October 21, 2017
Building wealth is a pretty simple exercise. But retiring on that wealth is less simple.
Here’s what I mean…
First of all, consider a couple with their house paid-off, worth one million dollars. You could definitely consider them wealthy. This is a millionaire couple!
While it sounds good, it doesn’t do a whole lot for them with regards to financial independence.
Sure, they can probably just do some part-time work now and cruise along. But having a net worth of one million dollars didn’t make much difference. It was the fact that they’d paid off their house, reducing their future expenses that did the trick.
Unfortunately the couple still has to work, as they have no other sources of income.
You might know people in this situation. Since many Australian households are equity rich, cashflow poor, this scenario is pretty common.
As a nation, our obsession with owning residential property almost ensures this is the case.
Let’s compare two people.
One we will call High-Roller Harry. The other we will call Moderately-well-off Martin.
Harry has a net worth of $1.5 million. Martin has a net worth of $900,000.
Who is in a more financially independent position? Would you say Harry?
I’d say it depends. Since all we know about them is their net worth, we need more information.
What if I said they both have the same level of living expenses, at around $40,000 per year?
Then clearly Harry wins, right? I would say there’s still not enough details to draw a conclusion.
After all, Harry could have all his money tied up in a million-dollar home, a boat and a couple of cars. So really, he has no level of financial independence at all. He still needs to work to cover his living expenses.
He is fully reliant on his work income, because he has no other income streams.
Compare this with Martin, who has his entire $900,000 invested in shares. Since he’s renting, he has no money tied up in home ownership.
If he has a portfolio of diversified Australian LICs, he is likely to be receiving dividend income of around $50,000, once franking credits are included. Sure, he has to pay some tax, but this income will easily cover his living expenses.
To me, despite having a much lower net worth, Martin is in a much stronger financial position.
Because Martin’s entire net worth is put into income-earning assets, his living expenses are fully covered. He could declare himself financially independent.
Since he’s renting and doesn’t have any luxury cars in the driveway, people are likely to think he’s not doing anywhere near as well as Harry. Clearly another example of the Wealth Illusion.
But the truth is Martin is fully financially independent. And he can now spend his time as he pleases. In contrast to Harry, who has no level of freedom at all, despite being a lot wealthier on paper.
So it’s not all about equity. It’s about what that equity is producing for you. A million dollars can mean complete financial independence. Or it can mean not much at all. Maybe just a nice house and some cars… but little freedom.
My point is, don’t tie up your capital in assets that are not helping you gain more freedom. And clearly, all equity is not equal… make sure you park it in the right place!
Maybe you think it’s an unfair comparison, because Harry wasn’t an investor like Martin…
This time, let’s assume Harry is an investor too.
Since he loves owning property, we’ll give Harry a good-sized property portfolio worth $3 million, with $2 million of debt. So he has $1m of equity in his property portfolio.
We’ll also assume he still has his home worth $1 million.
So all up, Harry has properties worth $4 million, and $2 million of debt. Therefore his net worth is $2 million!
Pretty damn rich on paper. And arguably an enviable position to be in!
But is he financially independent? Let’s see…
His property portfolio is capital-city based and has a rental yield of around 4%. Since expenses tend to gobble up around 30-40% of the rental income, the net yield will likely be around 2.6%.
Because of expenses, net rent received on his $3m investment property portfolio is around $80,000 per year. The interest on his $2m of debt, at current record low mortgage interest rates of 4%, is also around $80,000 per year.
So all up, despite his large stable of assets, and multi-millionaire net worth, his total passive income is… zero dollars.
Therefore, with no investment income, his level of freedom is also zero!
He is still entirely reliant on his work income to cover his own expenses. And if interest rates go up from here, he’s footing the bill for that too.
He’s definitely a wealthy guy. But unfortunately, he still can’t escape his job in his current scenario. All his equity is tied up and providing him with no extra income whatsoever.
Now of course, he could sell-down some of his portfolio and start using his equity to create income. Although many folks wouldn’t do this, as it means paying Capital Gains Tax, and having a smaller portfolio of assets.
There’s nothing really wrong with this thinking, to be fair. But I think there are far too many people out there with oodles of equity, but absolutely no freedom.
Since property tends to be viewed as a sacred asset, that should never be sold, many people miss out on using their equity to achieve real freedom.
It probably also doesn’t help that the sharemarket is seen as some sort of crazy-casino, which it most certainly is not!
While Harry has plenty of options, I would say that our old mate Martin is still in a much stronger financial position at this point.
He has hit financial independence with a net worth of $900,000.
Since we will go through a recession at some point, Martin knows dividends may be reduced, so the buffer is there to top-up his income for a few years, until dividends recover.
With Martin receiving dividends of 4% fully-franked (5.7% gross), his portfolio will be producing around $46,000 per year in dividend income, and his cash buffer earning around $2,500 per year in interest.
All up he receives $48,500, and after tax he clears just over $40,000.
Of course, there are many variables here.
His dividends may be higher or lower than this. He’ll clear more after-tax if he holds half the shares in his spouses name. But to me, these are fair ballpark figures to go on.
Finally, with all his bills covered, we can be certain Martin has a much higher level of freedom and flexibility in his life than high-roller Harry. Because Martin focused on building income instead of equity, he’s now financially independent, despite a vastly lower net worth.
In this silly but point-proving example, our non-millionaire Martin is financially independent, and our multi-millionaire Harry still has to work. Since Martin and Harry chose different assets to park their money in, their outcomes are very different.
There’s even a good chance Harry makes a lot more equity over the years, since he’s using leverage to enhance his returns. But there’s a price to pay for this… his freedom.
He can only continue achieving (possibly) higher returns if he’s highly leveraged, which can only occur if he keeps working.
As I’ve mentioned before, with a strong savings rate, there is simply no need for leverage.
And in fact, even though we used leverage on our journey, by far most of our results came from saving.
And somehow I don’t think Martin cares too much how rich Harry is on paper. As Monday morning rolls around, Martin will be feeling truly rich, while Harry contemplates another week at the office.
In comparing these two scenarios, it becomes clear to me that it’s much more appealing to be income-rich, as opposed to just equity-rich.
Despite paying some tax, my new outlook is that it’s more useful, reliable, offers greater peace of mind on the road to, and during early retirement. In contrast to a strategy based solely on increasing asset values.
While the above examples may be too simplistic, I think the underlying message is important.
If we want to gain as much freedom as we can, as soon as we can, we do that by using all our available cash to create a strong income stream. And funnily enough, as the income stream from our investments grow, the value of those investments increase too.
So we aren’t missing out on capital growth by choosing strong income producing investments like shares.
After all, as the dividend income increases from our shares over the years, it’s because the company has made more money, which in turn makes the company more valuable – hence the value increases.
But really, this is the icing on the cake. Most importantly, our focus is on a strong and steadily growing income stream.
The truth is, we’re retired today because we decided to bite the bullet and begin selling down our property portfolio, to convert our equity into a dividend income stream.
For some, this may look like bailing out, or not being fully committed to our initial plan. After all, some treat a property portfolio as a big shiny badge of honour.
But our plan was not to accumulate properties forever and build mammoth pools of equity.
Since the very beginning, our plan was financial independence as soon as possible.
It just so happens, that along our journey we found a better way (for us) of doing things, to reach our ultimate goal faster. And if that meant accepting we needed to change our strategy and adapt to the new information we learned, then so be it.
Today, we’re much better off for swallowing our pride and changing our approach. Maybe not financially, but we live a much richer life now, measured in freedom and happiness.
And as you can see, it’s not so much about how much equity you have or even being a multi-millionaire. It’s all about what your equity is providing for you!