This post is based on an article written by Michael Carman.

Michael Carman is the Managing Director of property investment information publisher Wealth Enhance. You can subscribe to the free ezine, Wealth Enhancement Bulletin, at the Wealth Enhance website at www.wealth-enhance.com.au. This is an edited version of ‘3 Ways to Retire on Property’, originally published in the December 2007 issue of Australian Property Investor magazine and shown here with permission of the author. © Michael Carman 2008.

Financial Independence: An Introduction

In the same way that there are many ways investing in properties, there are also many ways to use property to retire wealthy (or early). We’ll look here at three ways to do that, and the ins and outs of each, as well as examples of how an investor might use each one to retire. Before we do though, there are two key concepts that we need to understand.

The Three Phases on the Road to Retirement

The first is the distinction between the accumulation phase, transition phase and the drawdown phase.

The accumulation phase is what financial planners refer to as the time when you are building your portfolio of assets, usually while you’re in the workforce. These assets might be superannuation, shares, or profits from ownership of a business, but in this case the assets we’re talking about building up in the accumulation phase are properties.

The drawdown phase on the other hand is when you retire and ‘draw down’ income from your assets. The accumulation of assets has stopped and instead the investor is living off the income generated by the asset portfolio.

The transition phase is just that: the transition from the accumulation phase to the drawdown phase. It’s important to understand these phases because each one fulfils a different function and has its own characteristics.

Passive Income

The other key concept is passive income. Passive income (or residual income as it’s sometimes termed) is money you earn which comes to you without any effort on your part. As some authors and commentators like to describe it, passive income is money you earn without getting out of bed. The most obvious example familiar to property investors is rental income, but other examples of passive income include interest, dividends, profits, royalties and licensing fees.

These two concepts are linked: passive income is what you ‘draw down’ in the drawdown phase, generated by the portfolio of assets you built during the accumulation phase.

Obviously, the more passive income you have, the better. And the higher the proportion of your total income represented by passive income, the better. And the real coup de grace comes at the point when your passive income exceeds your expenses (or the level of your desired income). On that happy day: Voila! you are officially financially independent.

Method 1: Retire on rents

This is the ‘plain vanilla’ approach to retiring on property: the investor accumulates a leveraged portfolio of properties over time and then sells some properties to pay down debt. The remaining properties in the portfolio are either unencumbered (that is, there is no debt associated with the properties) or have only such a small amount of debt associated with them that the interest on the loan is minimal. The passive income supporting the investor in retirement is the rental income generated by the unencumbered properties.

With this method, extra properties have to be added to the portfolio which serve the purpose of generating equity that’s used to pay down debt (rather than generating rents to live off). The other, remaining properties are the ones that generate the rental income used for living expenses rather than repaying loans. In this method then, properties serve two purposes: they generate rents to live off, and equity through capital appreciation to pay down debt.

The twist here is that the properties used to add equity that pays down debt are themselves debt-financed, thereby adding more debt to the mix. That debt must also be paid down. All of this makes the calculation of how many properties are required to retire, and the size of the asset base needed to generate the retirement income, very complex.

Example: Jane calculates that she needs five unencumbered properties to retire. She acquires eight properties over a period of years, lets them appreciate to a value of $8 million financed by $3 million in borrowings, then sells three properties (paying sale costs and capital gains tax) leaving five unencumbered properties. The rent from these five properties provides the funds to pay Jane’s living expenses in retirement.

Method 2: Refinance in retirement

In this method a property portfolio is accumulated, but instead of selling properties to pay down debt (as in the Retire on Rents approach) the entire portfolio is refinanced in retirement so that the loan to value ratio is ‘topped up’ periodically to provide funds.

With this method the passive income is the additional borrowings made available by refinancing in retirement. In effect, the investor adds to their borrowings to pay for the groceries. The interest is capitalised, that is, it’s added to the principal and interest is payable on the new, larger borrowing amount. That makes this the riskiest of the three approaches.

The fly in the ointment with this approach is that the investor needs to have an accommodating bank or lender who is willing to grant additional borrowings when there is little or no increase in capacity to service the larger debt. In fact the only factor boosting the ability to service debt is the rise in rents, which is likely to be moderate.

The investor may need to rely on low doc or no doc loans and would open up a line of credit to allow them to borrow between 5 and 7 years’ worth of living expenses (to act as an equity cushion to buy time for the portfolio to appreciate further). Some commentators maintain that a bank will likely be happy to lend to a borrower with an LVR of 60 per cent or less without the borrower having to show a ‘real’ income.

Another consideration is that there must be ongoing capital growth somewhere in the portfolio to enable refinancing to occur.

On the plus side, however, the funds generated by the refinancing aren’t classed as income for tax purposes and hence income tax is not payable.

Example: Barry and his wife have accumulated a property portfolio worth $6 million, financed by $3 million in borrowings. Their LVR is therefore 50 per cent. They refinance to 60 per cent and pull out $600,000 in tax-free funds to live off for the next few years. The $600,000 is added to the $3 million debt, taking total borrowings to $3.6 million.

Method 3: Sell up and park the proceeds

The third approach to retiring on property involves accumulating a leveraged property portfolio, selling all the properties in the portfolio, and investing the proceeds in a low-risk investment vehicle such as a cash management trust. In this approach, the passive income which supports the retirement is the interest payment from the trust.

This method treats property investing as a means of accumulating wealth to retire, but not generating wealth in retirement. The capital growth of the portfolio is what creates the wealth with this approach, and the wealth is then transferred to a different vehicle that has no borrowing commitments, nor any tenant or property management concerns. An investor using this approach would build their property portfolio focusing on high capital growth properties rather than cash flow positive properties.

Example: Ted builds a high capital growth portfolio of four properties worth $3.5 million financed by loans of $2 million. He sells all four properties, and after extinguishing the loans and paying capital gains tax on the sale plus sale expenses, is left with net proceeds of $1.1 million. This amount is invested in a cash management trust which pays an average six per cent (or $66,000) interest per year, providing the passive income that pays Ted’s living costs in retirement.

The trade-off for these benefits however, is that in retirement the income is subject to other forces such as interest rates if you park the capital in a cash management trust, or the stock market if you park your capital in a managed fund that invests in shares.

Making your retirement yours

The beauty of property is that it can be a highly flexible means of accomplishing what you want to achieve. The methods outlined here are not mutually exclusive: they can be combined in innovative ways. For example, you might choose to adopt the Retire on Rents approach, but refinance to access funds on an ad hoc basis or in case of an emergency. Or you might favour the Sell Up & Park the Proceeds method, but retain one rental property and some debt in retirement in order to improve the tax effectiveness of your portfolio. There are many combinations to mix and match, according to your personal preferences and your preferred trade-off of risk and return.

It’s good to know that in considering how you’re going to spend the latter part of your life, that there are many options open to you in creating an earlier – or wealthier – retirement.

Comments by Retire on Property

The article written by Michael was part of a series on retirement through the use of property and published in API Magazine. We will soon either publish the remainder of the series which goes more in depth into the different phases (e.g. accumulation) and the methods (rent vs equity) or publish our own articles on these subjects.