July 20, 2019
There are many people in Australia today with plenty of equity, yet very little freedom. They are the definition of equity rich, cashflow poor. Maybe you’re one of them. I was.
And that’s usually because of our love of property. While it’s been a fine vehicle for building wealth, it’s a very hard asset to retire on.
Net rental yields are low. Ownership costs are very high. And the lending environment has changed.
So to actually escape the hamster wheel and create the freedom we’re really after, we need to be open to new ideas. That’s what this post is all about!
I learned this first-hand on my journey to Financial Independence. As I grew my property portfolio, the lending environment was changing dramatically – effectively squashing the plan of refinancing our portfolio to live off the steadily growing equity in perpetuity.
In this ‘live off equity’ strategy, you need to prove serviceability to the banks, which is much harder than it was years ago. Your cashflow needs to be high, or your loans (LVR) need to be very low.
The first criteria is extremely hard to meet, after costs, with property in most parts of Australia. And the second one means you’ll need a huge amount of equity (many millions) to make it work. Neither of which are likely to be an effective or efficient option for the majority of investors.
Living off rents is often more viable, but also not a very efficient strategy for generating income from your wealth. We’ll go into that later. But after considering all the options, I decided to look at what other assets can be used to create a good income stream to live on.
And it turns out, there was one asset class right under my nose the whole time. I’d just chosen to ignore, because I was afraid of it.
That asset class is Aussie shares. The reason I didn’t feel comfortable investing in shares (and many people don’t) was because, honestly, I didn’t understand it.
And that creates fear of the unknown. But after opening my mind and doing lots of reading, a light bulb went off in my head…
We needed much less equity to retire on, if those savings were just parked in the right place. Australian shares pay attractive dividends, and come with generous tax credits attached, which juice the income even further.
Which is why we’re free from mandatory work today, and have a growing portfolio of income-producing shares, rather than stuck at work for another 10 years, stubbornly trying to create the same freedom with property.
But I know, shares are scary, risky etc. I totally get it. I’ve been there. That’s why, today, we’ll cover all the most common worries about the sharemarket, from property investors and newbies alike!
And hopefully, by the end you’ll see shares in another light, and realise the massive opportunity available for those with property equity who want to be free sooner rather than later.
Well, where does this ‘casino’ label come from? Probably a few things. We see on the news each day, the market either went up or down, and we have no idea why.
We also see plenty of panicked headlines about ‘impending crash’, or ‘market sell-off’, or ‘billions wiped out’. Often times, that’s accompanied by frantic Wall Street traders yelling at each other and pulling their hair out!
No wonder we think it’s a casino! But let’s sit back and think about it for a minute. What exactly is the sharemarket?
It’s a market, where we can buy and sell shares. Thanks Captain Obvious. Shares of what? Of all the different listed businesses in Australia. Hmm, okay. So think of it as a big supermarket, for people wanting to buy and sell companies.
In fact, in the olden days, people used to actually exchange papers of ownership at coffee houses, in a dignified and business-like transaction.
Because they were, as we are today on a much larger scale, simply buying and selling businesses.
Obviously, nowadays it’s an online marketplace, which is more effortless. And we can also do it at near-zero cost. This, unfortunately, makes people more likely to trade more often.
The fact that we’re able to buy and sell at any time of the day, at any price we want, depending on how we feel, is what causes shares to fluctuate in price.
It certainly appears that way. But consider this.
If property was transacted the same way shares are, you’d likely see much more volatility than you do now. Imagine trying to sell your house every weekend. The turnout, mood, and offers will likely vary quite a bit. Some weeks people will fight over it. Other weeks, there’ll be little interest, or low-ball offers only.
One little fact that is often overlooked about property price indices, is that this price includes all renovations, extensions and improvements.
We know people tend to spend considerable amounts on their homes. Re-doing kitchens and bathrooms, putting in nice gardens, new floors etc.
So a $500k house, which 2 years later sells for $550k, could have had $50k of renovations done. No capital growth. But the 10% growth in sales price is what gets recorded. So there is a misleading upward bias to the data.
Because most approach property with a long term view, nobody worries about short term price drops. If someone comes and offers you 10% less for your house than you paid for it a few months ago, you have two options.
You can freak out about it, thinking you’ve lost money, or simply say “no thanks – I’m in it for the long term.”
The same common-sense thinking should be taken to the sharemarket. Just because you see the price, doesn’t mean you need to care about it. It can be tough at first, accepting the price movements of shares.
But all that price tells you, is what buyers and sellers were transacting for on that day. Most of the time, absolutely nothing has changed with those businesses.
The sharemarket has delivered very attractive returns for a long time. But to earn these returns, you need to be able to stomach a steep fall from time to time.
It’s a rare event, and nobody knows when it’ll be. Maybe once every couple of decades.
Just think about the long term trend of markets, and realise the world will keep turning, people will keep innovating, and the market, on average, will keep rising over time.
The other side of this coin is opportunity. When shares fall heavily, you have the very handy option to buy more shares at lower prices, and higher dividend yields.
If you’re building a portfolio, that’s exactly what you want! And if you’re living off the income from your portfolio, you can basically ignore it.
And isn’t it funny how the media loves to report the end of the world and markets falling, yet they pretty much never mention the steady yet enormous march upwards over the decades?
Often this is an emotional factor. If you buy shares in a company or index fund, you don’t control the actions of any of the people running it, or the results of the business.
But having direct control doesn’t mean you’ll get a better outcome.
I’m in 100% control of my Perth properties. I can do whatever I like with them. That hasn’t been the slightest bit helpful over the last 5 years.
On the flipside, I’m 100% responsible for them. Meaning, the burden of cost, issues and administration comes back to me.
Some point out the aspect of being able to renovate a property to add value. That’s definitely possible. And if you do the work yourself, it can work out quite well indeed.
But you can only do this once, and there’s risk involved. If the market falls slightly while you’re doing a renovation, you’ll be lucky to recoup your costs.
The other side of this is that renovations aren’t even optional. As property owners, we’re forced to repair, maintain and even upgrade the property over time, just to maintain market rents, otherwise nobody will want to live there!
Sure, you don’t control your shares. But that’s part of the benefit. There’s no responsibility on you and nothing to worry about. You also have more control over getting your cash when you need it.
You can sell off a chunk of shares and have $50k in your account in a day or two. Bit hard to do that with property!
This one is just flat out loopy. If you live in the big cities of Australia, look at the CBD. See the names on those skyscrapers. All very real businesses, wouldn’t you say?
Think of your local Woolies or Coles supermarket. Been to Sydney Airport lately? Driven on a toll-road? Visited a Westfield shopping centre? And most of us have loans with a major bank. They all seem pretty real to me.
There’d be hundreds of businesses or buildings you would use or walk past all the time. And without realising, many of those will be owned by a company listed on the ASX.
So by investing in an Australian index fund for example, while you might only own a tiny part of each business, you’re an owner nonetheless!
Try walking up and caressing the exterior of your investment property. Your tenants will likely call the police! Do it at Woolies, and people just think you’re a weirdo (I’ve only done it once – shut up!).
You know the term I hate the most? Dabbling. When you hear of someone ‘dabbling’ in shares, you can almost guarantee they have no idea what they’re doing. And that it’s going to end badly.
Many people who get into shares, for some reason, forget all common sense. It turns from investing into gambling.
Looking for the next big winner. Taking a hot tip from someone at the pub. Does anyone really believe that’s a realistic way to grow wealthy?
We love a punt in Australia. So unfortunately, the way many newbies approach the sharemarket is more like buying lottery tickets. Buy a bit of this and a bit of that and hope one of them goes to the moon. That’s not investing.
So I’m not surprised your mate/relative/work colleague lost money in the sharemarket! The market is very good at separating people who don’t know what they’re doing from their money. But that’s really down to an individual’s behaviour, not the market itself.
After all, go back to the long term performance of the sharemarket.
The only way you’re losing money is if you’re gambling, rather than investing. Or your time-frame is measured in months, rather than decades.
So approach the sharemarket in a healthy manner. Think very long term. Invest regularly. Diversify. Keep costs low. Buy and hold. Don’t trade. Reinvest your dividends.
And importantly, ignore the media! Do this, and you qualify for those healthy long term returns.
Ahh, this is a very good point! Shares are quite risky, individually. Companies can and do go broke and fall out of existence.
That’s not really going to happen with an individual property in a half-decent location.
So how do we fix this problem? Diversification. The more companies you own, the less reliant you are on any one company remaining prosperous. So if you own lots, like 50 or more, if one or two go broke, it won’t even matter.
By spreading your money across a diversified portfolio, you will have exposure to a range of industries too. Healthcare. Real estate. Financials. Mining. Utilities. Industrials. And so on.
Luckily you can do this at very low cost, by purchasing shares in listed investment companies (LICs), which may hold shares in 100 different companies, or a broad index fund, which will hold the largest 200-300 Aussie companies.
Okay, I think we’ve covered most of the main worries about investing in the sharemarket. Now let’s look at some other reasons why you should consider using shares to create an income stream.
If you’ve bought and sold property, you know there are substantial sums to pay. On the way in and out!
Stamp duty by itself is horrendous. Then we’ve got selling (and maybe buyers) agent fees, solicitor costs, bank fees etc. But let’s forget that and focus on what affects our cashflow.
Recently, I ran through our property costs since we’ve been doing our tax. And it’s actually a bit worse than I thought.
On multiple properties, various costs chewed up around half of the rental income. And that’s without anything major going wrong.
Just things like painting, carpets, special levies and a longer than expected vacancy. For most people, I think the ongoing costs are greatly underappreciated.
Each property will need you to tip in cash regularly for repairs and maintenance.
In fact, as I was writing this, my property manager informed me one of our tenants is saying they have no hot water!
Anyway, when measured over 10 years and then spread out annually, these costs alone puts a decent dent in your expected cashflow.
Then of course we’ve got the yearly costs, in addition to the lumpy ones above. Council rates. Water rates. Insurances. Strata fees. Management fees. Land tax. Which leads to my next point.
Shares on the other hand, require absolutely no extra cash from you to keep producing income.
The cash you receive is yours to keep. Rents and dividends are not equal. Not even close. Here’s why…
Take a 4% rental yield. After all the costs listed above, it’s going to erode at least a third of the rent. Usually closer to 40% or more. So you’re left with a net yield of around 2.5%.
Take a 4% dividend yield. This comes with no costs attached. And in fact, it comes with franking credits (a credit for the tax the company has already paid on this money before paying you a dividend).
A fully franked dividend means a 4% yield becomes 5.7% with franking. These credits either cover any tax owing on your dividend income, or if you’re in a low tax environment, will be refunded to you at tax time.
On the face of it the yields look the same. But in reality, the rent ends up being less than half. To get 5.7% rental income, after costs and before tax, you’d need a yield of 9-10%.
Can you get that? Maybe. But it’d have to be an extremely cheap (higher risk) location, likely with terrible growth prospects and perhaps questionable tenants. So you’d be sacrificing growing income for an ultra high yield today.
Ignore franking refunds for a minute. You’d likely need a rental yield of around 7% to match the 4% cash dividend yield. And that dividend yield will come with 30% tax paid, whereas the rent will be fully taxable.
What about commercial property? These deliver higher yields. But then your wealth is concentrated in one or two assets, with higher tenant/vacancy risk. Not ideal.
In short, Aussie shares generally provide a much higher cashflow, once all costs are taken into account. You could argue that rents may be more stable than dividends.
But rents can and do fall too. Coming from Perth, I’m speaking from painful experience. Even our well-located Brisbane property has had a double-digit decline in rent.
It’s often pointed out that while Aussie shares have franking credits, property has depreciation benefits. So they both have unique tax benefits. But these aren’t equal either.
You’re allowed to deduct your property depreciating over time, because its condition is literally declining with every year that passes. So while it makes for a nice tax deduction, it also means – yep you guessed it… future expenses!
The other thing is, depreciation is a tax deduction. Franking credits are a tax credit. That’s very different.
One is a real (future) cost you can use to reduce your tax. The other is real cash with your name on it, sitting with the tax office.
In addition, the value of franking credits are enormous. As mentioned above, it literally adds 1.5% or more to your yearly cashflow yield, if you’re in a very low tax situation, like early retirement for example. Or franking will cover a large portion of tax payable, if you’re on a high personal tax rate.
Even if we assume depreciation is a free kick, it may shield around a 25-30% of your rental income from tax in many cases. But then regular tax is payable on the rest of your rent. So depreciation is a real cost, and in any event, the tax saved is small in comparison to franking credits.
Even considering the yield differences, are rents and dividends likely to have the same growth?
Personally, I don’t think so. Some time ago I looked at this, measuring rental growth versus dividend growth, from two old fashioned widely diversified LICs Argo and AFIC (which are a decent proxy for the Aussie sharemarket as a whole).
While I’m sure the numbers aren’t perfect, in my view, a low cost diversified LIC or index fund is likely to provide similar or better growth in income over time, given the spread of quality businesses.
Why do I say this? Well for one, companies reinvest some of their earnings to help grow future profits and dividends.
Rents and property prices can’t grow faster than wages forever. Or people won’t be able to afford accommodation. And wages can’t grow faster than company profits forever. Or companies would go out of business.
So, in a grossly oversimplified way, company profits (whether listed or private) tend to sit at the top of the chain.
This is where value is created, through efficiency and innovation, which enables companies to afford higher wages, leading to higher rents for property over time.
While both rents and dividends are likely to outpace inflation over time, I think dividends may grow a little quicker.
This point is obvious, but worth mentioning. Having the investment income you’re living off, coming from only a handful of properties is pretty risky business.
You can diversify between locations, that’s fair. But you still have considerable amounts of money invested in a highly concentrated way.
When you compare that to owning say, 100-300 businesses from all over the country, which dominate here and also earn significant revenue from overseas, the difference is stark!
You’re then exposed to different companies, industries and economies. Even if the properties are in nice locations, the diversification is almost non-existent.
With your diversified shares, if a company or two goes out of business, you won’t even notice!
This can offer a bit of extra peace of mind, knowing your money is spread around, rather than concentrated in a few assets.
After having experience with both asset classes, the admin side of things is also different.
While we have property managers taking care of things, there are still semi-regular emails to attend to. Something needs fixed. Someone is moving out. You get the idea by now.
On the buying and selling side, there’s also no need to deal with banks, brokers, agents or solicitors.
Costs are insanely cheap ($9.50 flat fee to buy or sell $5k or $500k of shares with the click of a few buttons with a low cost broker, versus tens of thousands of dollars and a mountain of paperwork with property).
With shares, I’ve noticed there is basically no emails or maintenance. Rental statements come with bills and a list of costs attached. Dividend statements come with no bills, and instead, come with franking credits attached!
Given the simplicity of this, it’s also easier for record keeping and tax returns. Very much hassle-free.
We’re outsourcing both the management of our properties, and the management of our shares. And the costs here also differ.
Property managers tend to charge around 6-9% of the rental income as a management fee, in most cases.
But when all fees are included (inspection fees, property condition reports, admin fees, GST, letting/leasing fees, advertising), the real cost comes out at around 10-15% or more. I was also surprised to figure this out recently, having never really run the numbers.
Letting fees are usually a big one (often 2-4 weeks rent), and it usually occurs every couple of years as tenants move. Do the numbers for yourself, if you think I’m making this up!
So let’s say we’ve got $1 million invested in an Aussie index fund (the ASX 300), managed by Vanguard. Vanguard charges 0.10% per annum of the asset value to manage the fund. The fees taken out will amount to $1,000 per year. There are even cheaper funds than this, by the way!
Let’s say we’ve got $1m savings in a couple of paid off properties. If we assume a rental yield of 4%, the rent before costs will be $40,000. The total management fees, being 10-15% of the rent, will be around $4,000 to $6,000 per annum, on average. This is a decent difference in itself. Possibly $5,000 per year in cashflow.
What’s more, for the higher costs paid, you’re still on the hook for all decisions that need to be made. But at least you’ve got that much loved aspect of control! Looks like a high price to pay. On the other hand, your index fund will ask nothing of you, ever.
Instead, those 300 companies you own are being run by people trying to increase profits year after year, while you kick back with your feet up and watch those dividends hit the bank account!
While the income will flow in each year for both, with shares there are no vacancies to worry about.
Under this example, if one of your two properties is vacant, you might be missing half your income while you find new tenants. A little stressful, to say the least.
This post is not anti-property. We still own a handful of properties, which we’re slowly selling down over time.
And I’m not saying everyone should be fully invested in shares. But I am saying, if you have a decent amount of equity and it’s providing you little to no freedom, there are other options!
This is about overcoming the hurdles and worries to share investing. You don’t have to stay stuck being asset rich, cashflow poor. There is another way. Hopefully I’ve helped you see that today.
If you’re currently a property investor or newbie to shares, please think long and hard about the points raised here. Consider how you’re actually going to escape the daily grind.
Maybe, like me, you’ll decide that your capital is better off being invested in a low cost and low fuss diversified share portfolio, generating a strong and tax-effective income stream to live on.
That way, you can move forward with the next chapter of your life, from the happy position of Financial Independence.
In a future post, we’ll look at how you might go about transitioning from property to shares and live off your accumulated assets. Stay tuned! Update: here’s that post…
If you know someone who might benefit from this post, please share it with them. And thanks for reading!