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

8 – Insurance Deals

Here’s proof that it’s always worth calling your insurance company (or bank, for that matter) for a better deal.

I rang up the company that holds the house and contents policy for our PPOR to increase the sum insured amounts for both (the annual renewal was posted out to me with some increases to both house and contents but I tend to tweak—plus I had a recent valuation for the house to work from which notes an insurance cost).

The attendant confirmed we’d been with this insurer for some time and hey, guess what, I ended up paying $20 less than the renewal price. More importantly, I increased the sum insured amount for the house by $58k and added $20k for contents.

It’s also worth noting here, on the subject of insurance, that having your investment properties insured by the same company will generally entitle you to a multi-policy discount. Whereas conventional wisdom is to not cross-secure your loans by taking out mortgages with the same lender, a similar problem does not exist with insurance. In our case, we’ll be eligible for a 10% discount across all policies with our insurer when we tack on the IP. In other words, save some hassle, save some money, and use the same insurer where it makes sense to do so.

And a final postscript here: all insurance is definitely not the same so I advocate not buying insurance on cost alone. I took the time to read the PDS documents from several insurers last year—RAC, GIO, AMII, parent companies, subsidiaries, etc—and it was surprising what the extra spend will actually get you. The cheaper insurers, like RAC, exclude cover for things that I feel are important. Read the PDS and compare what you’re getting from a more expensive product when your insurance renewal next comes due and call up for a better deal at the very least!

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

7 – Progress Update: Land Settlement

As mentioned in previous posts, settlement on our Queensland block of land was delayed in late January; apparently adverse weather conditions over Christmas and throughout January “may” have led to delays for the developer—presumably in to relation finalising all things tied up as part of the land division such as sewerage and services, roads, lighting, etc.

I’ve now been told to expect settlement in the coming days (now late February) and this will mean building plans can be submitted to council for approval and building permits obtained.

This process is very opaque to me but from what I understand, the land developer is required to bring the land to an agreed standard as part of subdivision, council will then approve that work, and the development process for individual developments (i.e. construction) can then commence subject to the rigours of the council building process.

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

6 – Think Rich

Immediately after writing my last post “How to Spend Money”—in which I advocate being frugal and not spending money unnecessarily, a library book I’d reserved came available: Robert Kyosaki’s Rich Dad’s Guide to Investing. The first section of this book is almost entirely dedicated to the concept of retraining and refocusing your mind to think like the rich do. In other words, instead of pinching pennies as part of a frame of reference where money is scare, change your mindset to one in which money is abundant and don’t be cheap.

This makes a lot of sense to me. I won’t make a full about-face in follow up to “How to Spend Money” but am inclined to adjust my thinking somewhat. The standard disclaimer I include with every blog post includes a note that I’m learning too, so here’s direct evidence of that! Most importantly, I’m learning and have a very open mind on financial matters as I’m not yet prejudiced by a lot of experience; I’m therefore willing to adapt and adjust my thinking on the fly and explore new ideas and concepts like this one.

A note: I realise this post isn’t directly related to property investment but—for me—property investment is simply a means (a “vehicle” in rich dad speak) to wealth.

Although I’ve not necessarily been cheap, I’ve definitely been frugal often and modesty always has been—and always will be—a pillar of what it means to be me.

Rich dad wisdom suggests being frugal is okay but there’s no sense in being rich but living poor. As an extension to that, it’s worth pointing out another Rich Dad pearl, which suggests having a low income and high expenses is superior to the traditional goal of having a high income and low expenses. In other words, use good expenses to reduce your taxable income (and to tie that back to our current discussion: don’t be cheap by trying to keep your expenses low). I’ll add this book is by far the best of the three Rich Dad, Poor Dad books I’ve read to date—it’s very conceptual but so worth the read—see the Amazon.com link above to check it out.

Frugality I would define as choosing to not be extravagant in your daily spending habits (for me this also relates directly to my greenie sensibilities: I choose not to be a consumer and pollute my environment with unnecessary packaging and products). I always prefer to buy quality and do not buy to throw away—this is and always will be a way of life for me. If I were cheap, I would buy poorly made, disposable things in quantity—at the very least.

To quote from Kiyoaski’s book: “My rich dad would say, ‘There are two ways to become rich. One way is to earn more. The other way is to desire less. The problem is that most people are not good with either way.’ […] this book [is] about how you can earn more so you can desire more.”

I’ve not been too bad on the desiring less front but I do look at people around me who seem content spending a lot of money and wish I could be less frugal, if not less cheap! I certainly want to be more generous and focus the money I must spend on the positive aspects of life.

Kiyosaki also cites another article on this subject which suggests the wealth you can build by living as though you were poor is finite (the article cited also discusses penny pinching in the context of becoming not just a “millionaire” but a “multimillionaire”).

The book doesn’t offer much in terms of definition between frugality and cheapness but the author does leave us with another rich dad quote: “‘If you want to be really rich, you need to know when to be frugal and when to be a spendthrift. The problem is that too many people know how to be cheap only.’” I think this point also extends beyond the black and white argument of frugality versus cheapness and into the broader educational context of the investor: do we understand the difference between good debt and bad debt, good expenses and bad expenses, assets versus liabilities, taxation laws, ownership structures, etc, etc? In other words, are we being constantly cheap or are we being selectively cheap? I mentioned in the previous post not spending money on a depreciating asset like a car; that’s not frugality but rather understanding how not to waste money quickly.

Notably, Kiyosaki goes on to write (later in the book) that rich dad focused on delayed gratification in the short term in favour of a long-term reward. I think this is key and really at the crux of what I was suggesting in my earlier post. Nonetheless, I do believe in the power of setting goals and ‘thinking yourself’ into the reality you desire. 

As a final thought, I’ll suggest not being cheap doesn’t mean splashing out at every opportunity. Meanwhile, keep thinking rich!

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

5 - How to Spend Money

This is simple but for so many people the concept is something from the stratosphere. My rules are as follows:

1. Don’t spend money
2. Use other people’s money (a mortgage to buy property, interest free periods on a credit card) when you have to spend money
3. Build your credit history (if you’re new to borrowing)

Let me explain in a bit more detail…

1. Don’t Spend Money

This is really the golden rule. Some people might choose to read this as “don’t spend money you don’t have” but see Rule #2 before you adopt that approach. But there’s no need to interpret the wording at all: just don’t spend money!

Although simple in theory, this is extremely difficult for many people to implement in practice. We’re used to spending money and our culture conditions us to spend more money than we need through marketing and advertising and by watching our friends and families succeed. Break the habit, become wealthier, spare the planet the extra plastic, and change the world, maaaaan!!! Ignore the adverts and recognise and accept your friends might be earning more money than you are/in a different financial situation to yours/stupider than you are. Spending money is not a measure of success or intelligence.

If you don’t need something, don’t buy it. Live frugally, is what I always say (rather than calling myself cheap!). Don’t live in the moment and buy impulsively. The time for spending money will come but right now you need to accumulate money and wealth and the easiest way to do this is via the magical effects of compounding, a subject on which I’ll write more about in detail another day. For now, just understand the less money you throw away, the more money you’ll have to make more money.

Before you whip our your credit card, stop and think whether what you’re about to buy is going to increase the number of days (or months or years) you’re going to have a mortgage to repay—or increase the time it’s going to take to save up a deposit for a first home loan. Ask yourself if this doodad, that beer, this seemingly insignificant expenditure is really necessary to your wellbeing and fulfilment. Can it wait another month? Another year? I remember when I first reviewed the interest costs on our PPOR mortgage: over the thirty year term, we would ultimately end up paying the bank the value of our home again. The quicker we could repay the principal, the less we’d pay on interest.

The best way not to spend money is to understand what you need to spend to survive (i.e. a plan or budget—anything), spend that amount and record the transactions against your plan or budget, and treat  yourself occasionally but in moderation.

There are also many subtleties at play here. Never spend money on a depreciating asset like a car—i.e. don’t buy cars, at least not new ones, until you can genuinely afford to. Don’t buy an ultra HD curved OLED television. Don’t waste food. If you’re spending more than $50 a month on booze, you’re spending too much. Definitely don’t smoke or quit if you do. Take it easy on the holidays. Don’t eat out too much.

There are also some really easy things you can do. Buy store brand ketchup instead of Heinz ketchup. Mow your own lawn. Change your behaviours by wearing your clothes for a second season instead of refreshing your wardrobe every three months. Use grocery store fuel vouchers to save on petrol. Pay your bills on time to avoid fees. Ensure you’re never in a position where you have to pay late payment fees or, worse, credit card interest. Make your lunch and take it to work instead of buying lunch every day. Cancel your cable TV subscription. Become a vegetarian and stop eating meat. Ride a bike to work instead of catching the bus or train (or worse, driving your car and paying for parking). As you start thinking like this, you find all sorts of ways to save a few dollars and as my mom always said: “every penny counts!”

Keep the achievement of your long-term goals front of mind and what you give up today is easier to bear. We took on a $700k+ mortgage in 2006; it’s all but paid off less than ten years later through moderate (minimal, really) spending and careful saving.

Edit: Please read my follow up post “Think Rich”—it explores a valid counterpoint to this concept.

2. Use Other People’s Money

If you insist on spending money, don’t use your money, use someone else’s money—at least for as long as you can and if you can do so for free.

Credit cards are considered intrinsically evil by some people but if these facilities are not abused they can be used to your advantage. As long as your balance owing is paid by the due date—that is, you have the cash flow to afford what you’ve purchased—you won’t have any interest to pay for the privilege of borrowing that amount for up to sixty days.

We buy everything (EVERYTHING—except purchases that attract a fee) on a single credit card with a reasonable limit and we pay the credit card bill on time. Our typical credit card bills run between $2,000 and $3,000 (more around Christmas, sometimes less after a really good month); instead of being paid for immediately from our cash, the value of our monthly spend is being lent to us at no charge by the credit card company. During that interest free period, that lent money is working for us in our offset account—reducing the amount on which mortgage interest is charged.

The added bonus is having the majority of our transactions centralised on one card, which makes it easy to know how much we’re spending month to month; it’s also easy to spot any problems. I typically pay off the credit card, in full, a day or two before it’s due to maximise the credit benefit.

The key takeaway here is to never pay interest on your credit card. Most cards will charge interest at an annual rate of around 20%. This adds up to lot of money—I’m always astounded how my credit card statement tells me if I only pay the minimum amount I’ll pay off the closing balance in “58 years and 07 months” and “end up paying an estimated total interest charge of $22,828”! That’s crazy talk.

If you get stuck with credit card debt, plan on getting rid of that debt first before anything else because it will most likely be the highest interest rate you’re faced with (apart from a bad car loan, perhaps). Call your credit card company and have a chat with them about a repayment plan or an interest-free period—ask to speak to the manager if necessary. If your card company won’t help—and by help I mean be very generous to you—roll over the balance on the card to a new card with a 0% introductory balance for 12 months or whatever period you can find. Hopefully that will give you enough time to clear the debt without the interest burden accumulating on top of the original amount.

Finally, I don’t use cards that incur an annual fee just for the sake of a few perks.

When it comes to your home loan, you also need to be careful. If you have a number of debts (i.e. a car loan, credit card, personal loan, etc) you may be offered the option of consolidating all those loans into your home loan. The benefit of doing so is a better interest rate: instead of a 20% rate for your card debt, you’ll be paying 5% at today’s rates. The downside is that debt will follow you for the term of your home loan, meaning the interest on the amount you’ve consolidated will compound every year until it’s repaid—along with x number of years of interest. You could end up paying off that new car for thirty years—long after the car is gone!

You might similarly be tempted to refinance your home to free up equity for a holiday or a new toy (boat?) or a swimming pool. This is easily done but, again, be mindful that in doing so you’re hiding the true cost and using money you can’t really afford.

Credit cards and home loans are generally considered “bad debt” because it’s money that doesn’t work for you. Consider the alternative: “good debt”. This is money borrowed that you in turn use to make money through investing in real estate, a business, or stocks. In contrast to the loan on your PPOR which will cost you money on interest (this interest cannot be claimed as a tax deduction), a investment property mortgage will serve to earn you money. So as a footnote to this section, if you’re buying an investment property, use the bank’s money—secured by the equity in your home—instead of putting down your cash that can be better used elsewhere.

A student loan like a HECS debt is also someone else’s money. If you have the option to reduce interest by making early repayments, ask yourself if the cost of holding onto that loan and not making early repayments will allow you to use that money more productively elsewhere. How much will you save by making early repayments? How much do you stand to make by investing the value of those repayments elsewhere (e.g. in an offset transaction account, saving you interest of say 5% at today’s rates on your PPOR mortgage)?

3. Build your Credit History

If you’re new to property and are looking to take on your first home loan in the next twelve months or so you’re probably also saving for a deposit and implementing a lot of the tips I’ve offered above—good on you. The next step is to ensure you have some form of credit history for lenders to look at when assessing your eventual loan application. To carry on from Rule #2, the easiest way to build your credit history is to take on a single credit card, use it, and ensure it’s paid off in full by the due date. This will help identify you as a borrower with a proven track record of debt repayment—through both intention and financial means.

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