Our current situation: what would you do?

Hi PC’ers, I’m interested in your thoughts on our current situation and the next step in our journey.


PPOR: Melbourne metro
Ownership: Title and mortgage in wifes name.
Asset Value: $1.3m approx.
Debt: $780k
Capacity: Annual salary $125k pa gross & 1 dependant
Summary: This is our home for at least the next 10 years, we’ve no plans to move. Borrowing capacity exhausted on current wage.


IP’s 1 & 2: Regional CBD location, purchased block, subdivided and built 2 townhouses.
Ownership: Titles and mortgage in name of P/L as trustee of family trust. Husband is director of P/L and is sole gaurantor.
Asset Value: $1.120m
Debt: $895k, so LVR 80%
Capacity: Annual salary $110k pa gross & 1 dependant
Rental income $1000 per week = $52k pa
Summary: Intended to hold IP1 for long term. Attempted to sell IP 2 but it sat on the market for 6 months and we’ve made the decision to take off market and rent it out for the time being. Concern is if we keep developing in this regional city, liquidating could become a hinderance.



IP 3 & 4: Same Regional CBD location, purchased 110 year old brick home and did cosmetic reno, with rear street access has subdiv potential and currently at town planning for approval to subdiv and build townhouse.
Ownership: Same as IP1&2
Asset Value: $1.040m (forecasted after completion of townhouse)
Debt: $684k, so LVR 65% (forecasted after completion of townhouse)
Capacity: Annual salary $110k pa gross & 1 dependant (this base also IP1 &2 capacity)
Rental income $910 per week = $47k pa
Summary: We’ll likely refinance up to 80% and paydown PPOR debt (if borrowing capacity allows). Makes sense to sell the older home as the depreciation is not great.



So our current situation (upon completion of IP4) we’ll have $580k in IP equity and PPOR debt of $780k. Our goal is to pay down that non deductable debt and aim to own a $2m portfolio outright to provide $100k passive income, and we both stop working for the man. Ideally in 7 years.


The bank is essentially saying to us that on our current salaries/rental we are likely to only ever hold 4 IP’s at these prices, so how do we get to the $100k passive income if the rent returns are fundamentally cash flow neutral? Short of holding for the next 10 years and waiting for CG (currently the regional area is 5%CG over 10 years).


We can sell down 2 IP’s and hold 2 IP’s and free up capacity to keep developing. We’ve averaged circa $200k net profit each development so it’s feasible to keep doing this and seems to be our fastest route to paying down the non deductable debt and building a portfolio.

Are we on the right track?

What would you do to get to $100k passive income from here?

 

Refinancing 3&4 to pay down PPOR will have to be done carefully as interest won't be tax deductible and you must avoid mixing tax deductible borrowings with private (non-deductible) borrowings. Get good advice before you go down this path.
Marg

 

A few things

1. Forget equity in the equation. As you are learning, 580K of equity doesn't equal $1 of borrowing capacity. You may as well have $58K equity as far as borrowing capacity is concerned....

2. Debt reduction, as you have suggested - is the right plan. Starting with the 780K of PPOR debt - how will you pay that down within 7 years as planned? That's a lot of debt to pay down. I understand you "may" be able to access some funds from IP 3 and 4 to assist with this, but as you have stated, that's subject to borrowing capacity and at 80% of 1.04 Million it will only provide 148K at best. That leaves 632K. You would need to make some pretty serious extra repayments over the next 7 years. Now, IP's 1,2,3 and 4 would appear to be a little CF+ based on what you have mentioned, but not enough to make those sorts of extra repayments.... so whats the plan to get rid of that debt?

3. With the 780K of non income producing, non deductible debt gone, your borrowing capacity will be dramatically improved, but how do you then get to 100K income from there? Remember, the PPOR is not an income producer for you. Right now , you have 4 x income producers. IP 1,2,3 and 4 generate a combined 99K of rental income, based on your figures above. But you are carrying 895K against IP 1 and 2, and soon to be 832K against IP 3 and 4. Thats 1.727 Million. At just 4% I/O your costs are just over 69K per annum, plus whatever miscellaneous holding costs you have with the 4 dwellings. Probably 4 -5 K each dwelling I'm guessing. Total expenses therefore run at almost 90K . That only leaves @ 9K pre tax surplus, plus whatever depreciation you are able to squeeze out of the 4 dwellings. Its a long way from 100K passive income. At rates of 4.5% , you're looking at almost 78K in I/O costs, plus miscellaneous expenses approaching 20K ... leaving you with very little surplus cash flow at all , and reliant almost entirely on depreciation to stay CF+ . And if you are forced onto P&I at any stage, or if rates go to 5%, or if both things happen.... you will be running negatively....



So lets say that you are extremely disciplined and frugal and manage to use salary and whatever surpluses from IP 1,2,3 and 4 to get rid of the 780K within 7 years - and without selling any of the income producing properties to do so. Unless 1,2,3 and 4 double in value, and their rents triple in value, you have a conundrum.

If the prices double, you can sell IP 1 and 2 and pay out 3 and 4, or vice versa. Either way, after paying CGT that will leave you with 2 x unencumbered properties, but that also means you'll only have the income from those two properties.

If rents triple from 47K or 52K, to @ 150K per annum, after accounting for expenses and tax on that income, you would reach your goals....

Given the extremely low rental inflation we have been seeing and are likely to continue to see for several years, I imagine a tripling of rents in 7 years isnt realistic.... so you are likely going to need to think a bit differently. You really need to find much stronger cash flow and at lower price points in my view. Either that, or much more income from PAYG or the company, to get where you want to get in 15 years, let alone 7.

Imagine each property was making you 9K surplus. Thats 27K per annum, or 2275 per month... even with this sort of extra cash flow reinvested towards extra repayments of the 780K , it will take 15 years to clear the debt .... and right now you dont have 27K surplus income being generated by your 4 properties.... not even close. See below.

I'd be offloading 2 of these, or all 4 even, and replacing them with 3 x dual occs or NRAS in the 500K (ish ) range. You would have either 3 or 6, higher income producing dwellings but only $1.5 Million debt. It would triple your current surplus cash flow, helping you to pay down the 780K faster, but just as importantly that extra cash flow would buffer you against rates in excess of 6% or P&I , and it would mean you are carrying far less debt, far sooner. The power of compound. Your situation is a perfect illustration of what I post about so often.... you are seeing first hand that even with an above average PAYG income and strong equity, It's almost impossible to retire with a passive income from resi property in the post APRA era without paying down debt. The only exceptions are those on far higher incomes, or lottery winners, or those who receive a large inheritance.

This is why I advocate cash cows...anyone hoping to retire with a passive income only needs to look at the evidence below. It's pretty obvious

 

My initial thought (singular) at this stage is that you are trying to get ahead BUT you live in a $1.3M PPOR with an $800K loan on it that is not tax deductible. If I were in your position I'd be seeking to downsize my PPOR debt and do some more investing. Perhaps slum it up in a $600K PPOR for a few years?

 

Rentvesting?

 

This can be achieved without selling the PPOR. Flat out crazy to do that. They'll pay 3% to sell. 5% stamp duty to purchase elsewhere in Vic, and 5% again when they try to get back to that level of PPOR property in years to come.
Its just too expensive to downgrade now - especially if they dont need to. Far better off selling the IP's and replacing them with cash cows, and paying off the PPOR debt with the surpluses from those cash cows. What I have outlined above would have the PPOR paid off in 15 years - faster if they have the ability to add extra repayments themselves, aside from the surpluses from the NRAS or dual occ INV properties - and allow them to build a portfolio that would provide for a very comfy passive income.

You want to build a passive income from resi property, post APRA? Start treating it like a share portfolio/dividend reinvestment plan. Buy shares ( properties) that produce strong, reliable fully franked dividends ( surplus after tax CF+) and reinvest the dividends ( surplus after tax CF+) into the portfolio.

 

Sounds like you have structured the main residence well. I assume you mean the loan is in your wife's name only?

You should keep paying down that main residence loan as much as you can. But it is going to take you a long time to pay it off.

Even if you could pour your whole income into the loan it would take you more than 7 years to pay that off.

Then you would still be only getting low rents for the 4 existing properties.

Like Euro I would look at selling the 4 properties because

- regional so probably low growth prospects

- Diverting income from the paying down of the PPOR debt

- Tying up cash which could be going off the PPOR debt


Get 1 and 2 on the market to be sold and while this is happening finish 3 and 4 and sell in a different tax year.


If you have made a profit and think you could make more profit it may be worth doing another one – depending on how much profit.

Otherwise investing in high yielding properties would be the way to go as long as these can also give some capital growth as well.

 

Thanks for the advice Marg, I have a good accountant and will chat to him once I've got a few scenarios to throw at him

 

Yep take your point Y-man, lets call it a gain. Still a good result we were able to draw down on. I suspect we didn't sell as the asking price was at the higher end. The figures I posted are based on bank val, so yes at those prices we ought to be able to sell faster.

The IP interest is tax deductable. The PPOR interest is not.

 

Thanks euro73 firstly for your detailed and fast response. Much appreciated.

You've pretty much summarised my thoughts. Offloading all 4 will leave us with appprox $200k to $250k debt (dependant on tax and selling costs etc). If we can continue to do developments like these we can pay down the PPOR after the next project, say in 18 months.

Thereafter every development we do can be used to purchase properties either outright (without being contrained by borrowing capacity) or at an LVR ratio that allows us to continue developing within our borrowing capacity until we're in a position to consolidate the portfolio. Long road but I reckon we can do it 10 years.

 

Thanks Proportunity but my days of slumming are over besides we're well entrenched with schools etc.

 

Drawing down your IP and paying down PPOR debt would definitely not make the interest on this drawdown deductible, as you haven't used it for income-producing purposes. Even drawing it down and placing it into an empty offset account against the PPOR loan probably wouldn't either, as again, not income-producing. @Terry_w can probably clarify.

 

Thanks Terry that's comforting to know, yes loan is in my name only (I'm the wife )

Hmmm agree The regional location has been great because of the gap between land+construction and the end valuation/market values, but days on market are ridiculous. The upside is that the rental yield being enough to hold without too much stress.

We'll definitely look to liquidate and timing of it. Your comment about selling in different tax years is interesting. The family trusts I mentioned, well there's is actually 2 trusts. Am I right that although a family trust cannot distribute losses, I can however transfer assets from one trust to another?

So before we sell say IP1&2 is there any point transfer the assets to Trust 2, make the capital gain event and offset against the losses constructing IP3&4 in Trust 2 (that is until we sell IP3&4). Whilst the wash up (I think is the same), we won't have to pay the tax on the gain for all 4 IP's until much later, and can benefit from retaining the funds a bit longer (reduce PPOR interest)?

Hurts my head

 

opps, sorry about that. I try to say 'spouse' usually, but slipped up./

 

Indeed, this is the case. Security for a loan doesn't determine deductibility.

There are also legal issues because there is a trust that owns the other property.

 

They can, but there are consequences - stamp duty, CGT, new loans etc.

 

I think maybe you are talking about distributing income between trusts? That can be possible but lots of legal issues to consider.

 

@The Y-man @Thunder in the name of a trust or company?