would still have been possible had we bypassed capital city property and started in shares.

Yes, it sounds backwards and not what you’ll read in many other places.  But it was true for us!

Remember, I’m no property bear.  While we are slowly reducing our portfolio over time, we still have much of our net worth in property.

There’s plenty of people who’ll tell you how much money can be made from capital city property.  I’m not here to disagree with them at all.

My aim is to provide some balance to the conversation from someone who doesn’t have a business depending on it, and who’s seen both sides of the coin, while managing to reach early retirement.

 

What are your thoughts on leveraged property?  Is it part of your strategy for financial independence?

18 comments

  1. 2.5% for buyers agent fee seems a bit steep.

    My experience has been in the $8000-$10,000 range and more than worth it if investing interstate and you happen to be time-poor. Plenty of ways to avoid this cost though; if you’re willing to do your own research and then engaging with a local property manager to do the inspections.

    1. Yeah from memory I think it was 2 or 2.5% including GST. I was happy with the service overall though. It’s definitely the easier way to do it for an interstate investor. But for folks who want to dig deep into the research and build connections on the ground, that can work well and save on the fees.

  2. You might need to add an extra $25k to the $50k before breaking even since you will need to pay settlement cost + agent commission for selling + some money to tidy up the house before putting on the market.

    1. That’s true Jack. People will say ‘but I’m not selling’ so I wanted to leave it just as purchasing costs + holding costs, since folks will be more accepting of the example.

  3. We are building our LIC portfolio, pouncing on them as they hit NTA or less. We now hold Argo, AFIC, Milton, BKI and all the WAM’s (WLE, WAM, WAX, WAA, WMI and CYA) . SOL too (not an LIC obviously).

    My problem is impatience waiting for them to dip below NTA ….character building I suppose.

    1. That’s a fairly hefty collection of Wilson funds – my preferred is WAX out of the bunch.

      With the older LICs you mentioned, they tend to move around a bit so to me it doesn’t matter a great deal. I’m certainly not going to hold off waiting until it dips below NTA, I’ll just buy making sure it’s somewhere around NTA. If holding for multiple decades I just don’t think it matters that much.

      But for the likes of the Wilson funds and other LICs that regularly trade at premium, it’s a tricky trade-off. I think a premium can be justified if you expect them to outperform the market handsomely over a long time, they pay above average dividends and you have a very long time horizon – this will dilute the premium a fair bit when measured across a decade or longer. Plenty of folks are happy to buy them right now for those reasons. I purchased at a premium, but lower than current. It’s really for each individual to decide.

  4. Hi Dave

    Great post which made a lot of sense. You neglect to mention that investing in LICs is far less hassle than investing in property. No need for banks, real estate agents, tenants, insurers, lawyers, endless paperwork etc.
    Fully agree with your approach, although would recommend a broader mix of share market holdings besides Aussies LICs alone. Consider ETFs with exposure to major international markets.

    1. Thanks Jon. Good point – the paperwork and emails involved isn’t much fun at all.

      Appreciate that, we do plan on adding international index funds such as VGS later on, once our income stream is where we want it.

  5. Historically, Shares have outperformed properties in general.
    But to be honest, even if properties outperform shares in the future (say by 1 or 2% per annum), I would probably still want to invest in Lics instead of property because of the amount of hassle and headaches you get with owning properties.

    1. It’s basically impossible to calculate because there’s so many scenarios. There’ll never be agreement from either side. Leveraged property v leveraged shares. How much leverage? Or un-leveraged for both. Including franking credits or not. Deducting property expenses or not. Deducting transaction costs or not. Which city? Which shares?

      Both can work, it’s about finding the one that suits you and your situation. For the goal of financial independence as soon as possible, I’m taking the view that dividend investing via LICs/Index Funds is the fastest option when combined with strong saving.

  6. Yups….. you get good properties and bad properties just like you can buy good companies or bad companies…

    and I agree properties can work well for many people, I’m not anti-property as 80% of my wealth is in property…but hopefully over the next 5-10 years, that will become 50% or less as we slowly sell our properties and move the money into Lics..

    I think most people have the right attributes to be successful in property because whenever they make a purchase in property
    1) they intend to hold on for a long time
    2) they ignore the daily price volatility
    3) they usually do some research to find the ideal property, i.e. close to transport/school/jobs etc….
    4) they can have an edge as in they can improve the value of the property by renovation or improvement

    However, when people make purchase in shares, they have no idea and tend to listen to so called “experts” or “analysts” and focus too much on the price volatility without forming their own opinion…. if property investors can apply the same principles listed above when making a purchase in shares, I think they will also be rewarded handsomely.

    1. Good to see you’ve had experience in property too, or people will think we’re a couple of property haters on a pro-shares rant.

      Those points you highlight are important – it’s all about how the investor approaches it. For some reason shares are treated like a casino, like a roulette wheel with ticker symbols – and then the investor inevitably loses his mind through volatility and his money through panic-selling or buying speculative companies!

  7. I’ve never been that interested in property – not necessarily because I didn’t see it as a great asset, just that I felt I had no real ‘advantage’ or interest in that area. We already have so much wealth tied up in our primary residence, and shares are just much more suited to my strengths and interests. I’ve always felt a bit like the odd one out when it comes to investing as everyone else I seem to know solely focuses on property, so I enjoyed hearing more about your story!

    Savings is absolutely the core ingredient though, and its a great example you’ve set for others. Stories of very young people leveraging 6 or 8 properties to build wealth quickly, without a focus on savings, scares me a little – it all seems so easy when asset prices are going in the right direction….

    1. Thanks Frankie!

      You make a good point – many Aussies have nearly every dollar they have tied up in their own home. It’s good you’ve decided to do your own thing instead of follow your peers!

      And yes, the message by some vested interests that ‘saving is a waste of time’ and ‘you need leverage’ is simply not true, it really irritates me. People want to buy a magical asset that propels their net worth to the moon, allowing them to sit back, continue their ridiculous spending and wait to get rich. It’s not the strategy that bothers me, but that attitude/mantra.

      The conversation is usually not very balanced, so I hope to share some different angles and takes on it, that others may not have considered before 🙂

  8. Hi Dave

    Thanks for sharing this blog post, it is great to get some balanced perspective on this topic. Everyone seems to think shares and property is an either/or scenario, which is definitely not the case.

    I lean towards property myself, mainly because of the amount you can SAFELY leverage. Cash on cash returns are a powerful tool. To illustrate by way of example, a property growing at 5% per year (500k property, using a 20% deposit[100k]) will give you a gross return of 25k per year – and depending on the type of property you buy, after tax expenses can be lower than the figure you quoted.

    A property of mine, for example, has cost me 2.5k out of pocket per year. So the net result is a 22.5k increase in wealth per year, or a 22.5% ROI. Considering Buffet himself averaged about 17% ROI over his career, I think this is a pretty good return on investment – and 5% capital growth is a very conservative figure I think.

    The other benefit is there is no chance of a margin call, provided you can continue paying the mortgage. And even if you lose your job, you only really need to come up with 2.5k per year to keep the property (in the above scenario anyway) – the tenant and the tax man can pay the rest.

    The risks of property can be mitigated by buying in a good area with strong historical tenant demand, using a good property manager, having a good cash buffer in place and being aware of interest rate forecasts (i.e. the RBA is not looking at raising rates until 2020 per the implied yield curve).

    I consider this strategy less risky than the prevailing wisdom of buying the most expensive house you can afford with your salary, and then spending the next 30 years paying off the mortgage. If you lose your job or take a pay cut you will need to come up with maybe 30k+ per year, or become a forced seller.

    As for the wealth being tied up in property as non-cash, can you not just take out a line of credit? If the property grows to the point where the loan to valuation ratio (LVR) is say 50% , you can increase the loan up to 80% LVR and take this money as cash to live on.

    As you say though, the transaction costs are huge with property. I think property should be held for at least 30 years to make it worth your while…but if you buy a good quality property, why would you need to sell?

    The other point I would like to mention is that negatively geared properties are not negatively geared for life. The rent is likely to increase in line with wages (say 3% per year) while the interest will stay the same or decrease over time (if you are paying down the mortgage). Thus the property will eventually become positively geared and start bringing in money – admittedly the yield is far lower than dividend-paying shares.

    “Negative gearing”, by the way, is a term that has brought much confusion to the Australian public, and not many people really understand what it means in my humble opinion. I like to think of a property purchase as starting up a new business. You initially have to invest a bit of capital until the “business” gets going and you get into the groove, but eventually it starts providing income.

    But I digress. I would like to reiterate that I have found this to be a really thoughtful, well balanced blog post. Keep up the good work, I have just stumbled upon your site and I am enjoying having a look around!

    Cheers
    Dave

    1. Thanks a lot Dave! Great comment and really appreciated.

      The conversation is potentially endless. I could go on about each type of scenario and degrees of costs and leverage, so it’s hard to know where to stop.

      There’s also a case to be made for using property equity to invest in shares, topic for another day. And using a very low-cost and modest margin loan can improve the return from shares, which I’ll ignore for another day too. There really is too many rabbit-holes we could go down!

      Anyway I’d just say, in your example you don’t include purchase costs which will dilute return on equity. And personally I don’t think 5% p.a. is conservative, I think it’s optimistic, but not unreasonable. I think somewhere in the region or 3-4% is much more realistic , given inflation is very low and incomes are like to grow by 2-3%. So with 130k costs and 4% growth, that takes us down to 15% return on equity, which is still awesome!

      My thinking on this is that prices can’t grow faster than incomes forever…unless debt grows faster than income forever. Both of these don’t seem likely. Also, I don’t think prices can grow faster than rents forever. Yields will end up at zero in that case. They all have to be tied together in some way. And rents have even less capacity to grow faster than incomes forever, because there’s no borrowings to make the affordability stretchy. So with incomes growing at 2-3%, I think well located properties can grow at 3-4% reasonably. Interest rates can’t really go lower to boost borrowing power again, so I can’t see that continuing either. There’s a definite but impossible-to-define speed limit in there.

      But that’s before out of pocket expenses, which drops it down again to around 12-13% (using your figures) – still good. My next issue is, this return on equity figure declines every year as your equity rises in the property. Once your LVR drops, so does your leveraged return – even if it’s costing less or none out of pocket. Because think about it, unleveraged property will provide a pretty low return, so the closer we get to zero leverage, the lower our return gets overall. So while it will start bringing in income, this is when leverage and therefore returns lower.

      So we either need to keep leverage high to keep (maybe) achieving a higher return on equity, or accept returns will inevitably drop and decide what to do from there. If we choose long-term high leverage, we need to keep working to sustain it which I think isn’t very desirable. Our assets are supposed to be working for us, not the other way round.

      Property borrowing via LOC is not depending on your equity these days, it’s 100% about your income and servicing ability. Getting a line of credit to live on is not the same these days, the banking world has changed and the lending criteria is much more strict. I’ve seen several brokers say they know of nobody who has successfully done this. Retirement income is then at the whims of the banks appetite to lend to you. As for losing a job, I think it would be preferable to have income coming in from another source, rather than extra bills to pay on top of our own, in that situation. So while it might not be much extra to cough up, it will definitely add stress compared with an income investor.

      I don’t think property is all that risky, I just don’t think it’s the bees knees either, and the returns sometimes aren’t quite as attractive as they seem. Lately, I’m seeing more property investors start selling up to create an income stream from shares as they see the returns are roughly the same once their leverage is lower and the potential for income far higher.

      I guess I see it differently now – as the ‘business’ gets going and provides some income (when the leverage drops) is when it becomes pretty ordinary from a returns point of view. Then I don’t see the benefit of having to deal with the extra issues and having loans for no extra return. I’d then prefer a hassle free, low cost income stream.

      You raise some great conversation points and I’m glad you did. I may write about this more another time, but as I said, it can really go on forever lol!

      Thanks again for your kind words and thoughtful comment – hope to see you around here in the future 🙂

      1. Yes, you raise some very good points here. I agree that property cannot be expected to grow for the next 20 years as it has for the last 20, so perhaps my capital growth figure may be a bit optimistic.

        As one of the commenters below alluded to, since ’95 Aus. property has benefited from some huge tailwinds:
        – rise in 2 income households, increasing borrowing capacity
        – household debt rising from 50% to 150% of disposable income
        – cash rate dropping from ~17% to 1.5% and
        – deregulation of the lending market, giving more people access to credit.

        I agree that this cannot continue, but I still feel that it is a worthy asset class.

        As you say though, we could debate this forever. As long as you save money and put it towards growth asset classes (shares or property), then you will do well.

        You have definitely given me a lot of food for thought and made me question my assumptions, which is never a bad thing. I will adjust my future portfolio more towards fully-franked shares I think, probably the LICs as you suggest.

        Cheers mate and I will definitely keep an eye out for future posts 🙂

  9. What I’ve noticed with my perth properties is that rent hasn’t increase 2-3% per year, in fact its dropped 2-3% per year for the past 10 years. You’re correct in holding for the long term, but the main theme in this blog is retiring early so unless you are good at market timing and knows when the housing will go up or down, bleeding money for 10+ years doesnt really help in retire early.

    Whats worse, all the rates have gone up, especially land tax (doubled) because of government’s cash grabbing. If you need to live off your rent in retirement then good luck….

    Whats happening in the past 30 years in Australia that affected the housing market
    1. Only one working in the family becomes 2 as mum works as well
    2. Interest rate has dropped to historical lows
    3. People have leveraged to their eyeball
    4. Strong migration coming into the country
    5. 20+ years without a recession

    we all agree rental income sucks, so the only thing we can rely on is Capital gain…all 5 factors above cannot stretch much further maybe except point 4…..so we can’t expect the same level of growth as the past……

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