Passive Income – what’s your target?

Passive Income

In my last post I explained the primary reasons as to why you should consider buying investment properties. You can create long term wealth, set yourself up for financial freedom and take full responsibility for a self-funded retirement by creating a Passive Income.

In this post I am going to outline how a portfolio of properties could achieve this, but first lets reiterate what financial freedom is:

Financial freedom is achieved when your Passive Income is greater than all your expenses after tax.

Everyone has a different personal situation and future goals. You should work out what level of Passive Income you would like to achieve to meet your future goals. You might want a modest Passive Income that just supplements your regular income or you may aspire to replace your entire salary.

Passive Income Strategies

I am going to outline three different strategies available to produce a Passive Income from property investing. The first is when you have a high positive cash flow across your portfolio. This is where the rent you receive is much greater than all your property expenses. The difference between the two is net Passive Income.

The second strategy is to sell all your investment properties at some point in the future and pay off any remaining debt. You can then invest the proceeds into an interest bearing account. The regular interest you receive then becomes your Passive Income.

The third strategy might be a combination of both. You could sell a portion of your investment portfolio and use the proceeds to reduce the debt on the remaining properties. This would then give you a much greater positive cash flow than you previously had. You continue to receive a Passive Income from your remaining properties and they continue to grow in value.

The strategy you go for now might change over time but what’s important is setting a target that you can aim for. The easiest goal to set now is a net worth figure that you would like to achieve at some point in the future. You can use the second strategy of selling down your portfolio to estimate a future net worth and therefore a Passive Income.

Future Net Worth

Today the average salary in Australia is about $80,000, but considering inflation we will use a Passive Income target of $100,000. To achieve this you would need a net worth of around $2 million after selling all your properties and investing the proceeds into a cash investment paying 5% interest. This might sound like a high net worth now, but we know from using the power of leverage and compound growth that over at least a 15 year period this can be achievable.

Despite what some property spruikers out there might tell you, investing in property is not a get rich quick scheme. If you set aspirational goals, formulate a plan and carry out your strategy over the long term you can build substantial wealth from property.

Example Portfolio

The table below shows an example portfolio where a $400,000 investment property is purchased each year for five years and allowed to grow over the long term. You can see the capital growth increasing on average each year whilst the total debt remains the same after the fifth property purchase. This results in a net worth position of $2 milllion after 15 years which could equate to a Passive Income of $100,000.

 Total AssetsTotal DebtEquityGrowth @ 5%
Year 1$400,000$320,000$80,000$20,000
Year 2$820,000$640,000$180,000$41,000
Year 3$1,261,000$960,000$301,000$63,050
Year 4$1,724,050$1,280,000$444,050$86,203
Year 5$2,210,253$1,600,000$610,253$110,513
Year 6$2,320,765$1,600,000$720,765$116,038
Year 7$2,436,803$1,600,000$836,803$121,840
Year 8$2,558,644$1,600,000$958,644$127,932
Year 9$2,686,576$1,600,000$1,086,576$134,329
Year 10$2,820,905$1,600,000$1,220,905$141,045
Year 11$2,961,950$1,600,000$1,361,950$148,097
Year 12$3,110,047$1,600,000$1,510,047$155,502
Year 13$3,265,550$1,600,000$1,665,550$163,277
Year 14$3,428,827$1,600,000$1,828,827$171,441
Year 15$3,600,268$1,600,000$2,000,268$180,013

Again, I have used a conservative capital growth rate of 5% and assumed that none of the investment debt has been reduced over the 15 year period. In reality, once you have eliminated all personal non deductible debt, you can start to reduce your investment debt. If you have a positive cash flow portfolio this can speed up the rate at which you can reduce your loans too. Therefore your net worth position could be much higher in 15 years or a target Passive Income of $100,000 could be achievable with a smaller portfolio.

Summary

A Passive Income of $100,000 is an aspirational number and buying five $400,000 properties in five years is a big target. Not everyone will be in a position to undertake this, but what is important is setting a target that is realistic to you. If you were able to achieve a Passive Income of $50,000 in 15 years this would still make a huge difference to your financial wellbeing.

When a portfolio of properties combines leverage and compound growth for the long term, significant wealth can be created. What is your Passive Income target?

 

7 Comments

  1. Good blog. Makes you realise that setting a passive income target is one of the most important goals when starting and building your property portfolio .

  2. How does the networth jump so much in the early years? Are the property deposits being funded out of savings?

    I think a more realistic example would be perhaps 2-3 properties in the first few years at 90-95% LVR and then waiting for a property cycle before borrowing against the equity to fund further purchases.

    • Michael Ossitt

      June 20, 2016 at 8:26 pm

      Hi Jack, thanks for the comment. Apologies, the 4th column should read ‘Equity’. The assumption is that the deposits are funded from existing equity that a home owner might be sitting on (as per my first blog post) along with any savings that can be committed. As I suggested not everyone is going to be in a position to purchase 5 properties in 5 years, especially if existing equity is not available.
      Your example is certainly more suited to someone with no equity and using a higher LVR for the first 2 or 3 properties to then leverage into further properties down the track. Using a 5 or 10% deposit is a personal decision and should reflect your appetite for risk and your personal risk profile.
      My preference is to use a 20% deposit as it gives you a bigger safety margin in your portfolio but I appreciate that for someone who needs to leverage more aggressively to get started then a higher LVR might be appropriate. Thanks, Michael.

  3. Im a bit confused. IN this scenario, where is the passive income drawn from? If the person is still servicing $1.6mill in debt, at lets say 5% interest, that equals $80k p/a interest. If they are getting a 4% yield on their $3.6mill portfolio that equals $144k rent. This equals $64k passive income. Are you saying they need to sell down the $1.6m in debt to be left with a $2mill portfolio that is getting 4-5% yield which equals $80-100k income?

    • Michael Ossitt

      August 12, 2016 at 12:27 pm

      Hi Fred, yes that is correct. As per the 3 different strategies outlined in the post, this example assumes that strategy 2 is used and all the properties are sold, the debt is paid off and you live off the passive income from $2 million using an interest bearing product. This strategy is a good target to aim for when you are starting out as it is much easier to model. In reality your exit strategy might change as you get closer to your desired retirement date and your goals change. As suggested in the post, you might have a better than expected cash flow in your portfolio, therefore you don’t need to sell some or all of your portfolio to be receiving a sufficient passive income. What is important is that you set a target now that you can work towards and have a benchmark to assess against. Hope this makes sense. Thanks, Michael

  4. Great post Michael! You’re a wealth of knowledge pardon the pun. You have inspired me!

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