Disclaimer: Nothing is this article is meant to constitute financial advice of any kind, and is the opinion of the author only. Seek professional advice before making any financial decision.
Building a Solid Foundation in Real Estate (Part 2, 2015).
The first article I did on building a foundation was an outline of why it’s so important if you are serious about your investing, and want it to be one of if not your main source of wealth and income long term. If property investing is more of a hobby than a passion, then it is not so important.
So if you are wanting to be more actively involved and reliant on property investing for an income in the future, here are some things that will make your overall foundation stronger and also some things that will make your foundation weaker.
All these will make it stronger.
1) Buying any property below market value
2) Paying a deposit of 20% - 30% when purchasing
3) Not refinancing existing properties at any time
4) Increase in market prices of your properties (outside your control)
5) Having good tenants and or property managers
6) Keeping up with any maintenance that needs doing
7) Using P & I loans to gradually pay down your mortgages
8) If loans are fixed at a higher interest rate than current rates, pay down up to 5% p.a. on outstanding balance on as many loans as you can
9) Increase your equity in your portfolio every year
10) Buying more properties and repeating the above
All these will make it weaker.
1) Paying market price or above (not knowing the market well enough)
2) Putting in low or no deposits when buying properties
3) Using high registered valuations and then refinancing, or refinancing if prices go up. In other words – revaluing your portfolio and borrowing on increased equity
4) Property prices falling
5) Using interest only loans
6) Not doing maintenance on properties when required and so getting lower rents
7) Not reducing your debt/equity ratio every year
8) Selling properties because you think they are not performing (going up in value)
9) Increasing debt with every purchase i.e. debt to equity ratio may stay the same but when buying new properties, overall debt always increases
10) Buying more properties and repeating the above.
Many people come to me or e-mail me having already been doing a lot of the things mentioned above which make their foundation weaker, not stronger.
As time goes by, more and more properties are purchased and then refinanced (people will also often do this on their own homes).
Then they are often refinanced again to a high debt level again if prices go up. This is usually using unrealistic registered valuations which aren’t worth the paper they are written on.
Now instead of building a strong and solid foundation, they are in fact building a negative foundation. It would look kind of like an upside down pyramid. A foundation that gets easier and easier to fall over and be destroyed with any unexpected circumstances that can arrive at any time. Things such as a change in tax or government policy, loss of income from a job, a separation, interest rate increases, changes in LVR rules, property prices falling etc.
Lots of investors lost everything who were investing in Auckland around 2007 – 2008 with only a 5% or so decrease in prices. If their foundation was strong to begin with, this would not have happened.
The safest of all ways, and to have the most solid foundation in property investing would be to have no debt at all. To me that is the end goal, i.e. when you feel you have enough income from your properties, and are not buying any more to hold long term.
That way if interest rates went up very high, or market prices say halved in value, then it would have no affect on you.
This is not practical when starting out, so you do want to use leverage, but use it responsibly.
By using it responsibly, this would be as mentioned above using a 20 – 30% deposit on properties purchased and not refinancing them. By doing this, you are using a small portion of your own money and borrowing a larger part from the bank to buy properties. This is called leverage - or doing more with less.
With any form of leverage there are risks associated.
In this case of buying properties with a small deposit, the main risks are:
The banks want their money back at short noticeInterest rates increase to a point where you are having to top up the mortgagesPrices decrease and you lose your equity
The other leverage which you are using with P & I loans is the leverage of other peoples’ time and money. This to me is what a true ‘investment’ is – i.e. something that somebody else pays you to own.
With P & I loans, the rent received goes towards your mortgage and slowly pays the loan off that you have with your bank.
At the start of the loan, you are paying almost all interest and very little principal. As time goes on, you pay more and more principal and less and less interest.
To start with, it seems almost pointless paying off such a little amount of principal, and you may think why even bother?
But by using this method (as opposed to interest only where nobody is paying off the loan) you do start to see results and moreso if you have several properties.
It may be that you only pay off $200 - $300 a month off the principal part of the loan early on, but if you had 10 properties like this, it would be $2,000 - $3,000 a month.
This increases slightly each and every month as I mentioned, until at the end of the loans you will be paying almost no interest, and almost all principal.
For me at the moment, about $6,250 a week or $27,000 a month gets paid off principal. That’s over $300,000 a year and this will keep increasing until all the loans are paid off in full. If market prices of my properties go up, go down or stay the same, it doesn’t matter at all because it’s not only - not important, but irrelevant to my overall picture or plan.
You may have heard of the example of taking 1c at the start of the month and doubling it every day for one month (31 days) and being surprised at how much it grows to.
At day one, it would be 1c, day two it will be 2 cents, day three 4 cents and so on.
After 10 days, it’s still only $5.00 which is about 1/3 of the way through the month.
Day 15 is $164, so still not a lot considering its already half way through the month.
At day 20 it would have grown to just over $5,000 so looking a bit healthier.
Day 25 it’s now $168,000, day 26 is $335,000, day 27 is $671,000 and at day 28 finally a million is reached with $1.34 million.
Then another 3 days later at day 31 being the end of the month it has now grown to an amazing $10,737,000!
That is the power of compounding.
When you use the power of leverage combined with the power of compounding, you can achieve what seemed like the impossible in a relatively short period of time.
Doing this sensibly in a way that you strengthen your foundation with each and every property purchase with leverage, and the power of compounding, you will be well on your way to achieving great financial success.
Graeme Fowler