Balancing a Property Portfolio
The key to balancing a portfolio is to create a portfolio that pays you, and you never pay for it. By adding properties that increase your before-tax income as well as your equity position, there is no risk of overextension.
An unbalanced portfolio is one where you don’t have direct control over your capital or your cash flow or worse still, both. You lose control of your capital when you are 100% reliant on the market movements to give you all of your capital growth. You lose control of your cash flow when your portfolio requires input from your salary to maintain itself. I want to stress here that this includes any reliance on your tax deductions, because if you lose your job these quickly disappear, and you clearly have no control over that.
The most dangerous thing about an overextended portfolio is that most people only discover that they have made this mistake when something goes wrong. If you build a portfolio that requires everything to go perfectly every single time, obviously at first everything looks great. It is only when your circumstances change that this error is exposed, and you instantly understand the danger you are in. That’s why it is critical to only invest in properties with a safety margin built in.
We work on three key safety margins with our clients: deposit preservation, cash flow security and safety buffers.
Deposit Preservation
The approach most investors use is what we call the “buy, hope and pray” approach. Buying at full retail prices leaves your deposit tied up in a property, waiting for the market to move. In the current market conditions, people are discovering the limitations of this and how they can in fact lose money this way. That is why we make sure our clients generate their own equity in a deal. We want to create equity instantly in a deal so that upon completion, we can immediately recycle our deposit back out of the deal no matter what the market is doing. This way we never run out of deposit funds because it is never left tied up in an investment and we lose control of our money.
Cash flow security
Never create a property portfolio that requires you to have a job to sustain it. If you are tipping in money each week or you are dependent on tax deductions for cash flow, your portfolio is exposed. The day your employment changes, your portfolio cannot sustain itself and it is overextended. Worse still, in a flat market, you are locked into working at your job for many more years, because you are unable to sell down your portfolio and realise profits to eliminate some of your debt.
We only invest in properties that are cash flow positive before tax. This means that every time you add a property to your portfolio your cash flow security increases, it doesn’t decrease. Tax deductions are great and you should most certainly consider them, but they are not enough to sustain a portfolio. My personal portfolio is positive cash flow by $87,000 a year, but I also get over $142,000 in tax deductions so I get the best of both worlds. If I were to stop earning, my portfolio is clearly safe and I am not overextended. However while I am earning, my portfolio gives me amazing tax savings.
Some people believe that you need to choose between equity creation, growth opportunity and cash flow, and it’s simply not the case. We invest in properties that have all three, all the time. We highly recommend having the right Safety Buffers in place. We constantly tell our clients to plan for the worst but hope for the best, this way they are prepared. Overextending ourselves happens when we can’t handle a single thing going wrong. We encourage our clients to keep safety buffers for these events in their offset accounts. What usually surprises most people is that the amount they need is significantly less than what they are imagining.
Vacancy Buffers
How long do you really think it would take to get a new tenant? If you think conservatively 4 weeks (representing a 7.7% vacancy rate, well above the average), then you keep 4 weeks’ worth of interest repayments in your offset account. On a $500,000 mortgage that’s only around $435/week, so a tiny buffer of just $1,740 easily has you covered. Very inexpensive peace of mind.
Do you fear an interest rate increase? If so, by how much? If your portfolio is struggling to be cash flow positive then a 0.5% rise can send you into negative territory. If that happens, how much additional money would you need to make up the difference? Let’s say this puts you negative to the tune of $100/week, then for peace of mind, you keep $5,200 in your offset account to cover it.
Unemployment buffer
People always ask, “what if I lose my job?” and believe they need to save up their entire salary as a buffer but this isn’t the case. Others mistakenly believe they need to save up all the interest repayments for the portfolio, but you don’t need anywhere near that much.
The first question is, how long do you believe it would be before you find a new job? 12 months would have to be the nightmare scenario, so let’s factor that in. Right now, how much cash are you tipping into maintaining your portfolio each week? You need to include the tax savings you are getting too if they contribute to your portfolio survival. If you’re really negative on your portfolio and you are putting in $100 a week and you get $200 a week from tax too, that’s $300 a week you need to cover. For a full year of unemployment, all you need to keep your portfolio protected is $15,600 in your offset account. If you think 6 months is much more probable, then you just need $7,800 to cover your employment exposure.
So, you can see that even if the perfect storm were to hit and you had all three happen at once, for around $20,000 you can have it all covered off and know that your portfolio is secure.
Balancing a portfolio by investing in properties with safety margins built in, is the most reliable way to create wealth with property. This will also mean you avoid getting stuck in underperforming assets and slow your wealth creation by years. Overextending your finances by building a portfolio that’s dependent on your income is a ticking time bomb. While buffers will help, the safest and most reliable path to wealth, is building a portfolio that pays you and you don’t pay for it.