BUILDING YOUR ASSET BASE

Strategically, we feel most people should initially be overweight in property and with the use of leverage.

This is best done via your principal place of residence (PPOR) and/or residential investment properties.

This is a way of growing your asset base, in a relatively passive way, by leveraging into an asset class that is relatively safer and easier to leverage in.

We also suggest you start doing so as early in your investing lifecycle as possible, when you may be younger, have a higher income earning capacity and higher capacity to leverage, and a longer time to recover from any potential negative outcomes.

The income from these assets is initially a secondary consideration and is mainly used to service the loans against the properties, as at the outset we are mainly investing in them for their longer-term capital growth potential.

We need to build up enough capital early on while in the “accumulation” or “growth” phase of investing, so as to be able to invest in passive income-generating assets in a meaningful way later on, when we really need that passive income.

After accumulating some residential property assets, we feel you should then diversify more into either shares or commercial property depending on your financial position, and avoid too much concentration of your assets in residential property.

And whether you invest in shares or commercial property, residential property has an important strategic role in being a low-cost way of financing share and commercial property investments due to traditionally relatively low interest rates available for loans secured against residential property.

CONVERTING YOUR ASSET BASE INTO AN INCOME STREAM

Later on as you approach retirement or the need for passive income becomes more necessary (the timing of which can be hard to predict), we feel people should be more overweight in shares and commercial property (with less or no leverage, and either directly or indirectly), and with a much smaller weighting towards residential property (ie. PPOR and investment properties).

This re-weighting process can occur gradually over time by leveraging off residential property into shares and commercial property, and/or by gradually selling residential properties and using the proceeds along with your cash savings and/or borrowings to invest in more shares and commercial property.

The main reason for doing this is that we feel shares and commercial property are better assets for generating a higher passive income stream that grows faster over time; whereas although residential property can be good for long-term capital growth, annual property expenses can vary significantly each year, leading to a lower, more variable and less predictable net rental income, and one that may not grow as fast as share dividends or commercial property rents can.

When comparing share dividends with commercial property rents, share dividends tend to grow faster as they are tied to business earnings growth which tends to be faster, but are generally paid only twice a year, and may potentially fluctuate more depending on the particular shares purchased.

Commercial property rents usually increase by at least the rate of inflation, but may grow faster depending on market rates and lease terms, as well as any value-add/renovation/development that can be done to the property and any change to the zoning and/or permitted use that can effectively “re-set” the rent to a much higher level.

This is the “control” aspect of commercial property that, in the right person’s hands, can create a significant advantage over listed company shares; but doing so in the first place requires a much greater financial capacity and risk tolerance, and a more “active” investment approach compared to shares which are a far more passive investment in this sense.

Furthermore, depending on what type of commercial property you invest in rents may be paid monthly (usually with direct commercial property), quarterly or twice-yearly (usually with indirect commercial property), and may be more stable.

Monthly and quarterly rent payments in particular can help smooth out cash flows and complement twice-yearly share dividend payments.

This is one of the key reasons we like investing in both shares and commercial property together, ie. to generate a regular, reliable and predictable income stream.

Further to this, when you are in or nearing retirement we feel that having less or no leverage is better to reduce your overall risk levels – so although using leverage is important initially, at some point you need to stop or slow down from taking on more debt and start to reduce debt.

Some lower-risk and smaller allocation to cash, term deposits and bonds can also be used to provide a regular monthly income.

ALLOCATED INCOME STREAM

In terms of deciding how to allocate funds between shares, commercial property and cash/term deposits/bonds when needing a passive income stream, as a basic guide we suggest that the amount needed to give you the minimum monthly income you need to meet your basic living expenses be held in some combination of commercial property and cash/term deposits/bonds.

This will give you a regular, reliable, predictable and monthly or quarterly income stream you can consistently use to meet your daily living expenses.

The rest of your capital can be held in shares, and the dividends received can be considered as a bonus income (paid twice-yearly) that can be used to further improve your lifestyle.

The more dependent you are on your investment income to meet your living expenses, or the older you are and less tolerant of risk you are, the more overweight you should be in commercial property and cash/term deposits/bonds to meet these living expenses.

Having said this, if you have a very small amount of capital with which to invest, investing a lot of it in cash/term deposits/bonds may result in a very low income due to the lower yield on these assets, and as such you may have to take on more risk with your limited capital by weighting/tilting it more towards commercial property and shares to generate enough income to meet your living expenses.

If you are less dependent on your investment income (eg. due to having other sources of active income, as your living expenses are a very small proportion of your investment income, or as you are eligible to receive the government aged pension as another source of income), then you may potentially be able to afford to be more overweight in shares.

Or, if you just have a very large capital base of shares, then the dividends from this alone may be enough for you to live on despite the potential fluctuations in dividend amounts and twice-yearly dividend payments.

Alternatively, if you have a really, really long-term time frame, ie. multi-generational and/or indefinite, then it makes even more sense to be more overweight in shares – again as dividends tend to grow faster as they are tied to business earnings growth which tends to be faster.

The overall approach here with respect to developing a passive income stream is to choose the right form of income stream that meets your objectives, circumstances and risk tolerance, and to diversify that income stream appropriately.

So diversification is seen from a non-traditional perspective, where usually it is used for capital diversity and to improve total portfolio returns, reduce capital volatility and capital draw-down risk.

For passive investors, it is the regularity, reliability and predictability of the income stream that is paramount.

There are lots of variations to all of this and this is just a basic guide; you can do something similar or in between depending on your personal situation.

A MORE DETAILED AND PRACTICAL EXAMPLE

We will elaborate further on what we have discussed above now with a more in depth look at creating and implementing a passive income stream for retirement.

To start off with we suggest having at least 3-4 years of basic/essential daily living expenses in a secure and liquid combination of cash, term deposits and bonds (with staggered investment terms, and re-investing all interest income received).

You could use up to 1 years worth of this for the first year of retirement while waiting for regular investment income (ie. from interest, dividends or rents) to come in that year (ie. this is the “timing effect” of the first year of retirement).

And then keep the remaining 2-3 years worth of this amount as your long-term cash buffer to be tapped into only in case of a significant drop in investment income.

We assume here that any reduction in investment income will recover in this time-frame, and is unlikely to go to zero for this long anyway, ie. it is more likely to partially drop so this long-term cash buffer may actually supplement a reduced investment income for many more years.

Having said this we also don’t think you should have too much funds sitting in cash or short-term cash equivalents due to inflation risk, so a balance is required here.

The rest of your capital could be allocated towards some combination of shares, commercial property and also more cash/term deposits/bonds depending on your individual circumstances, risk tolerance, personality and income requirements.

This capital will generate the investment income you need to meet your annual living expenses.

We would also only spend or re-invest investment income after first topping-up any long-term cash buffer shortfalls to certain minimum required levels first (eg. to 3 years worth of basic living expenses).

And although not essential, if possible we also suggest gradually building up a separate investment cash reserve to invest further at times when share and property markets are very undervalued.

This could be built up slowly before markets start to peak by saving a portion of your investment income for this purpose.

In the example below, we will use commercial property rents to cover annual basic living expenses (on top of the long-term cash buffer), and share dividends for any extra income above this.

In the example below we assume the following:

Annual basic living expenses = 50k p.a.
Initial long-term cash buffer setup = 50k x 4 = 200k (ie. 4 years of basic living expenses).
Ongoing long-term cash buffer = 200k – 50k = 150k (ie. 4 years of basic living expenses minus consumption of first year of retirement’s basic living expenses).
Lump sum to provide for ongoing annual basic living expenses = 50k / 8% net commercial property yield (assumed yield) = 625k.
Additional/discretionary/long-term income = 50k p.a.
Lump sum to provide for additional/discretionary/long-term income = 50k / 6% grossed-up share dividend yield (assumed yield) = 833k.
So in this case 100k p.a. of total investment income is generated by 1.458M of capital (at ~7% yield).
Of the 100k p.a., 50k p.a. is used for basic living expenses and 50k p.a. is used for additional/discretionary/long-term income.
And this is with an initial 200k to setup a long-term cash buffer, so a total of 1.658M capital is required to implement this.
This assumes full retirement with 100% passive income and no active income.
And excludes any investment cash reserve at the beginning.

The above example is of course just one way of constructing a passive income stream, and you can modify this in many different ways eg. by only using commercial property rents or by only using share dividends for all of your investment income, by using any other combination of cash/term deposits/bonds and commercial property rents and share dividends for your investment income, or if you have a very large amount of capital and wanted to be more conservative you could generate all your of investment income just through interest from cash/term deposits/bonds and invest the rest more aggressively with less of an income focus and more of a total return focus.

In general the less capital you have the harder things get, in that on the one hand you may be more dependent on your investment income so you don’t want to take on too much risk, but on the other hand if you don’t take on much risk (ie. by investing in shares and commercial property for instance) you may not be able to generate enough investment income to meet your living expenses.

WHAT ABOUT RESIDENTIAL PROPERTY INCOME?

Although we have down-played the role of rental income from residential property when creating a passive income stream, having a few residential investment properties generating some net positive cash flow on the side certainly won’t hurt!

Our approach with this asset class has been to use it primarily for three things: capital and equity growth, a low-cost source of finance to leverage into shares and commercial property, and to meet certain lifestyle objectives, eg. having a property that you can sell to help pay off your PPOR loan, a property that you can downside to later in life and a property or two that could be used as a form of inheritance for your kids.

So if you have created enough passive income to meet your living expenses through the ways we have suggested above, then holding on to a few residential investment properties for some extra income, long-term capital growth and to meet some lifestyle objectives also makes a lot of sense.

A NOTE ABOUT ASSET CLASS RISK

When considering the risks of different investments, sometimes it is worth thinking of the risks in terms of a particular investment and the income it generates, rather than the asset class to which it belongs.

For example, some dividend-paying shares and commercial property investments may be more “bond-like” in terms of their risk profile/characteristics than other investments in those respective asset classes.

So rather than brushing all individual investments in a particular asset class as higher risk, it may be worthwhile paying closer attention to the specific nature of the individual investments concerned.

THE ROLE OF SUPER

Also, as you get closer to your super preservation age, eg. 60 y/o, moving and having more of your investments in the super tax structure becomes more effective.

We suggest that from as early as 40-55 y/o onwards, a much greater focus needs to be placed on gradually moving assets held outside super into super, and making more contributions (deductible and non-deductible) and future investments in the super structure.

There is of course always legislative risk when investing in a long-term investment structure like super, but we feel that for the foreseeable future the tax advantages of this structure are too compelling to ignore.

When balancing the amount of assets held outside super versus inside super one approach would be to have assets outside super that generate enough income to meet your basic living expenses today, and then have all further assets inside super.

Another approach would be to have assets outside super to a point that the income they generate exceeds you and/or your partner’s combined tax-free thresholds, and then have any other assets inside super for long-term tax-effectiveness.

INFLATION AND LONGEVITY RISK

More broadly speaking, we encourage a strong focus on using the growth assets of residential property, shares and commercial property to best manage two key risks all investors face, which are inflation and longevity risk.

Over the long-term, inflation will eat away at the returns you will get from cash, term deposits and bonds.

There is one small exception to this though, which are inflation-linked bonds, which we will discuss in more detail later on as this website develops.

And if you live as long as 90, 95 or 100 y/o, having most of your investments in these conservative assets could result in your money running out well before you do – ie. longevity risk!

Our strategic focus on developing a passive income stream means we will not have to worry about selling assets due to short-term fluctuations in capital values and needing to sell assets in depressed markets (eg. like the Global Financial Crisis) to survive and meet our income needs.

CONCLUDING THOUGHTS

We have spent a lot of time here discussing our overall big picture investment strategy and asset allocation approach as we believe that this is central to successful long-term investing.

A significant body of academic evidence suggests the two biggest factors influencing your long-term investment returns are asset allocation and costs – get these two right and everything else is just icing on the cake!

Sure, you still need to pick a good property or stock, but you don’t have to get this perfectly right!

Note that our strategy is a general guide only, and that each person needs to adapt it to their own situation, needs, risk tolerance and personality.

Also, having specialised skills and expertise in certain areas may mean you may be better off re-weighting your asset allocation strategy to play to these strengths, rather than follow our suggested strategy prescriptively.

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