9 - Performance Measurement

My wife is my yardstick for measuring reality. I’m admittedly a bit of a dreamer at times (with the ability to get mired in the details, mind!) but my Dr. wife, being smarter than me, is always ready to offer the checks and balances I occasionally require to cool me off when I get carried away.

Part of that is because she hasn’t learned what I’ve learned so she asks a lot of tough questions which forces me to think hard about the answers. She’s also far more conservative than I am and could probably be labelled a reluctant partner in all of this—her preferred approach to investment is to save cash in the bank.

Related to all of this, Cam McLellan over at Open Wealth, with who we’re building our first investment property, did an early podcast on the subject of what he calls “Dream Crushers”. A Dream Crusher tells you what they think (i.e. which is usually a negative, subjective view about what you’re thinking about doing) without having the experience or objective education on the particular subject to support their comments. This commentary gets you down and ultimately prevents you from taking action. The wife is effectively my lead Dream Crusher—although she usually comes around, either because I babble at her so much she wants to shut me up or because what I’m saying makes sense to her and she comes to understand my intention.

Which leads me into the subject of today’s post.

The investment strategy I had yet to—until yesterday—articulate to my beloved wife was to complete construction of IP #1 by mid-year (ish) and look at identifying and securing finance for IP #2 (and possibly IP #3) through the end of Q3 and the start of Q4 2015. This would tie in well with the fact I’d be back at work full time by that point, which the banks would hopefully look at favourably in terms of debt serviceability.

Then my wife hit me with her strategy: evaluate the performance of IP #1 before rushing forward. To me that was the sound of the cord being pulled and the lights going out. Fizzle. Zap. “No more property investing for you, dear hubby!”

We didn’t speak more on the matter initially but her comments certainly got me thinking: what is the detailed set of criteria we might use to define performance?

I’ve honestly been a little bit stumped about how to measure performance for a while now.

The easy one, of course, is a doubling in value (capital increase of 100%) every 7-11 years for good metro properties. The market will generally do this for you unless you’re adding value somehow (i.e. through renovations or infrastructure projects coming online).

Gross—or better yet—net rental yield is a good starting point as it’s a metric that’s easy to calculate and track.

Perhaps more important is the transition from negative gearing to neutral or positive gearing within a timeframe you can afford. Let’s say 1 to 5 or 7 years. This might happen in a number of different ways. Rents increase. Debt might be reduced or retired (but I wouldn’t take this approach) and interest rates might move—down like we’re seeing these days. You earned income may increase as you progress in your career, allowing for more effective tax deductions.

The conclusion that I’ve come to is performance must be measured over specified time intervals: 1 year (or less initially); 3 years; 5 years; 10 years; 15 years; 20 years. My strategy is to hold for the very long term and hence I believe performance should therefore be measured over the long term too. Hopefully in that time our property would have become positively geared and seen reliable capital growth.

Simply looking at results year on year doesn’t work for me. A property might be sitting pretty one year but take a step backwards the next before recovering again in year three, for example. The contextual economics need to be factored in to your assessment at the very least and this will happen automatically by measuring performance over a multi-year period.

More importantly, deciding to invest or not invest in a second property, which will likely be in a different suburb if not a different market (i.e. a different capital city), based on the performance of the first property isn’t an equitable comparison.

There are also other factors that I’ll say are beyond your control, for lack of a better expression. Let’s say you buy a negatively geared property in the years before you retire.  Your income is hopefully at the highest level it ever has been and so your tax deductions go further and, were you to keep working, that negatively geared property might be able to generate a positive cash flow for you in a few years.

And then you retire, hopefully with structures in place that will minimise your tax burden. Realistically your income will likely decrease in retirement. But what about those deductions?! That negatively geared property might remain that way for longer than you anticipate if you’re not able to pay down debt. At worst, it might eat into your retirement income and put a hold on your big retirement plans. Moreover that property may have seen only insignificant capital growth in the short term, making any sale not worthwhile despite the potential CGT savings.

If you’re younger, as I am, what if you’re working full-time one year but not earning at all the next? This is my reality as a stay-at-home dad. Bring forward tax deductions, yes, but that muddies the waters somewhat across the financial year boundaries.

Tenant churn might be a problem. That is, you might struggle to retain tenants, leading to more vacancy periods than another investor might have with an elderly couple who’ve been in the rental for a decade—doing their own light maintenance no less! (I read an investor profile just like this one in API). If you’ve got a strong property manager now, what happens if he or she moves on and you’re left with an average manager?

What about bad tenants? Insurance claims? Construction defects if you’re building new?

Interest rates may (will) increase, reducing positive cash flow.

Special circumstances may also intervene. Let’s say you lose a tenant for a length of time greater than you planned for because a major industry pulls out of the local market and rental demand evaporates. Or a flood leads to a broad stagnation in the market in terms of capital growth (as per Brisbane). I can only imagine what impact the earthquakes in New Zealand had on rental property there.

If you’re holding long-term, these sorts of events that occur in one year, or even over a number of years, don’t necessarily mean you’ve bought a dud. It might, if you’re being forced to subsidise a negatively geared property you easily can’t afford—in which case you’ll probably want the situation to come good within a defined time period (i.e. five to ten years); you’ll also need to decide whether that subsidy is worth the cost to you—especially if it’s not a burden. The selling costs (agent’s fees, possibly CGT, timing, etc)—coupled with the costs to acquire a replacement property (stamp duty, possibly LMI, time lost in the market)—make selling off an “underperforming” asset problematic.

I’ve written previously that time heals all problems but the flip side to this statement, of course, is that time is not on our side! Even for me as a relatively young man I’ll only get two to three decades (two to three growth cycles) before we both retire and our earned income dries up. With a goal of holding 6-10 properties at minimum, and natural constraints around how quickly we can do that, time is most definitely not on our side!

I’ll keep working through this one but I wanted to share while the subject was front of mind.

I’ve been reading a lot of Robert Kiyosaki lately so I’ll close by highlighting a recurring theme in all of his Rich Dad books: don’t buy investments that will cost you money. Speaking to us Aussies, I’m pretty sure he’d say “buy positively geared properties, mate”. That doesn’t completely solve our performance question—a positively geared property could revert back—but it’s a sound idea where it’s possible to find and buy such an asset.

I suppose a disclaimer is also worth posting: I'm just a guy, I'm not an accountant, lawyer, solicitor, tax agent, mortgage broker, banker, financial adviser, insurance agent, land developer, builder, government agent, or anything else so I disclaim your application of anything I write here is to be applied at your own risk. What I write may be incorrect and you are best to seek your own professional advice (tax, legal, financial, and otherwise) before entering into contracts or spending your money. Your situation is unique to you and what I write here reflects my experience only. This content is not professional advice and is not tailored to your situation. I'm learning too and expect to make many, many mistakes along the way.

Enjoy,

Michael

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