Begin with a Property Investment End in Mind
By Cam McLellan
You should always begin with the end in mind, because once your property investment journey begins, it’s easy to get distracted and stray from your desired path of systematic investment.
Like any major decision, it pays to seek counsel from your accountant and/or property manager about your initial setup and holding structure, as this will have an impact on the timing of your desired exit strategy.
Below are four popular exit strategies for property investors:
1.Sell Properties to Pay Off Your Debt
There are some pros and cons to this exit strategy, many of which revolve around the notion people have about debt and their ultimate financial goal to become debt free by paying off the family home.
From time to time you will hear people toss around the saying ‘work smarter, not harder’. But the majority of people don’t do this. Instead, they work hard to pay off the family home with income they earn from a job. And that is a big waste of time.
Many people have been conditioned to think this way by their parents and society as a whole, but that doesn’t make it a viable strategy.
Here’s an example that shows why paying off the family home over 25 or 30 years with earned income is a bad strategy:
Let’s say you only ever buy three properties in your life, two well-chosen investment properties bought at $500,000 each and the family home also bought for $500,000.
Investment property value – $1,000,000
Family home value – $500,000
Total property value $1,500,000
To keep it simple, let’s say that the total loan amount is also $1,500,000.
Remember tax breaks and rental income will help you fund most of the loan repayments.
As we know, well-chosen property will double in value about every 7 to 10 years. That being the case, you can become debt free simply by holding the investment properties through one full growth cycle and then selling your two investment properties, which have increased in value from $1,000,000 to $2,000,000.
If you were to sell the two investment properties for $2,000,000 you would incur capital gains tax of 25% on the profit from the sales (25% rather than 50% as these properties have been held for longer than 12 months). The remaining amount available to reduce debt after tax will be $1,750,000.
You can now pay back the $1,500,000 debt on the investment properties and your own home, leaving you with $250,000 to play with. I’m sure you’ll think of something to do with the extra money.
This is a simple example of what you can do, though it’s not the strategy I recommend. Remember, if the rent is covering the repayments on your portfolio, then what you have is good debt. It’s worth examining whether your desire to reduce debt is due to society’s deep-seated belief that all debt is bad.
2. Move One of Your Loans to Principal and Interest (P&I)
Move one of your loans to P&I or keep it as interest only but start paying off the principal from your excess cash flow. Then, once you pay off the debt on this property, focus your increased cash flow on your remaining total debt.
Your interest repayments have been reduced because you’ve already paid off one house, which allows you to pay off your next house in an even shorter time-frame. This is called the domino effect.
As each loan or house is paid off, cash flow improves and subsequent loans are paid off at a faster rate until you are debt free. This is a reasonable strategy while you are still working and it will allow you to have a stress-free retirement with a solid income.
Those who want to become debt free more quickly or to fast track their wealth building may need to use the selling exit strategy in conjunction with the domino effect.
3. Make Interest-Only (IO) Payments and Live Off Equity & Rental Yield Gains
The first two strategies have merit but by far my preferred choice is to make interest-only payments and live off the equity gains and increases in rental yield.
This is a relatively simple process. Once a property portfolio increases in value, you can get it revalued and subsequently create a line of credit with the banks. You now have these funds to live off, which is an ideal situation as long as your portfolio grows in value faster than your living expenses.
Most people want to know how they can eventually own their properties outright. However, if your portfolio is supporting your loan repayments and providing you with an adequate income, this question becomes redundant. There is simply no need to pay them off.
With your portfolio at a positive or neutral cash flow position, you can just leave it to increase in value. Meanwhile you live off the equity gains. If the value of your portfolio increases at a faster rate than your yearly expenses, this may be the right strategy for you.
4. Hand Your Property Investments to Your Kids
Our final exit strategy recommendation is to hand over control of your property portfolio to your kids, provided they are smart enough to handle it. This can be done by transferring control of a portfolio that’s held in a trust through the appointment of a new company director.
The benefit to this strategy is that the actual asset never changes hands so no tax is incurred. You are simply signing across control of the asset’s holding entity. But of course, as with any exit strategy, the right ownership structure is very important.
Another positive aspect of this exit strategy is that it can be used in conjunction with the other strategies, mentioned above.
Remember, your portfolio will be equity rich and positive in cash flow by the time you make an exit. An exit strategy is all about minimising tax and maximising returns.
No matter which exit strategy you prefer, it is extremely beneficial to plan ahead, to always begin with the end in mind. With that said, take a look at our article on 11 common property investment mistakes to avoid, or get in touch to plan your strategy today.