Retirement Roadmap # 1:

Quality assets and cash flow…

Richard and Andrea (first names have been changed for privacy) have been clients of our firm since 2010 when they approached us for finance to purchase a second investment property. Richard (38) and Andrea (41) have two children aged 6 and 8. Richard is an IT contractor that earns over $190,000 per year (pre-tax) and Andrea is a stay-at-home mother but plans to return to the workforce in about 3 years’ time. Richard estimates the family spends $5,700 per month on living expenses (excluding mortgages and car repayments of $700 per month).

Their home’s value is estimated to be $730,000 and their home loan balance is currently $460,000. They own two investment properties. One property in Murrumbeena was purchased in joint names in 2007 for $350,000 and is now estimated to be worth more than $350,000. A second property was purchased in Lysterfield (Victoria) for $400,000 and the current market value is estimate to be $400,000 (i.e. what they paid for it in 2011). This property is owned as tenants in common (99% by Richard and 1% by Andrea).

Richard’s super balance is relatively low at $30,000 and Andrea’s is $20,000. Both are invested in retail super funds. Andrea has a small account with an industry super fund (industry funds are not-for-profit).

Richard and Andrea would like to retire when Richard is 55 in approximately 17 years.

I have set out below some comments from my review of their situation.

Current investments

I will assume that Murrumbeena is worth say $370,000 in today’s market. That implies an annual growth rate of less than 1% over the 5-6 year ownership period which is very poor. The median price in Melbourne has grown at 6.2% over the same period (so at the same growth rate, your property should be worth in the vicinity of $520,000 by now). This implies that something is probably wrong with the property from an investment perspective. Murrumbeena is approximately 16 kms from the CBD which isn’t too far but probably close to the limit for an investment grade property. I think the issue might be that it is located on a busy main road. I recommend that you seek advice from a trusted investment property advisor (we can refer you to one) to assess the quality of this asset. We need to know why the property has performed poorly and if I was you, I’d want to see some strong evidence as to why the future performance will improve. Otherwise, (and if the asset is deemed not to be investment grade, you should sell it now (in the 2013 spring market). [FYI – investment-grade property should increase in value at the rate of 7% to 10% p.a. over the long term.]

Your second investment property is located in Lysterfield which is 33 kms from the CBD. Often (but not always), a property this distance from the CBD is unlikely to experience the same level of sustained excessive demand as a property located closer to the CBD (it is excessive demand that is mostly responsible for driving up property prices). It appears that the dwelling on the property is relatively new and that the land has been sub-divided. From the limited information I have, it would appear that this investment has more building value than land value which hampers capital growth. Again, I think you need to get some independent advice as to the quality of this asset as I suspect it’s not investment grade. If I am correct, you should sell it.

The quality of your assets will determine 90% of your financial outcomes. That is, it is very difficult (impossible) to create wealth with low quality assets. A wise entrepreneur once said to me (so eloquently), “you can’t turn crap into gold Stuart”. Therefore, your first port of call is to review these two existing assets, dispose of them if they are poor quality and replace them with better quality property investments. Sure, this will cost you money (i.e. selling costs and stamp duty when you buy again), but holding onto them will cost you a whole lot more (in lost time – and you can never get time back again). Murrumbeena, for example, has already cost you $150,000 in underperformance (as it should be worth at least $520,000 by now).

Future investments

I have forecast that you have a cash flow surplus (income less all expenses and commitments) of approximately $10,000 per year at the moment. When Andrea returns to the workforce, I estimate that the cash flow surplus will increase to approximately $40,000 p.a.

I recommend that you consider making additional superannuation contributions of approximately 3% of your salary (being approximately $6,000 p.a.). Half of this amount can be directed into Andrea’s super account so that you’d qualify for the spouse super rebate of $540. The rest could go into your super as a salary sacrifice contribution. I considered the option of not making these contributions and repaying your home loan at a faster rate instead. However, given you have a lot of wealth (and will have more in the future) invested in property, you need some diversification and liquidity.

Any additional surplus cash flow should be directed into the home loan (or offset).

When Andrea returns to work (in 3 years’ time), I recommend that you invest in a 3rd investment property for approximately $750,000 – perhaps in a State other than Victoria for diversification and to reduce land tax.

How to fund retirement

After you have invested in your 3rd property in 3 years’ time, you should continue to direct all surplus cash flow into your home loan. I estimate the home loan will be fully repaid (or offset) in approximately 10 years. Once the home loan is repaid, you should direct your surplus cash flow into offset account/s linked to your investment loans.

You would like to retire at around 55 years of age. At this age, I have projected that you will have approximately $850,000 of cash in offset accounts linked to your investment loans. You will not be able to access your super until age 60 so you will need to draw on these monies in the offset to assist with funding living expenses (I project you’ll need to use approximately $90,000 between the age of 55 and 60). Once you are 60, you can begin to draw an allocated pension from super.

Cash flow is king!

Your family’s net wealth at age 55 (i.e. approximately in 17 years) is projected to be $5.5 million in today’s dollars if my forecasting assumptions turn out to be correct. There are two very important assumptions. The first one is that you only invest in top quality property and it increases in value at 8% p.a. over the long term (which is 5% above inflation). The second is cash flow management. I have assumed that your expenditure is contained at $5,700 per month and only increases with inflation. Cash flow management is the number one critical success factor when it comes to wealth accumulation. Put simply, spend less than you earn and invest regularly and wisely.

Superannuation and estate planning

Your super balances are relatively low for your age. You need to ensure that you invest your super in a low-cost environment so that less money is “eaten” up by fees. Both your super funds appear to be relatively expensive fee-wise. I recommend considering switching your super to an industry fund (such as AustralianSuper) and invest mainly in a “growth” investment option. Please ensure that you have current binding death benefit nominations.

Your wills were prepared in 2007 after you had your first child. As such, they should still be adequately up-to-date but it’s wise to “check in” with your estate planning lawyer every 5 years or so to double check.

Summary of our recommended strategy for Richard and Andrea

  1. Use the current buoyant spring property market to divest of any poor quality investment properties and replace these investments with investment-grade property
  2. Focus on repaying your home loan whilst at the same time make additional contributions into super in the form of salary sacrifice contributions and spouse contributions (to get the tax rebate)
  3. When Andrea returns to work, invest in a third investment property in Sydney or Brisbane (assuming cash flow is as projected)
  4. Focus on good cash flow management by maintaining current expenditure levels. I estimate you should be able to repay your home loan in approximately 10 years
  5. Once home loan is fully offset, direct surplus cash flow into offset accounts linked to your investment loan. The aim is to increase liquidity and reduce debt exposure (to increase equity)
  6. Consider retiring when Richard is 55 and using projected substantial cash flow reserves (in offset) to assist in funding living expenses until you can draw a pension from super at age 60.

Lesson for other clients reading this article

There are two common themes we come across when we review a client’s financial position and retirement plans.

The first one is to unemotionally review the performance of each investment to ensure that it’s up to scratch. If not, get an expert assessment of the asset’s quality and if it’s not investment grade, dispose of the asset as promptly as possible whilst maximising the sale value. There’s no good time to continue to hold a poor investment as it “wastes” time and you can never replace time. You must hold the best quality assets possible to ensure investment success. I really can’t make this point strongly enough.

Secondly, as noted already, spend less than you earn and invest regularly and wisely.

It might be time for you to consider/review your situation. In fact, you might take advantage of the current buoyancy in the spring property market and the low interest rate environment to put some of your investment plans into action.

Are you interested in having your financial situations and plans reviewed by the team at ProSolution? If so, send us an email.