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So when can LOE be useful ?

Discussion in 'Property Finance' started by keithj, 15th Jul, 2015.

  1. keithj

    keithj Moderator Staff Member

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    Pure LOE based on IP growth & continued borrowing is usually seen as highly risky.

    However, there are situations when LOE can be useful, either as a short term solution or as longer term solution by accessing equity for use as partial living expenses.

    Both of these are relatively lower risk - neither has the assumption of capital growth, nor do they have any dependency on the future cooperation of the bank. However, they both rely on having sufficient positive c/f to fund living expenses at some time in the future.


    Short Term LOE.

    This can be used when you're highly likely to get access to significant funds at some time in the future. eg an inheritance, super, sale of property with long settlement, shares coming out of escrow etc. These future funds will need to be enough to either pay down debt or invest in income producing assets to support all your lifestyle expenses.

    The idea is to borrow sufficient funds before you stop work to keep you afloat until you can get access to the big future payout.

    eg You expect $1M profit from a property sale with a 2 yr settlement, but you want to stop work now & need $50K pa living expenses. Your c/f neutral IP portfolio (with 50% LVR) won't give you any income. An LOE based solution is to borrow 2 yrs worth of living expenses plus a bit extra for interest on those borrowings. The $1M profit invested at 5% will give you a guaranteed income after the 2 yr period, so the 2 yr income gap is funded by your borrowings.

    The important feature of this type of LOE scenario is that you're not exposed to many of the risks outlined in LOE anyone ?, particularly the reliance on bank cooperation & the expectation IP growth.


    Partial LOE

    This can be used to supplement a reliable income stream (eg rent/dividends/annuity/pension etc). One common use case is if you have IP portfolio that is sufficiently c/f+ to cover only your essential lifestyle expenses, (but not enough for the luxuries), and lowish LVR - this is the classic case of asset rich / cashflow poor. The assumption is that the income from your asset base grows at more than your lifestyle expenses so that in the medium term they will exceed all your lifestyle expenses. When this occurs you can start paying down debt with your excess income.

    An LOE solution is to establish a LOC before stopping work, and draw down on it to fund the luxuries. Over time the portfolio income will increase and eventually cover all expenses. There is the expectation that rents will increase at the same rate at lifestyle expenses - this is an important difference from Pure LOE which depends on Capital Values increasing rather than incomes.

    eg. You need $40Kpa for living essentials, but would like an extra $20Kpa for holidays. You have $2M of IPs returning positive cashflow of $40Kpa with a 50% LVR. Rather than waiting for rents to increase to give you the $60Kpa +ve c/f, establish a $200K LOC and draw down $20Kpa for each of the next 10 yrs. The forecast is that rents will increase sufficiently after that 10 yr period to support the extra $200K debt and also your spending on luxuries. At this point you are well & truly c/f +ve & can begin to reduce your debt.

    This scenario needs careful spreadsheeting. It will also avoid many of the risks outlined elsewhere.

    The big advantage of partial LOE is that you are unlikely to ever be a forced seller, because if the worst case scenario happened you will always have your essential living expenses covered, and only have to forego the luxuries (hopefully temporarily). Many IP investors who have experienced a couple of cycles are in the asset rich/ cashflow poor category and could benefit from an exit strategy similar to this.


    Other LOE

    There are other types of LOE - the most well known is the Reverse Mortgage. And sometimes banks will do asset lends against larger portfolios, but usually only at a relatively low LVR. Both these are usually only applicable to v. specific circumstances, rather than the general scenarios outlined above.

    And another variation on LOE is the dumb luck scenario. For example, if you suddenly happen upon a lump sum (eg inheritance, redundancy payout) you can consider LOE by drawing down on that equity until your portfolio becomes c/f+ enough to support you.



    There are many other variations of LOE, including other growth asset classes such as shares combined with margin lending.

    The above is a very high level overview of the possibilities - there are of course many other considerations & many other risks to be mitigated.
     
    Jingo, willair, WattleIdo and 2 others like this.
  2. D.T.

    D.T. Adelaide Property Manager Business Member

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    Keith

    I guess the way of rewording your entire post into a few words is : In what circumstances would you use investment-gained equity for personal expenses / lifestyle?
     
  3. Terry_w

    Terry_w Solicitor, Finance Broker, CTA Business Member

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    Great post Keith

    LOE can allow someone to give up their employment earlier than usual but to keep from killing of the goose that is laying the golden eggs (which tend to get larger year by year)
     
  4. MTR

    MTR Well-Known Member Premium Member

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    Keith
    I expect there are investors doing this now in various variations.

    I think this is no biggy but you would want income streams in place already and method to continually replace the equity.

    MTR
     
  5. WattleIdo

    WattleIdo renovating Premium Member

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    Once again, great food for thought! Thanks keithj.
     
  6. ellejay

    ellejay Well-Known Member

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    Partial LOE scenario sounds like were we're at but not sure that I'd be comfortable even then spending $20k p/a on luxuries. I am thinking about it though, a bit of extra work for half of the year could replace most or all of the money from LOC used, so it wouldn't be so scary. Will let you know how that goes next year.
     
  7. Redwing

    Redwing Well-Known Member

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    LOE until Super kicks in?
     
    Terry_w likes this.