Property as an Investment: Building on Solid Foundation | PVP S1E02

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The Property Voice Podcast - Series 1: Episode 2

Last time we looked at property strategy as that is the place that many people start when considering investing in property. However, perhaps a better place to start is considering property as an investment and to compare and contrast this with some other the other investment alternatives that we might have. Today’s episode does just that by looking at many of the common investment principles, such as risk and reward, diversification & taxation. We also consider what makes property investing special by considering leverage, cash-on-cash-return, compound growth and inflation. Before weaving all of these together into a Wealth Creation strategy.

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Resources mentioned

• Property Investor Toolkit – here is the book link on amazon.co.uk & amazon.com in case you would like to get yourself a copy to accompany this series
• Average FTSE 100 dividend income source: Motley Fool & average rental income Kate Faulkner
• The FTSE 100 has averaged 5.3% annual growth over the last 20 years according to Moneystepper & house prices have averaged 7.1% per House Price Predictions website
• ‘The Number’ – this is how to calculate a safe withdrawal income based on an asset base
• Book reference – The Millionaire Next Door – Thomas J Stanley.
• Business Insider article referencing the value of mentors

Today’s must Dos

1. Consider how the general and specific investment principles could help you in your property journey
2. Subscribe to the show in iTunes…and while you are at it please help us to spread the word by telling all your friends too!
3. Send in your property stories, questions or moans to podcast@thepropertyvoice.net and we will try and feature YOU on the show too!
4. Rate and review the show on iTunes…this helps us to get noticed and that means more people can get to hear our property content and join in
5. If you would like to, grab yourself a copy of the book: Property Investor Toolkit (link in Resources above)

Get talking!

• Join in the discussion, either here in the comments section below, or anywhere else on the Blog
• Start a conversation on Twitter with us @PropertyVoiceUK or on our Facebook page

Transcription of the show

Casa: Welcome to The Property Voice Podcast. My name is Casa and I thought I would kick off the show for you this week. I hope you are enjoying the show so far? I have had a little bit of fan mail already, so thank you so much for that. I am of course joined by, The Property Voice himself; Richard Brown. How are you doing Richard, did you get any fan mail yet? Shall we get started?

Richard: Well help there Casa and hello there listeners. I am very glad to be hear and yes I am very well thank you very much for asking Casa. Fan mail – does a Whatsapp message from my daughter count as fan mail? I suspect you are probably going to say not, so no need to answer that.

OK, so what have we got coming up in today’s show? We have the usual great segments, so another great topic under Property Chatter. Then we’ve got Your Voice and this week we have an interesting listener question. Finally, under Shout Out, we have a new application for an established technology, so stick around for that.

Property Chatter

“He who has a why to live can bear almost any how.” Nietzsche

Last time we looked at the RIGHT property strategy. This makes a lot of sense as that’s where most people look to start too.

Today, however we are going to look at property as an investment, which is actually where I started. I might even go on to say, aside from your personal goals, lifestyle and preferences that this is the best place to begin.

If you are following along in my book, Property Investor Toolkit we are actually looking at the themes addressed in Section 7…just to keep you on your toes of course!

Types of investment we could look at as an average person, so ignoring sophisticated investments for now:

·         Bank, building society or similar type of savings plan

·         Stocks & shares – directly or via an ISA say

·         Pensions – company, SIPP and personal stakeholder types

·         Property – residential, commercial, directly or via funds

·         Others – incl P2P (Peer 2 Peer) lending, Government or corporate backed securities like bonds and gilts or if you are feeling very brave commodities and precious metals and such like.

Financial advice disclaimer

No financial advice is given in the podcast – always seek your own independent financial advice when taking investment decisions

Risk & Reward

Whenever we think of investing, regardless of what type, the main principles that come to mind are: risk & reward.

Usually, the rule goes that the higher the potential rewards, the higher the potential risks. This is largely true but notice how I used the word ‘potential’ here. By using the word potential I am really referring to a concept called risk mitigation or ways to help make risks managed and controlled in more plain speak.

I would say that in any investment situation that we should try and identify as many of the risks as we can, take steps to manage, reduce or control them and then take decisions based on the balance between our personal goals, required returns and what is known as risk appetite.

So, one of the first things to understand is your personal attitude to risk and to have an idea of what your risk appetite is. The next thing to do is to look at ways in which you can mitigate that risk.

Mitigate risk by diversification

One example of a risk mitigation approach is diversification of course. Diversification as is suggested put simply means spreading your money around into different places. There are lots of views on this subject also, such as how far to diversify in terms of individual investments and also across different investment types, or asset classes and geographies.

Investment Returns

The upside in the investment equation.

Returns are usually either capital returns or income returns.

In simple terms, money made from buying and selling an asset would be classed as a capital return. Whereas, money earned through our labour or receipts resulting from an asset would be classed as an income return.

Our investment goals ought to consider how important each of these types of return is to us.

Taxation

One final point to consider at the top level is taxation. Be warned however not to let the taxation tail wag the investment dog if that makes any sense as an analogy?

Having just read The Millionaire Next Door and noted that in the extensive research referenced in the book was a consistent them that US millionaires had low tax rates and so paid less tax as a proportion of their wealth than non-millionaires.

This does not say they are all tax-evaders and crooks, it merely says that they took steps to maximise their tax position so that they retained more of their wealth by paying less tax.

By considering the tax implications of our investments and at least giving tax some thought and / or planning.

We shall see that there are lots of interdependencies with investing and so at this point it might be worth recalling the words of the owner of a plumbing and heating business I was once advising.

I mentioned that in an acquisition that we should look at the most tax-efficient way of structuring the deal.

His response was stark and simple: ‘if I am paying tax I am making a profit and that’s good enough for me’. You have to admire the simple logic and it is fair to say that we can at times attempt to overcomplicate things, especially with investing and tax can get very complex too.

So I guess, having an eye on it, making sensible provisions and talking to professional advisers at the right time is the conclusion here.

So, that’s something of a preamble that addresses investing in general, regardless of the type of investment or asset class.

Property Investing

So, given this is a podcast about property investing, what characteristics are there about property investing that make it appealing?

Let me start with the headlines:

·         Leverage and how to look at cash-on-cash returns

·         Compound growth and how inflation impacts our investment

I think it is appropriate to share with you the story of what I called my Eureka moment now.

My Eureka Moment

Around ten years ago, I was sat in a quiet country pub one summer’s evening after a hard week at work. I was occupying my mind by scribbling on a napkin or piece of paper and started looking at property.

I started looking at property prices and rental income and projecting these forward by using inflation or other growth rates, such as house price increases (a variation of inflation if you like). I think I got as far as around 14 properties over about 15-20 years and my mind was blown away completely by the result. The net equity and net rental income written on the scrappy pieces of paper was very impressive and at that moment I knew what I wanted to do as far as investing was concerned. This was my Eureka moment and my world changed right after that summer’s evening pint I can tell you!

Investment Principles in terms of Wealth Creation

Before going too far here though, let’s make sure we are thinking of the same thing when we are discussing investment principles and returns.

I will cover lots of specific investment measures in another episode. Suffice to say that today what I would like to focus on is the notion of long-term wealth creation.

How am I defining wealth creation here:

An accumulation of assets generating a passive income sufficient to fund our lifestyle expenses forever.

Leverage & cash-on-cash return

 Leverage - the concept of using somebody else’s money to grow the size of our investment fund.

Examples of leverage in some of the investment alternatives are:

·         Company contributions into a pension scheme

·         Government contributions into a pension or savings scheme

·         Funds from a lender to provide a buy-to-let mortgage

Another word for leverage is ‘multiply’. So, it follows that if we take an initial investment amount and add to it some leverage (company contribution, tax credit or bank loan in our examples above), that our returns will be multiplied by adding the two sums together.

This means our total returns are achieved based on the total amount invested – our own funds and the leveraged funds we have enjoyed.

This is brilliant if you think about it. Someone else gives us money and we get paid a return not only on the amount we provide but also the amount given to us.

A word of caution is required here of course. Rarely does someone give us something and not want something back. A bank wants their loan back and interest in between. The Government wants us to pay tax on our income and capital gains and a company wants us to deliver productivity and profit for them. I will try and keep the discussion as simple as this for now.

How do we calculate leverage?

Well in reality, the value of leverage is only realised substantially through three of the investments types I mentioned above: ISAs, pensions and property investing. The reason for this is that the leverage here is adding to the capital element of the investment in the most part.

Before going on, I would say that having ISAs, pensions and property investing in the overall investment portfolio to me makes a lot of sense just because of the principle of leverage alone and so personally I have all of these in my investment portfolio.

ISAs

With ISAs, the money gained from selling shares at a profit and that from dividends is retained in the investment fund with no tax deducted. Note with an ISA that the leverage is limited to the tax on the gains and not on the entire investment fund itself.

For this reason I am not going to illustrate the extent of leverage involved as it is often much lower in comparison to pensions and property, even if it is higher than other investments outside of ISAs

Pensions

With a pension the leverage will be the amount a company pays in on our behalf, if we are fortunate enough to be in a company pension scheme plus the tax-credit we receive from HMRC based on our personal contribution. Usually, a company will match our personal contribution and so if we paid in say £2000 each year, then so too would the company. Then, the tax man gives us a nice boost by putting the tax we would otherwise have paid them on that same contribution into the fund as well. In this example, that would turn our £2000 personal contribution into £4400 or £4800, again depending on whether we are basic or higher rate tax payers. The leverage here is 2.2 or 2.4 depending on your tax rate. Or put another way, due to the contributions of other, our investment fund has grown by at least 2.2 times and we will achieve returns based on this total fund and not just our own contribution. Cool eh?

Property

With property the leverage will be the amount of money we receive from a lender for a mortgage on the property. Whilst the range of products and terms does vary, very typically a property investor should be able to get what is called a 75% loan-to-vale mortgage. If we had an investment fund of say £20,000, then we could leverage this up to £80,000 by using the banks lending. The leverage here is 4. Or put another way, our own investment fund has grown by at least 4 times and we achieve returns (in the form of rent) based on the total investment fund and not just our own contribution. Even cooler!

One word of caution here of course is that in this example there is a little more to it…we need to pay the lender interest on their money and so this does actually reduce our total returns. The golden rule here is to make sure that the total returns as a percentage are higher than the lender interest rate. There is a bit more to it than that but that has to happen to make sure the leverage is worthwhile.

Leverage in conclusion

Another phrase to describe leverage is ‘using other people’s money to help us grow our investment return’. If we remember this concept we will start to think how best to apply it with our investing.

Cash-on-cash return (COCR)

This is the amount of money we make on the actual cash amount of our own personal funds invested

The distinction here is to measure the returns on our own personal money, even though in reality we generate some of those returns from other people’s money too. Another brilliant concept!

Taking our examples of pensions and property above we can see a little more how this idea works.

If with our pension we were to achieve an investment return of say 3.5% based on average FTSE 100 dividend income source: Motley Fool then our pension contributions would generate around £154 per year. But if you remember, our own personal contribution was £2000 and so our cash-on-cash return would in fact be 7.7%...that is how leverage increases our cash-on-cash returns.

If with our property investment we achieve a 5.3% return based on the UK average rental income collated by Kate Faulkner then our property investment would generate £4,240 per year. Again, our actual cash invested was £20,000 and so our cash-on-cash return would in fact be 9.2% after allowing for mortgage interest at 4%.

In both investments there are additional costs to take into consideration so this analysis is simplified to illustrate the point.

I have also not yet mentioned capital growth but the principle is the same.

The FTSE 100 has averaged 5.3% annual growth over the last 20 years according to Moneystepper

House prices have averaged 7.1% per House Price Predictions website but even if we were to assume the same rate of growth of say 5.3% the cash on cash returns would be as follows based on our own cash invested funds:

Pension 11.7%

Property 21.2%

The property example is before making allowance for the mortgage it has to be said.

Compound growth & inflation

Compound Growth

‘Compound growth is the eighth wonder of the world’ according to Albert Einstein, who goes on to say, ‘those that understand it earn it, whilst those that do not pay it’.

Compound growth - compound growth is: interest added to interest.

If we had an interest rate of 3% per year and started with £10,000 we would earn £300 in the first year.

However, rather than that same £300 in the second year (called ‘simple interest’), we would in fact earn £309 instead.

That extra £9 is the compound interest we get, or the interest on the interest.

£9 might not sound like too much but if we projected that same rate of growth forward by the typical mortgage term of 25 years, then our £10,000 starting fund will have grown to £20,938… a 209% return on our cash compared with £17,500 or 175% if all we got was simple interest of £300 each year with no compounding.

That extra 34% is the total value gained purely by compound interest. That is impressive.

Inflation

Inflation – is a reflection of the purchasing power of money over time (i.e. in ‘real terms’) and is actually another form of compounding.

Inflation either increases or decreases the value of our money depending on whether it is an appreciating asset or not. When faced with a choice of investment options, one golden rule for capital growth that I look for is:

If capital growth rate exceeds inflation, then my assets are growing in ‘real terms’ & if below, then my assets are shrinking in ‘real terms’.

Another factor that inflation can influence is by reducing the real terms value of our debt in a similar way. To explain, in our example, we had a mortgage of £75,000, so applying a 3% inflation rate would effectively erode its real terms value to £35,820 in today’s equivalent money. In other words, it more than halves the real terms value of our debt over time.

Basically, inflation should increase the value of our investments and reduce the value of our liabilities after taking inflation into account. The extent depends on our investment returns when compared to inflation. In general the combined returns from investments we are looking at here have far exceeded the rate of inflation over time.

Wealth Creation – Putting it all together

As I stated, wealth creation to me is to build an asset-based portfolio that generates a passive income to fund our lifestyle expenses forever.

Step one – determine The Number

First, we need to establish how large our asset value needs to be – I call this ‘The Number’. In the simplest of terms, The Number calculated as follows:

Total annual lifestyle expenses x 25

For example, if we have annual expenses of £20,000 then we would need a total net asset value of £500,000 to fund our lifestyle for the rest of our lives. I have written more on ‘The Number’ in the blog but for now, we at least have a target to aim at.

Step two – determine when we need this

This could be our normal retirement date, or an earlier or later date depending on our plans. This might identify a gap…

Step three – set some asset acquisition targets & a plan of how to get there

With standard buy-to-let property we would usually always need to raise a deposit of c25% of the property value plus fees and other purchase related costs, so nearer 30% in reality. This will require a committed savings plan and I would definitely encourage that to happen.

However, as I outlined in Section 1 – Strategy, there are many ways to generate money through property. For example, with lease options or rent-to-rent we could reduce the starting investment significantly, or by deal sourcing, project managing or managing lets for others we can convert our time & skills into money. Similarly, if we recycle our funds by adding value, invest in higher cashflow HMO properties, or undertake development projects, then we can generate funds to set aside to invest in longer-term investment assets. And finally…

“He who has a why to live can bear almost any how.” Nietzsche

Therefore, it matters less about ‘how’; it matters more about ‘why’…

It is important to have a clear picture of why we want to invest at all. Is it to have a pension, retire early, pay off debt, leave an inheritance, travel the world, give to family, support good causes, or just have a great time? That decision is yours but thinking it through and have a clear mental image of it will help immensely.

Once we know the ‘why’ (purpose) and have the ‘what’ (The Number), we can then set about working out the ‘How’ (strategy).

Things are likely to change as we go but we will never get to where we want unless we start, even if we end up take a different route!

By understanding applying the principles of leverage, cash-on-cash returns, compound growth and inflation we will be better equipped to look at how they affect our long-term wealth creation and take action accordingly.

Have you had your Eureka moment yet? I would love to hear it…

Your Voice

Casa: Richard, we have a very interesting listener question for you this time. I won’t mention his name but the question is this: Did you have a mentor when you started investing in property yourself Richard?

Richard: Yes, thank you Casa…yes I think that is a really interesting question. My answer to that is that really I depends on how you define a mentor really. Most people will start thinking of a mentor as an actual person. That could be an experienced investor, who is there to help you, lead the way for you, guide you, give you confidence, challenge and support you. People often start with that kind of mentor.

But early on, we could gain some insights through other types of learning. It could be through books, forums and blogs and that type of thing. It could also be attending online and offline property networking meetings and asking other investors their opinions. It could also be through property forums and that type of thing either through asking questions or by observing what the experienced investors have to say.

I have to say that over the years, I have had business, personal and property mentors and I continue to build those mentoring relationships today. Ironically though, when I started investing in property, I adopted something of a virtual mentoring approach. By this what I mean is that I went on a lot of forums and read a lot of books and that kind of thing. It was a little while later before I got my own property mentor even though I had business and personal mentors before that.

I would say this about mentoring based on Business Insider article:

Mentors are not for everyone, with 24% of ‘the rich’ using mentors. However, of those that did use a mentor, a staggering 93% attributed their success to their mentor! The take away from this is that, whilst mentors are not for everyone; if it is for you, then the results and difference in your life can be absolutely staggering! I myself have got mentors and am happy with the progress that I am making.

Shout Out

In the shout out segment we are trying to share tools, tips and resources that perhaps you might not be that familiar with to aid you in your property journey. Today’s shout out might just surprise in that case; so would you like to share it with us then Casa?

Casa: Yes Richard, I was a little surprised to hear about this myself. In technology terms YouTube is like a grandfather to me as you know. However, I recently discovered that you can actually listen to books on YouTube now. I know that you have experienced this recently yourself Richard, so perhaps you could elaborate a little more…

Yes Casa YouTube has a range of books and other audio content that we can listen to freely to further develop our knowledge. I recently listened to Think and Grow Rich from Napoleon Hill again. An abridged version admittedly but it was great to have on in the background whilst I was doing some admin tasks. So, YouTube is today’s Shout Out.

OK, so that about wraps it up for another week, I hope that you enjoyed the show. Don’t forget to check out the show notes and get involved in the discussion over at www.thepropertyvoice.net. Don’t forget those Your Voice contributions either.

Until next time on The Property Voice Podcast…ciao-ciao