The Best Question I Can Remember Being Asked by an Investor by Graeme Fowler
Updated: Oct 7, 2019
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.
Question...... Because it seems like such a fine balancing act between expanding the portfolio versus paying down debt, I am keen to understand your view on the following: If you were to start all over again, would you allocate any extra funds left over at Year End (say, over five years) towards deposits for the next property purchases, or would you use it to pay down principal? And if used for paying down debt, would there be a certain LVR% that you might target before you start expanding again? I think your cash-flow strategy aligns closely with my values and goals, so I'm interested to see how quickly a sensible portfolio could grow.
Out of all the questions anyone has ever asked me in the last few years, I think that one has got to be the best one, so it deserves an equally good answer! That level of thinking, your mindset and questioning will take you a long way, so good on you.
When starting out, you want to first of all buy well. Take the time to know the market really well before making any offers.
If you can buy your first investment property at a good discount (not that easy to do in most locations right now, but definitely still possible), it will set you up well. If it was me, I would still finance it at 80% and work on ways to pay the debt down at no longer than on a 20 year P & I loan.
If the price goes up, do not borrow against any increase in value. That way of thinking and mindset will get you into trouble eventually. I only refinanced the 20 properties that I bought in 2014 as an experiment, and it was due to buying well below market value. I wasn’t hoping for increases in market values later on. I also had a good solid foundation of around 40 properties before starting to do this.
So, with your first property, pay it down at a rate where you are not compromising what you would normally do with your fixed expenses, in other words, be sensible. With any extra money you receive, look at paying down the loan further.
Once you have paid the loan down to around 60 – 70% of the price you paid (not market value now) then you could look at borrowing again from that equity, but no more than say 75%.
So for example, let’s say the property you purchased was $200,000 and your original loan was 80% of that ($160,000).
You could pay the loan down to say $130,000. Don’t borrow any more than say an extra $20,000 now against that property (taking the loan now back up to $150,000 - which is 75% of original $200,000). That is, unless the market value has gone up greatly. Then you could borrow back up to the 80% again of the original purchase price. So that would be $30,000 you could then borrow, which you could use towards your next purchase.
N.B. The mistake most people make is by borrowing 80% on any increased value. So if it was now worth say $300,000 (up from the original $200,000 you paid), many investors would increase their borrowings up to $240,000 (80% of $300,000) and also have the next one leveraged at 80%, and continue on like that. So do not do that if you want to invest safely.
I would carry on like that, and always be slightly reducing your LVR each year.
But do this with the property values being the same as they were the previous year (12 months ago), not where they are now if they have gone up in value.
For example, let’s say you have four properties with a value of $1 million and a debt of $700,000 (70% LVR).
In 12 months time, if the properties combined are now worth say $1.4 million and the debt is down to $650,000 you’ve been doing well to reduce the debt. Your actual LVR would now be around 46%.
However, if you borrow back up to 70% of the new value of $1.4 million, you would now have $980,000 borrowed. Then if the market prices dropped down to where they were in the previous year, you are now leveraged at an extremely high and very risky 98%!! ($980,000 debt with only $1 million of property).
So keep on paying down the debt as fast as you can, and make your position, or your foundation, stronger each year by reducing your LVR.
Then when you do have occasional years that the market prices may go down, you aren’t as exposed as many of the investors out there generally are.
Once you get more experienced, you may also want to do trades, renos etc for extra money.
N.B. When to trade/reno properties and when not to.
I've bought properties to trade in a rising market and then been stuck with them when the market has changed over a very short time-frame. Suddenly, there were hardly any buyers around and I couldn't sell the properties, so I ended up keeping them. Some were only recently changed into my original holding trust and the GST was paid back, this is now 10 years later.
If the market is not declining like that (which can happen anytime without warning), it’s better if you can buy properties that you can also rent at a reasonable yield, if the market does change. But it's a catch 22 situation as ‘why would you not hold them to start with?’ Sometimes you want the equity and sometimes you want to make some quick cash, and at times a property could be suitable for either a trade or a buy and hold. If you don’t want to buy any more rentals at any point in time, then it's good to do trades for extra income, if you can.
But the other big thing is properties that don't fit within your investing rules for your buy and holds may be fine to trade or reno, and sell on again. These may be in worse locations than you would normally have your buy and holds in, or they could be more expensive properties that don't suit being rentals as the yields are too low, or some other factors they have that don't fit your rules and strategy for long term holds. If you are doing trades or renos with these types of properties that don’t fit into your buy and hold rules, then it's even more important to have other cash-flow available, if you do get stuck with them in a market that turns quickly. In that case it may be better to just sell at a lower price, and maybe even take a loss if you need to, in order to sell. Trades and renos can be very profitable as long as you know the market well, know your total costs, and know your end buyer requirements. Also making sure you don't go too much over your original budget, unless you are confident of getting that money back when you sell. After taxes (GST and income tax) are taken out, you lose about 40% of your profit, so it makes sense to focus more on your buy and holds when building your portfolio. But you may want to use trading/renovating properties and then selling them on, as an option to help create your new deposits for rentals, or in certain markets and certain situations.
This is what I did mostly in the early stages of building my property portfolio. The money generated from doing trades/renos was used for deposits to purchase more buy and hold properties. With all of those rentals that were purchased, I put in a 20% deposit. I didn’t use any equity from any of the other properties that were being paid down, even though some of those original properties had doubled in value over two to three years. The only time I ever did refinance a few properties was to borrow $200,000 to set up a business (franchise) back in 2002. Hope that helps, thanks again for the excellent question.