By Cam McLellan, Director & Co-founder
Building a property portfolio that will provide strong growth and – in the not-too-distant future – the lifestyle you aspire to could be more straightforward than you think.
The key to building a strong portfolio is identifying when your usable equity has increased. Banks will convert this usable equity into cash, which can be used for deposits on further investments. This is called duplication, and understanding it will greatly help your investment strategy.
If you learn to continually buy good investments, duplication can be a fantastic strategy. Duplication without a system, however, only compounds risk.
The core theory of duplication has been around for centuries, although there are people in the investment world who would have you believe they created this basic system. Duplication has been around since the first time someone planted an apple seed!
Unlock usable equity
The key to duplication is to have a system that closely monitors market price movement. When a lift in price is identified, re-value your portfolio, increase your line of credit (or ‘contingent liability’) and unlock usable equity and duplicate.
Usable equity just sitting doing nothing is called ‘lazy equity’, and if you’re growing your property portfolio, having lazy equity is one of the biggest and most common mistakes you can make.
To supercharge your investment strategy, use available equity for the deposits on additional investments. Every day that passes when you have lazy equity sitting idle means you are missing out on opportunities to duplicate and move closer to financial freedom.
The ‘5 in 12’ diagram below shows how to duplicate your portfolio by using the increase in usable equity from one property to purchase another. This means that you don’t have to save for each deposit. Imagine when you have a number of properties and they all go through a growth cycle. The large increase in equity means that your ability to duplicate compounds.
Now, let’s look at a very conservative scenario that shows what is achievable through duplication.
The more property value you hold in your portfolio when a price rise occurs, the more usable equity you create and therefore the more substantial the equity platform you have to duplicate from.
This is called the ‘compounding effect’. You will notice this compounding effect once you have multiple properties that go through a growth period. When this happens, let the good times roll.
The key is to enter the market as soon as possible and then duplicate each time as soon as you have usable equity. Importantly, while you invest your equity into your investments, also ensure you invest your time into education. Investment knowledge will help you to avoid costly mistakes over the long run.
The rich are getting richer
According to the Australian Taxation Office (ATO), just over 19,000 people in Australia own more than six properties.
That means the people who do own more than six properties essentially own a lot more than six properties. This means the rich are still getting richer and everyone else is still doing the same old thing. The good news is that investing is not that hard once you’ve started.
Now let’s look at a safe example of what’s achievable. I want to illustrate that you don’t have to own an entire suburb to achieve financial independence. In reality, a handful of smart investments are all that are required.
Let’s look at a scenario …
I have outlined a scenario of five very conservative properties purchased over a 12-year period, then the growth that occurs until the 20-year mark – even if you were to stop acquiring additional properties at the 12-year mark.
I have used some standard assumptions that are factored evenly each year, and remember that things such as capital growth, rental yield and wage increases never increase evenly each year. Over a longer period – say 10 or 20 years – I’d still expect some variance, but the examples below are reasonable assumptions to use for this exercise.
For this example, I have used a salary of $120k per annum (which equates to the average Australian household income).
- Factored in is a 5% wage increase per year.
- First property purchased at $560,000.
- An increase of 8% in property value per year.
- Rental yield of 5% of the property’s value.
- Interest rate of 5%.
Something to understand when building wealth is that it’s not all about the amount of individual properties that you accumulate; it’s the net wealth that’s built over time that really matters.
I have specifically made this example very conservative – five properties purchased over 12 years – to show that real wealth is achievable at a very safe level.
The ‘5 in 12’ diagram illustrates a number of things.
Firstly, the year in which each of the five properties is purchased, the portfolio’s total value, the net wealth, as well as debt that accumulates and also the weekly holding costs, all increase. For the first five or six years, things build slowly, but as growth occurs while holding a reasonable asset base, your wealth compounds and starts to climb at a much faster rate.
You will also notice that the debt level remains the same after year 12, which is when the final property has been acquired.
I have noted against each year along the bottom of the chart the weekly holding costs after rent and tax. I haven’t sugar-coated these figures. You may note that the weekly holding costs around years 11 to 13 may seem hard to sustain on the basic household wage.
The holding costs at this point are at their peak (approximately $70 a week) per property. That’s around $14k per year net, after tax. Now that’s a very large amount of money if you were to use your earned income to cover the holding costs. Never fear. What you will also notice is that during these years the net wealth is increasing, on ‘average’ at a much faster rate per year than the holding costs.
What I recommend at this point is that you access your growing equity to cover your holding costs; you will do this by refinancing and creating a line of credit. For a period of time you’ll need to utilise these funds until the rent increases to the point that it will cover the holding costs of your portfolio. This is standard practice for anyone building a property investment portfolio.
Also, by having this line of credit available, you are able to cover any loss of income for the weeks between tenants and any repairs that may be needed. This way, along your investment journey, you will still be able to live a reasonable lifestyle while building your wealth.
Remember, this equity is to be used for holding costs or future deposits, not toys!
What is important to focus on is the level of net wealth achieved by year 15.
You may seem amazed by the results, but as Einstein said in reference to the compounding effect:
“Compound interest is the eighth wonder of the world. He, who understands it, earns it … he who doesn’t … pays it.”
The amount of net wealth at year 15 will be in the vicinity of $4.3m and the portfolio’s total value will be around $8.2m. A pretty impressive set of numbers!
If you factor growth of 8% on your $6.2m portfolio value (growth of 8% on $8.2m is approximately $680k per annum) you are now simply able to live off the equity growth on your property portfolio. This is why an equity growth strategy will always smash an initial positive cash flow strategy.
You will never save your way to wealth from a wage or rental income.
As mentioned, it’s important to understand that growth won’t occur evenly each year, but once you do experience a growth period while holding a number of properties, working for a living at this point becomes a choice!
Five properties in 12 years is a very conservative approach to investment. But these five well-chosen properties are all that are required to give you a very comfortable lifestyle.
Another very achievable aim is to build a portfolio of 10 properties in 10 years. I’ve seen many people achieve this, but this does require a larger personal income to assist with the portfolio’s initial holding costs.
The key is to build momentum so that by years eight, nine and 10, you can purchase two properties a year. It may sound hard but when you have, for example, four properties that all increase in value, picking up an extra two or more at a time after that is easy.
You may find that you purchase one property in the first year and then none for a couple of years. You’ll then find that you might purchase two, three or more properties in a single year.
To achieve this you must follow a system that allows you to accurately monitor the market price on a regular basis. Checks every three months are ideal; six months worst case.
Once you achieve a gain in usable equity, the key is to act swiftly and purchase again. Then once you’ve purchased all the properties possible using your usable equity, sit back, enjoy life and wait for a market rise to occur again.
In summary, understanding duplication will allow you to use the short-term financial growth of your property portfolio to realise even greater gains in the longer term.
Summarising the key points:
- Banks will convert usable equity into cash, which can be used for deposits on further investments. This is called duplication.
- Usable equity just sitting doing nothing is called ‘lazy equity’.
- The more property value you hold in your portfolio when a rise occurs, the more usable equity you create and therefore the more substantial the equity platform you have to duplicate further from. This is called the ‘compounding effect’.
- The key is to enter the market as soon as possible and then duplicate each time, as soon as you have enough usable equity.
I hope you enjoyed this article. It has been sourced from book, My Four Year Old the Property Investor. If you’d like your free copy, please click here.