July 10, 2020

Property investment: 4 exit strategies

OpenCorp

By Cam McLellan, Director & Co-founder

When it comes to property investment, like many other endeavours in life, it’s critical that you begin with the end in mind.

Not having a clear view of the outcome you’re trying to achieve can potentially derail your efforts: you’ll more likely be distracted and may stray from your path of systematic investment.

Remember to ask yourself from the get-go: what is my vision?

Get that clear, then it’s time to meet with your accountant to ensure you create the correct investment ownership structure. It’s important you do this before you start investing. See, you’re already starting to think long term!

Okay, with this in mind – let’s continue with the theme.

I’ve listed below the four main exit strategies that will suit most people. Again, talk to your accountant about your initial set-up and holding structure as it will have a bearing on your exit strategy, especially the timing. N.B. I’ll discuss the use of trusts at a later point.

Here are the four main exit strategies, as I see them:

1. Sell to pay off your debt.

There are some pros and cons to this strategy. Some people feel they must be debt-free, that their only financial goal in life is to pay off the family home.

But here’s the thing: trying to achieve this goal using earned income – that is, paying off the family home over 25 or 30 years using savings from your work salary – is a tough call. Indeed, I’d go as far to say it’s a waste of time. I can appreciate why people think this way; we’ve been conditioned to this way of thinking by our parents, and society as a whole. But just because it’s something that our parents told us doesn’t mean it’s something I’ll encourage you to do.

The good news is paying off your own home can be a lot easier than you think if we work smarter.

I’ll make this a very simple example, with very basic figures to show you how it’s done.

Let’s say that you only ever make three property purchases: two well-chosen investment properties, purchased at $500,000 each plus the family home, also purchased at $500,000. This is what our portfolio will look like:

Value of x2 investment properties – $1,000,000
Value of the family home – $500,000
Total property value $1,500,000

For simplicity, we will assume the total loan amount is also $1,500,000.

Remember you will have the help of the government’s taxation laws around negative gearing plus your tenants will obviously be contributing to the repayments of this substantial loan amount.

As a general rule, experience tells us a well-chosen property will double in value approximately every 7–10 years. This being the case, all that’s required to be debt-free on the family home is to hold the investment properties through one full growth cycle, and then sell them at a profit.

This will mean your two investment properties will increase in value from $1,000,000 to $2,000,000, remembering that the total debt on all three properties is only $1,500,000.

Again very simply, if you were to then sell the two investment properties at this point for $2,000,000 you would incur capital gain tax of 25% on the profit from the sales (25% rather than 50% as these properties will have been held for a period longer than 12 months). The remaining amount available to reduce debt after tax therefore will be $1,750,000.

You are now able to pay back the entire debt on the investment properties and also the debt on your own home. This also leaves an additional $250,000 for you to play with. I’m sure you’ll think of something to do with the extra money!

(I explain this concept in more detail in this video)

Again, this is a simple example and not my recommendation. Remember, this is good debt and if the rent is covering repayments, then you should ask yourself: is your desire to reduce your debt a matter of your conditioning to believe that all ‘debt is bad’?

2. Move one of your loans to principal-and-interest (P&I)

Strategy #2 is to move one of your investment property loans to principal-and-interest, or keep it as interest-only but start paying off the principal from the excess cash flow.

Once this property is free of debt, you can then channel your excess cashflow – which should now be a greater amount – towards your total debt as the interest repayments have been reduced by paying off one property. This means the next property you’re focusing on should be paid off in an even shorter time. We call this the ‘domino effect’.

As each loan/property is paid off, cashflow improves and subsequent loans are paid off faster until there’s no more debt. This is a reasonable strategy to use while you are still working as it will ensure you will have a solid income in retirement.

To truly become debt free or to fast track this situation, you may need to use the selling exit strategy detailed above in conjunction with the domino effect.

3. Focus on interest-only payments (and live off equity and rental yield gains)

The first two strategies are not my preferred options. Personally, I prefer to make interest-only payments and live off the equity gains and increase in rental yield.

A question nearly everyone asks is: “When and how will I end up owning all these properties?”

A better question would be: “If your investment properties are supporting the loan repayments and providing enough usable funds to live off, why do I need to pay them all off at all?”

I get it. Most folks want a concluding and final exit strategy that revolves around debt reduction, which is why I have listed the strategies above.

An alternative idea may be to simply keep your portfolio at a positive (or neutral) cashflow position and leave it to increase in value, in turn allowing you to live off the equity gains. If the value of your portfolio increases on average at a rate faster than that of your yearly expenses, this may be a satisfactory position for you.

4. Hand over your property investment portfolio to your children

This final strategy involves handing over your investment properties to your kids (if they are smart enough not to lose them!). This may be in conjunction with any of the above strategies.

Transferring control of your portfolio, if held in trust, is simply a matter of appointing a new company director. The actual asset never changes hands, so no tax is incurred. You are simply signing across control of the asset’s holding entity.

With any exit strategy, the right trust ownership structure is very important. This is why, as we stressed at the beginning of the article, it’s critical you start with the end in mind.

Remember, your portfolio will be equity rich and positive in cashflow by the time you have to make an exit. An exit strategy is all about minimising tax and maximising returns.

ROUNDING UP: