Nice family homes in well-established, blue-chip suburbs close to the CBD are becoming increasingly difficult to acquire from an affordability perspective.
And if you do successfully purchase an expensive home, it puts pressure on your capacity to fund an investment strategy whilst still repaying a large loan. So, a few years ago, a strategy called Rentvesting was popularised. But this has some practical limitations. I have formulated an alternative strategy which I’ll call Livevesting. It won’t suit everyone but its a strategy that has a lot of merit and deserves some consideration.
What is rentvesting?
Rentvesting involves renting a house in a location where you would like to live. One that has all the lifestyle benefits and amenities that you desire, thereby freeing up as much cash and equity as possible to allow you to invest in pure investment locations. Investments that you can make without needing to consider lifestyle considerations.
In reality, there’s a couple of challenges associated with rentvesting.
Firstly, there’s an emotional consideration. That is, some people feel more comfortable living in a home of which they own rather than renting. To some people, rent money feels like dead money.
Secondly, schooling can be a concern. There’s not a lot of certainty with respect to the longevity of the renting relationship. That is, the landlord can decide to sell or occupy the property and not renew your lease. If that happens, you’ve got to find a new home. And if your children are attending a school in that location, then you’re forced to find another house close to their schooling. That can be difficult at times, depending on what sort of rental stock is on the market.
And lastly, the other complication with rentvesting is a possible change of mind. If you implement a strategy that requires you to rent for the next twenty years, what happens if you change your mind in five years’ time? You might find that because you have exhausted your borrowing capacity, you’re unable to buy a home.
Spreading yourself too thin
One of the challenges that people are finding today, especially in light of the tighter credit market, is that they could be spreading themselves too thin. That is, their borrowing capacity might restrict them from being able to afford the size of home or location that they truly desire. Plus, their borrowing capacity might restrict how much they’re able to invest once they have purchased their desired home. In this situation, sometimes people are seduced into compromising on the quality/location of both home and investments. In this situation, it’s possible for people to end up owning two or three very average quality property assets.
A new strategy: Livevesting
In short, an alternative strategy is Livevesting. This involves using your full financial capacity to buy the best quality home in the best location that has all the investment fundamentals but also fulfils your lifestyle requirements.
This strategy has added benefits if you’re able to buy a home that’s located in a really good quality public school zone for two reasons. Firstly, properties located in public school zones that contain highly desired and rated public schools, tend to exhibit higher capital growth. And secondly, if you’re able to buy a home in that school zone, perhaps that negates the need or desire to send your children to private schools, thereby saving you a lot of money.
The premise behind the Livevesting strategy is that you occupy a property that is expected to generate a significant amount of tax-free capital growth. You service the inevitably large mortgage through the period of occupation with the intention of crystallising the tax-free capital gains when you downsize in the future (i.e. prior to retirement). Part of that equity will help you fund retirement.
This strategy is distinct from one that involves you buying a home with a view to eventually repaying the mortgage and occupying that property for the foreseeable future. The benefit of this strategy is it allows you to direct all your financial resources into buying a stellar property asset. Because it’s of such a high quality, it’s likely to result in substantial capital gains over a period of one or two decades.
Here is an example of how this might work
Rick and Karen are married with two children and have an annual family income of $370,000. They currently own their home which is worth $1.5 million with a $500,000 home loan.
Rick and Karen have two options:
– Option one: upgrade to a family home worth $2 million and buy a non-investment-grade property for $600,000; or
– Option two: upgrade the family home to $3 million and don’t buy any investment property.
The challenge with option one is they could be spreading themselves too thin. That is, a $2 million budget might allow them to get close to their desired area but not perfectly in it. They may need to make compromises in terms of accommodation size and also land size. Additionally, once they do that, they might have to make compromises on their investment property too (quality-wise) – which is likely to result in a lower capital growth rate.
Let’s assume that in option one, both properties grow at a growth rate of 6% p.a. Option two is potentially better because it gives Rick and Karen a much larger budget, therefore allowing them to buy a very high-quality asset. That is, they might be able to buy in a perfect suburb in a nice quiet street without needing to compromise on land size or accommodation size.
Assuming that they get this asset selection perfect, let’s assume the growth rate for that asset is 9% p.a. Looking at the numbers over the long term, under option one, if the properties grow at 6% p.a., both properties will be worth $8 million in total in 20 years’ time. As such, Rick and Karen will have $6.2 million in equity.
However, under option two, if the growth rate is close to 9% p.a., their home will be worth $16 million in 20 years. As such, Rick and Karen with $13.8 million of equity.
I’ll remind you that this strategy’s premised on two very, very important assumptions. Firstly, that Rick and Karen don’t have the capacity to buy a home and invest without compromising on the quality of either or both property assets. Secondly, that they get the asset selection absolutely perfect. That is, that if they’re going put all their financial resources into one property, it must be a perfect property from a future capital growth perspective.
Four risks with this strategy that you must consider
There are four risks that must be considered when assessing whether a Livevesting strategy is appropriate for you.
(1) Concentration risk
This strategy has significant concentration risk. That is, all your wealth is concentrated into one asset (excluding super). If you select the wrong asset, then your overall wealth building success will be adversely impacted. It is never good to put all your eggs in one basket except if its an exceptional quality basket.
(2) Borrowing risk
Often this strategy requires people to borrow substantial amounts of non-tax-deductible debt. This has cash flow implications. You must consider this very carefully, you must build in buffers and ensure that you have appropriate insurance arrangements to mitigate foreseeable risks. Home loans are great servants but terrible masters. You certainly don’t want to put yourself in a situation where you expose your family to avoidable risks.
(3) Unwillingness to downsize
One of the challenges with this strategy is that possibly you’ll get used to living in a certain location. You’ll build a community and friendships in that location. It’s quite possible that in 10, 20 or 30 years you might not actually want to downsize to another location. So, you really need to consider your financial capacity to be able to stay in that location if you think that’s going to be a risk.
(4) Poor implementation.
If you determine the wrong budget (i.e. over-borrow), have the wrong loan structure or select the wrong assets, this strategy is not going to work. You must absolutely ensure that your strategy implementation execution is nothing short of perfect.
How we live with property is changing.
In my opinion, the way we interact with property has changed over the past number of decades. In the 60s, 70s, and 80s, the conventional wisdom was to get married, have kids, buy a home, build a career with the same employer, repay your home loan and retire.
This changed in the 90s as people became more proactive with respect to managing their money. People started to use the equity in properties to buy investment properties, build their careers (not necessarily with the same employer) and so on.
Today, people tend to get married later in life, spend more time building their careers and in the main, are more proactive with their wealth accumulation activities. People are less willing to make compromises. I suspect that in the future, the strategy of buying a home, occupying it and repaying the home loan to zero will be less popular. Especially for high income earning professionals that want to live and work close to the city. As such, it might become more common to occupy a property with a view to downsizing as a way of repaying debt as opposed to using cash flow.
Also, another experience that’s becoming more prevalent is receiving a substantial inheritance. There are predictions that there’ll be a massive transfer of intergenerational wealth (circa $3 trillion) over the now coming decades. This will also inevitably be factored into people’s debt repayment and retirement strategies.
It’s not for everyone – proceed with caution
Obviously, I’ve talked about some of the risks associated with Livevesting as a strategy. These risks cannot be underestimated, and this strategy will only be appropriate for a select few. However, it could be a perfect solution for some people and if nothing else, the strategy that should receive some consideration (in addition to other strategies). You must absolutely ensure you get independent financial advice, to ensure that you’ve planned out your cash flow, considered all the risks associated with the strategy and ensured that it’s in line with your risk profile.
Finally, as I’ve mentioned above, this strategy must be implemented perfectly. Of all the risks associated with this strategy, the implementation risk is probably the highest one in my opinion. Therefore, if you’re going to do it, make sure you do it properly and pay to get the right asset selection advice.