The Situation

Carina walked into my office early this year. She’s a successful businesswoman in her late 30s. Currently, she owns two properties – her own home and an investment property on Waiheke Island.

She bought the Waiheke property 10 years ago for $1.2 million, which is now worth $2.2 million. This property earns $45,000 in rent per year and has a mortgage of $850,000.

On top of this she’s saved a significant amount of money. She has $100,000 in shares and $390,000 in cash.

Her goal was to build a passive income of about $100,000 over the next three-tofive years. She wanted to know whether this was realistic, and what strategies she could use to create this passive income using a passive buy-and-hold strategy.

The Challenges

The first challenge was the low yield of the Waiheke property; $45,000 in rent per year ($865 a week) sounds like a lot of money, but when compared to the property’s value, the gross yield is a measly 2%.

So this is not the sort of property that would build Carina – or any investor – a sizeable passive income.

We then modelled the cashflow over 15 years. And although the property would have had positive cashflow of $105k before the government’s interest deductibility changes, after the changes are phased in the story is completely different. Over the same 15 years the property was now forecast to be negatively geared by $50,000.

On top of this, some typical strategies wouldn’t fit this situation. For instance, we would usually consider selling her shares to pay down debt to increase cashflow.

However, as these had recently dropped in value, doing so would crystalise her losses. So, we were determined not to sell these as part of this plan.

The Changes

Because Carina’s Waiheke property had a poor yield, her first move was to sell it. After paying the real estate agent, we estimated she would walk away with $1.25 million in cash.

Because she also had $390,000 cash on hand, she’ll have $1.64 million to invest without taking out a mortgage.

We’re now in the process of buying three dual-key apartments. These multi-income properties tend to be high yielding and are the right fit for investors looking to build a passive income.

The three we’re considering range in price from $789,000 to $915,000. One’s in Wellington, and two are in Auckland.

The plan is that two of these properties will have no or very low debt. Together these will produce an after-tax cashflow of $41,000 per year. This free cashflow will then be used to pay down the debt of the third property.

Aggressively paying down the mortgage will decrease her costs and increase the passive income she could earn on her properties.

Once she’s ready for her passive income to start, she’ll refinance and restructure her debt to use Resimac’s 20-year interest-only product. This will give her certainty that her mortgage costs won’t change any time soon for the little debt she’ll have left.

The Impact

Based on our modelling, in five years Carina will have just under $2.3 million worth of net assets (assets – mortgages).

If she can earn a 4.5% net yield on those assets, she’ll make a passive income of $103,300 per year (all adjusted for inflation).

This will allow her to grow her business, knowing that her rental properties pay her living expenses.

The Lessons

There are a couple of lessons here:

• If your goal isn’t that far away (less than five years away), then you can’t rely on capital growth alone for your passive income strategy. Sure, over the long term the market tends to increase, but in the short term it may not. That’s why Carina is pursuing a strategy focusing on reducing debt

• You need to assess your rental property’s yield on today’s value, not based on what you purchased it for. Carina’s Waiheke property earned her a lot of equity, but wasn’t a cashflow focussed asset

• If you want to build a passive income, you need to get rid of mortgage debt. This will reduce your costs so that your investments produce cashflow.

In all my columns I mention creating 15-year cashflow projections. You can download the spreadsheet I use – minus a few special features – here: opespartners.co.nz/roi

Disclaimer: Just remember this is a column in a magazine that goes out to thousands of people. It’s not personal financial advice. But it is an example of what happens when you get personalised financial advice. So, if you’d like me to create the above analysis for you, come see me. At Opes I offer a portfolio analysis for $999 incl. GST. Email Andrew.nicol@opespartners.co.nz to book.