June 30, 2018
Welcome to the first reader case study on Strong Money!
This series will look at different reader’s situations, and see if we can come up with a way for them to create more freedom in their life than what they currently have.
While acknowledging I’m not a financial advisor, this is about throwing ideas around and giving some perspective on what I might do in a similar situation.
Any suggestions from you – the readers – are most welcome too!
Our first case study comes to us from Daniel* in Sydney. He’s 32 years old and single, working towards financial independence. But he’s not quite sure where the finish line is.
Let’s take a look at his position…
Current Work Income (After Tax):
Current Living Expenses (Including Rent):
Investment Property Equity: $923,000 (see details below)
Vanguard Shares: $20,000
Argo Shares: $5,000
Cash Savings: $50,000
Vintage Car: $40,000
=Net Worth: $1,038,000
Investment Property Figures:
Property Value: $1,200,000 (conservative according to Daniel)
Loan Amount Owning: $277,000
Rent: $41,600 ($800 per week)
Strata Fees: $6,400
Management Fees: $2,500
Council + Water Rates: $2,500
Repairs + Maintenance: $2,000
Vacancy: $1600 (2 weeks per year)
Annual Rental Income: $26,000 after expenses
Loan Repayments: $20,400 ($1,700 per month)
Positive Cashflow After Loan Repayments: $5,600 per annum
As we can see, Daniel is quite wealthy at this point. In fact, he’s a millionaire. But he’s realised it’s not much fun being Equity Rich, Cashflow Poor when you want to retire early.
He’s already winding down his work situation and wants to quit his part-time job as soon as possible to give him space to relax for a while and do his own thing.
While I don’t have all the juicy details, Daniel is living an impressively low-cost lifestyle in Sydney. The next thing to note is, the cash tied up in the Vintage car can probably be put to better use!
Unless it’s an important family treasure with huge sentimental value, there’s little reason to keep it. Sure it may appreciate in value, but our reader needs to start collecting dividends, not dust!
What do you think? Can Daniel declare freedom at this point? Or should he stick at it for a while longer?
Well, leaving things the way they are is probably not a good idea. Although there’s over $900,000 of equity in the property, it’s only providing $5,600 of income each year. Something needs to change.
Even if he somehow manages to pay it off, the rental income is still not enough to live on. After costs, the net yield from the investment property is just over 2%. Certainly not an ideal income stream for early retirement.
After some extra correspondence with our reader, he told me this property used to be his home, which he’s rented out for the last 5 years.
This is wonderful news! Daniel can actually sell his property and pay absolutely no Capital Gains Tax. How?
Currently, the ATO allows you to still claim the CGT exemption if you sell your home within 6 years of moving out, even if you use it to earn rental income during that time. Here’s the ATO explainer.
Of course, our reader will have to pay selling agents fees and settlement costs, which would likely amount to around $30,000 – $35,000 (commission is likely to be around 2.5% and the remainder being settlement costs).
So after selling the property, Daniel would be left with around $890,000 in cash, free and clear. And if he decides to sell the vintage car, he’ll have a total of $930,000 of investable cash.
So far his portfolio contains some income-producing shares already, including Argo.
The best way for Daniel to maximise his passive income in a diversified and simple way, could be to plough his property proceeds into low-cost dividend-paying funds like an Aussie index fund or LIC like Argo, for example.
This would take the portfolio of shares up to $955,000. At an average yield of 4% the dividend income received would be $38,200 per year, along with franking credits of up to $16,300.
Under current franking rules, this gives a gross income of $54,500, and an after-tax income of $44,365.
If franking refunds are abolished, Daniel would still receive his $38,200 of dividends and pay no additional tax.
In both scenarios the dividends cover his spending and he still has some cash set aside for a rainy day.
Initially, our reader raised some concerns about a sharemarket downturn and how that would affect his income. The assumption was the property income would be safer. Let’s see.
For this example, we’ll pretend Daniel has paid off his property worth $1.2m.
If there’s a recession and we assume property rents stay stable, Daniel would earn $26,000 from his property. The same $1.2m would be earning $48,000 in dividends, plus franking credits.
But if we assume dividends drop by 30% in the recession, Daniel would earn $33,600, plus franking credits – still much higher than the rent.
So while the property income might feel safer, the numbers don’t make much sense. Leveraged property can create large wealth, but it’s notoriously bad at generating income.
Since share prices move around constantly, and they mention it on the news every bloody day, we think it matters. It doesn’t.
What matters is the companies going about their daily business, and the earnings and income they generate over the long term. That’s how they create wealth. And those long term earnings and dividends are generally more stable than share prices.
That’s why focusing on the growing dividend stream is a more reliable strategy and easier to stick with, rather than worrying whether your retirement is going to be affected by fluctuating markets.
After further discussion, Daniel even shared that he was looking at moving out to a bush-land area where he’d have more space to relax and grow his own food. And he said this would also drop his living expenses dramatically.
So it seems Daniel is definitely ready for early retirement.
By massively increasing his investment income through dividend-paying shares, reducing his expenses and keeping some cash on the side, it looks as though his situation is shaping up to be pretty rock-solid.
Even in a worst case scenario, a very small amount of part-time work will easily smooth over any bumps in the road. This is unlikely to be necessary though, given his passive income looks set to be much higher than his expenses.
The only other thing he could do to boost his safety margin is increase how much cash he holds. However, this will decrease his dividend income, so it comes at a slight cost.
Another decision to make is whether Daniel invests the lump-sum all at once, or drip feeds it into the market on a monthly basis via dollar-cost-averaging.
Statistically, research shows the lump-sum approach to be superior most of the time, although we just don’t know the future. He may invest all the money and then the market drops, meaning he could’ve got a much better price when buying in.
To avoid regret, many people (myself included) would use a combination of lump-sum and monthly investing. There’s a trade-off in Daniel’s case though.
The slower he is to put the money in the market, the longer he has to work. That part is up to him. But there’s probably a happy medium in there somewhere and investing large sums of money is not something you want to rush.
Some of the main takeaways are things we’ve discussed here on the blog.
It’s crucial your equity is put to good use in creating a strong income stream for you to live on. Being equity rich, cashflow poor leaves you stuck in your job, albeit with the warm and fuzzy safety of property. Even if sharemarkets crash, dividends are much more stable than share prices, as we saw with AFIC during the GFC.
And finally, lower expenses are your fastest ticket to financial independence. Clearly Daniel has mastered the art of killing his bills!
Hopefully you enjoyed our first reader case study. Let’s wish Daniel all the best on the next chapter of his life, and congratulate him on his upcoming freedom!