Why living off equity is dangerous
One of the strategies that is regularly advocated in the property investment sphere is living off equity. However, I believe this strategy is fundamentally flawed and here is why.
Your debt keeps growing
Firstly, your debt is forever escalating.
Plus, there will come a point in time — such as now for example — when the lenders might turn around and simply say “no” and that means there is no more money for you to live off on.
Secondly, it basically locks you into a job, because the first criteria banks look at is your ability to repay the loans.
The thing is this strategy was developed when low-doc loans were easy to get approved, but that is no longer the case.
Property selection was also paramount — as it always is — because it had to grow strongly to be able to extract the equity.
As an example, let’s consider someone with a portfolio of five properties that each grows in value by $100,000 per annum.
The strategy supposedly works by extracting $80,000 from one property one year and then the next year you do the same with the second property and so on and so forth.
The thing is it works perfectly — but only on paper.
Wealth reduction
However, what happens when there is a GFC or the debt is so high that your rental yield drops to one or two per cent? How are you going to service the debt, because at the end of the day you will need to pay the loan down?
That is the biggest flaw with this non-strategy because you’re basically funding your lifestyle with debt. What you’re doing is actually spending your wealth rather than your cash flow. You’re slowly eroding your net wealth.
I would rather that you maintain your wealth and spend your cash flow, which involves paying down the loans or not touching them at all.
That’s because over a period of time, when you hit that inflection point where the rent surpasses the expenditure, you’re preserving the original loan amount while your property continues to grow in value.
Eventually, you’ll have positive cash flow to fund your lifestyle.
As an example, the very first property I bought was $137,000 and the rent was $285 per week. Today, 20 years later, that property is probably worth about $700,000 and the rent is $440 per week.
If I had preserved my debt, then the rent more than services the debt and there is still money left over, too.
If you have multiple of those scenarios, you could obviously live off that income — but you would need a large number of properties to do so.
So, to reduce the number of properties required to do that, instead of waiting for that inflection point, you could force the loans down by either developing or selling some to reduce the debt.
Then you can live off the income, rather than living off the equity.
At the end of the day, if you’re double-dipping into your equity, by the time you retire there is no significant wealth left. Plus, if there was another GFC, then you’re pretty much cactus.
You always must be mindful of the strategy that you’re undertaking to ensure that it will weather every market cycle.
That way you’re able to sell yourself out of trouble, but more importantly you’ll be able to hold your portfolio over the long term with your current cash flow — regardless of the market conditions at that point in time.
