Essentially, selecting a property strategy is all about the numbers. The good thing about numbers is that as long as your assumptions are sensible, they never lie.
To get the numbers as close to perfect as possible there are two things you must consider. The first is your cash flow. This is particularly important through the initial stage of investing – the acquisition stage. There are three stages of property investing:
· The acquisition stage – when you’re going to acquire a portfolio;
· The holding stage – generally when you hold the assets until they appreciate in value and/or produce an adequate income
· The retirement stage – which may mean no changes are made to your portfolio or it may mean selling an asset and repaying debt or living off equity, etc. (more on this later).
Cash is king
Cash flow is very important at all times, but obviously must be managed carefully during that crucial first stage to make sure you complete the initial acquisition quickly and carefully. To ensure success, you need to obtain as much investment as possible, which gives you more time in the market, because ultimately time is what’s going to create wealth. Cash flow again takes priority in the retirement stage of your investment career, because you clearly want to be able to fund your post-work lifestyle.
The second consideration when crunching the numbers is your net worth. You should continuously monitor the changes in your net worth to make sure you’re on track and heading towards your ultimate investment and financial goals. Your net worth acts as a tool, whereby you can measure your progress, so after year two, year three, year four, five and so on, you can ascertain how far you have come in your overall plan and make sure you’re on the right track. Your net worth is the key because it provides flexibility and options. That is, when you enter into retirement, you might decide to sell everything and put your money in a bank account. A higher net worth will therefore produce more cash and therefore more income.
Net worth can also be important in retirement, depending on the investment strategy you choose. You might choose to place a higher emphasis on net worth than cash flow and plan to live off the equity the net worth will provide.
Cash flow and net worth are the two financial elements of your investment journey that you must plan well and monitor as you go.
Developing a cash-flow forecast
While some people might find the prospect of analysing numbers like cash flow and net worth daunting, the reality is developing a cash-flow forecast is really not difficult. In fact, it’s as simple as:
• Adding up all your current income and expected income for each year,
• Adding up all your expenses and expected expenses for each year; deductible and non-deductible, which includes living expenses, property holding expenses, etc.
• Deducting your total expenses from your total income for each year
• Seeing what you’re left with.
Calculating some of these items, like how your income tax will change, can be a bit tricky. Of course, you want to end up in a positive cash-flow position and ideally you will have some type of buffer in case of emergencies or that odd rainy day. There’s really no rule of thumb that states how much buffer you should have, as it depends on many personal factors including how risk averse you are.
Buffer is key
If you are left with a very small buffer, then you should really consider the other risks in your cash-flow forecast carefully, including your risk of reduced income and increasing expenses. To minimise these risks if you are on a very tight budget, you might look at fixing a larger portion of your interest rates than you otherwise might. On the other hand, if you have a very loose budget with a significant surplus, then fixing your loans isn’t as important, because you can weather the peaks and troughs of interest rate movements with far more comfort. It’s common for people to question how much money they should have left over, but the answer depends entirely on your situation – it’s a very personal thing. For many people, a couple of month’s living expenses is probably the minimum.
So how do you project forward and forecast things like changes in income as accurately as possible?
Forecasting changes in income
It’s relatively easy to predict changes in your earned income because most people have a pretty good idea of what direction their career and job will take. Of course, it gets even easier if you have reached a ‘glass ceiling’ in your chosen field and your income has levelled out somewhat. If anything, be conservative. If you don’t have any idea how your income will change then just assume no change (or change in line with inflation). It is better to be too conservative than too bullish.
But what about calculating the projected rental income from your property portfolio? We would generally forecast this income as a percentage rental yield, so the amount it generates really depends on what the expected value movements of your property portfolio are. In other words, if the value of your property increases, so too should your rental income. Naturally your rental income will not be consistent year in year out, but the best way to forecast this income is to assume uniform increases regardless of the ups and downs, as it should all average out to be fairly accurate over the long term.
Changes in expenses
When it comes to forecasting expenses, again there is not going to be consistency of the numbers. Interest rates fluctuate for a start, causing increases and decreases in expenses such as property related holding costs. To allow for this, we tend to use the long-term interest rate of 7% (as average, since 1990 is 7.7% and since 2000 is 6.6% so 7% is about the midpoint).
If you adopt this method with your cash-flow projections, perhaps taking up a fixed rate on your loan when fixed interest rates are below your long-term forecast and maintaining a variable rate when they surpass it, again this should average out to be fairly accurate in the long term.
With regard to other expenses, such as general living expenses, we base our forecasts on the projected rate of inflation and allow for annual increases accordingly. The Reserve Bank of Australia ideally likes to manage the economy at an inflationary rate of about 2 to 3%, so we tend to meet somewhere in the middle at 2.5% to allow for inflation.
Just remember, essentially your cash-flow forecast is all about adding and subtracting – it is basic maths 101 and should not be considered too terrifying to tackle. When you can see your financial situation in black and white, it will give you all the more confidence to move forward in your property investment endeavours and make the planning and strategy selection stage that much easier.
Your accountant or financial planner might be able to help with the preparation of a long-term forecast.
