Wealth Planning - Baseline and Personal Ratios

In the heady days of 1998 to 2007, like so many others with paper profits, my appetite for investment debt was immense.

April 2008 came along - Oh dear. I was just planning to remortgage the investment properties and cash out almost enough to pay off the entire mortgage on our home when ………..WHAM ………….. the banks stopped doing what they had done so well for a decade – lend any property investor 85% or even 90% of the VALUATION of the property.

So like others who had learned the No Money Down method of multiplying investment holdings, I ploughed into multiple purchases in 2007 without any serious planning of the debt repayment schedule.

“Price inflation will take care of that……….. prices will double in ten years …………. I only have to collect sufficient rent to cover mortgage interest, management fees, insurance and (an underestimated) contingency for repairs and maintenance”.

Base rate was 5.75%. Cash flow was zero. Sound familiar? I broke my own investment rules built up over twenty years. I had to go back and continue consulting and work for my living. I felt sorry for myself. Well we survived, and that MoneySavingExpert budget planner was one of the first things I revisited.

By that stage, property was only one of three businesses we had nurtured over the past fifteen years, so the UK banking crisis did not impact us as much as I thought it might. But it brought me back to basics. As Robert Kiyosaki, the author of the famous Rich Dad, Poor Dad series of books, so eloquently puts it

“an asset is something that puts money in your pocket, and a liability is something that takes money out of your pocket”.

I had to go back and relearn that in a hurry. No matter where you are in the investment cycle, it’s always good to know your baseline, and to continually reassess your goals. Part of the correction process we went through in 2008 and early 2009 was to look at our personal expenditure, which had grown by over 100% in the last 10 years. Though that rate of growth is, in my opinion, the same as real inflation, I had become slack on the cost side of the equation as the income side had increased dramatically.

Recall that I had said that one of the ratios I have used for 20 years was to ensure that 10% of your earned income was to be invested. Another way of stating this is to say that your personal budget should ensure that you spend no more than 90% of your income on all personal expenditure. If you have completed a first pass of the budget planner, and find that your personal expenditure is more than 90% of your income, you will never become wealthy unless you either increase your income (preferred), decrease your spending (recommended) or plan a combination of both (the perfect plan)

Some other ratios I have used throughout the last twenty years, but not applicable to individuals with net debt,are:

Maximum percentages of net equity to allocate:

•  25% to principal private residence
•   5% to personal cars
• 10% to cash, jewellery / precious stones & metals
• 20% on individual investments

This was purely a personal decision when I finally came out of net debt twenty years ago, but I have stuck with these ratios since then.

Some additional ratios more recently used in balancing allocations of income:

•  30% of total income spent on essential costs
•  30% of total income spent on optional costs
•  30% of total income assigned to investments
•  10% of total income assigned to charitable causes

 Note that if total costs currently exceed total income, it is advisable to allocate time to charitable causes instead of income.

 Your first pass personal budget will be nowhere near these ratios. However, when you have identified essential or irreducible costs, it’s much easier to analyze the optional, investments and charity costs to adjust your expenditure budget to ensure there is more than zero for investment.

A word of caution.

 Financial security precedes financial independence. Your first goal is to make sure that you have three months expenditure available to you quickly should you need it. An example is an unexpected loss of primary income due to illness or job loss, or an unexpected and large bill. That doesn’t mean you need to keep three months cash available, but it does mean that you should aim to have a facility that allows you to quickly make use of funds for unexpected events. An example would be an offset mortgage.

Some useful links to get you on your way to increasing your income and reducing your outgoings are:

•  How to get a pay rise

http://www.thisismoney.co.uk/payrise

•  50 ways to save money

http://www.thisismoney.co.uk/50-ways

In the next article, we will discuss goals and plans – first pass, and introduce a Terms of Reference template in which the goals, long term plans and short term actions required to achieve the plans can be logically written and broken down into manageable lumps to achieve those goals.

The Richest Man in Babylon

A very famous book by George S Clason called The Richest Man in Babylon was released in 1926 and still sells thousands of copies each year, with good reason: the advice in the book stands the test of time.

The book describes 'seven cures for a lean purse' and it's worth having a look at these cures and how they might be applied to your own finances.

The First Cure

The first cure is to 'start thy purse to fattening'. The key message here is to save. The book says that for every 10 coins you earn, spend only nine. The same principle can be applied to your own finances - save one tenth of what you earn. If you start this discipline early in life and maintain it, you'll find your financial resources will grow considerably over time.

The Second Cure

The second cure is to 'control thy expenditures'. The book makes it clear we need to separate our needs from our wants and not waste money on our wants when this money would be better saved or invested. So don't waste money on flat screen TVs, take away coffees and gadgets. Instead, save this money and put it aside to help contribute to your long-term financial wealth.

The Third Cure

The third cure is to 'make thy gold multiply'. The idea here is to invest excess capital wisely, in investments that will return your capital plus interest so you earn an income stream on your money invested.

The Fourth Cure

The fourth cure is 'guard thy treasures from loss'. This means not risking your principle investment chasing high returns. It's better to invest conservatively and aim for modest returns that try to make a quick buck.

The Fifth Cure

The fifth cure is to 'make of thy dwelling a profitable investment.' So make sure your family home is in a good location and maintain it so when you want to sell it, you'll get a good price (the fact you don't have to pay capital gains tax on the family home in the UK makes it a particularly profitable investment)

The Sixth Cure

The sixth cure is to “ensure a future income”. This means putting enough money aside for retirement and also making provisions for your family in case you die or are incapacitated. So make voluntary contributions over and above the contributions your employer makes to your pension fund. And ensure you have life insurance and, if possible, income protection insurance.

The Seventh Cure

The seventh cure is to 'increase thy ability to earn'. This means actually wanting to increase your income. But it's not enough to want to be rich - you have to have definite targets. For example, a date you want to have your home paid off by, or a particular amount of money you want to save each month.

Where are you in the wealth building process?

Let’s review what I covered previously in What is Wealth?
• Invest 10% of your earned income for life
• Net wealth equal to all earned income within 50 years, but achieved in 20 years

 

• How much do you need to become financially independent?
• Whatever it is, it needs to last 50 years because most of you will live to 100

 

So where are you in the wealth building process? I will define four categories of wealth, regardless of age. All categories exclude any net asset value of your home, or principal private residence. These are:

 

Level 0 – Indebted individual.
This category describes individuals whose net debt exceeds their net assets. A person with a credit card debt of £10,000 and no net assets is no worse off than an individual with £10,000 in the bank, and a property mortgaged for £100,000 with a market value of £80,000. Both people are in net debt of £10,000.

 

Level 1 – Ordinary individual.
This category describes individuals whose net assets are between £0 and £50,000.

 

Level 2 – Sub-HNWI* individual,
 or affluent. This category describes individuals whose net assets are between £50,000 and £500,000.

 

Level 3 – HNWI* individual.
This category describes individuals whose net assets are between £500,000 and £5M.

 

* HNWI means High Net Worth Individual.

 

Analysis of a high net worth individual.
In 2007, there were approximately 500,000 HNWI individuals in the UK, or just under 1% of the population.

Thomas J Stanley, the author of  The Millionaire Next Door, characterizes HNWI individuals as having seven traits:

• 1. they live well below their means
• 2. they allocate their time, money and energy efficiently in ways conducive to building wealth
• 3. they believe that financial independence is more important than displaying high social status
• 4. their parents did not supply economic outpatient care
• 5. their adult children are economically self-sufficient
• 6. they are proficient in targeting marketing opportunities
• 7. they chose the right occupation

 

I would be surprised if readers of this blog did not aspire to being at least a level 3 person, and it’s a fair bet that readers represent all four levels described above.

Regardless of level, we are all interested in reaching a level which ensures we are financially independent, meaning that our net income from investments exceeds our net outgoings or expenditure.

So how much is enough? The numerical value of wealth is not the determinant. It is the ability of that wealth to generate a permanent income which exceeds expenditure.

Let’s take two examples:
1   A pensioner sells her London flat wholly owned for £650,000 and moves into a retirement community in Llandudno, purchasing an apartment for £150,000. She puts her remaining capital into a government bond scheme which guarantees 2% return with capital increasing with inflation price index. She receives 2% of £500,000, or £10,000 per year, increasing every year with inflation. Her total outgoings are £8,000 per year. She is financially independent.

2   A middle aged property investor has accumulated a portfolio of properties worth £4M with a 50% debt to equity ratio. At the age of 60, he decides he wants to retire. He sells half the portfolio, using the cash from sales to pay off the remaining debts, and maintains a £2M portfolio with gross income of £150,000 and net income of £50,000. His total outgoings are £40,000 per year. He is financially independent.

Both these individuals have taken a different route to protecting the real value of their capital investment whilst producing an income which exceeds their personal expenditure. But because the government figures relating to inflation, whether CPI, RPI or any other indicator favoured during the term of a government tend to grossly underestimate real inflation, the first example is less likely to maintain the living standard than the second example.

 

Goals and plans.

End game.

If you get in your car without knowing where you want to drive to, you won’t get there.
Financially speaking, this is the equivalent of starting on the path to accumulating wealth without having an end goal. That end goal should be a time in the future at which you will be generating an investment income sufficient to exceed your personal expenditure at that future time.

Decisions along the way.

If you get in your car to drive to London without a Satellite Navigator, road map, or without reading any of the road signs, and stop off at every place that looks interesting, you won’t know how long it will take you to get there, or if you will ever get there at all. Financially speaking, this is the equivalent of knowing your end goal, but taking every opportunity along the way to invest in something just because it looks good, or better than the last investment.

In both cases, you need a starting point, or where you are driving FROM. Financially speaking, that is an income and expenditure statement.

Whether you are in debt, have a JOB (stands for Just Over Broke) or have a clear business plan to become wealthy, 2009 is the year to revisit basic planning and make sure your plans deliver increasing net income every year. See the blog post Simple Wealth Planning Template 00 where I have placed two links to templates that will allow you to get your financial house in order.

Simple Wealth Planning Template 00

The purpose of this document is to provide a simple planning tool for wealth creation. Wealth is defined as financial freedom to choose what you do in life. The end purpose is to have sufficient wealth that income from investments exceeds personal outgoings. At this stage, you choose whether or not to work.

This template is for people who are currently in debt

http://tinyurl.com/ydrmozr


Or if you don't like that one, try the Google template for home budget planning

http://spreadsheets.google.com/ccc?key=t6ACqFwp5Q-rY8HCg45lU8w

Valuing Residential Property from LHA rate tables

I had occasion to look at three separate areas yesterday to determine the Local Housing Allowance (LHA) for 2, 3 and 4 bedroom properties since I thought the private rent for a 4 bed of ours was too low, and was contemplating letting it to tenants with housing allowance.

https://lha-direct.voa.gov.uk/Secure...?SearchType=LA

After noting both the regional, local and time based variations in LHA allowance in the different areas, it occurred to me that I had not thought previously of using this as an independent method of valuing a property.

Anyone who has read Ajay Ahujas' book Beating the Property Clock will know that Ajay refers to the "intrinsic value" of a property. The intrinsic value to one investor may not be the same intrinsic value to anther investor, but Ajay calculates intrinsic value to determine if a property in a particular area at a particular point in time in the life cycle of property price increases and decreases is above or below intrinsic value.

Intrinsic value is the price of a property below which it will be attractive for an investor to purchase, and is related to the gross yield or return on capital value of that property.

Capital value is what you paid for it.

Target Gross yield is monthly rent x 12 divided by capital value, and it's this target that you set in your mind as a minimum achievable yield.

Let's say that your target gross yield is a minimum of 8% per year.

Intrinsic Value = Annual rent divided by gross yield.

You are looking at a 3 bedroom property that has an LHA allowance of £135 per week in the rate table of the web link above. So £135 per week is £584.55 per month or £7,020 per year.

Intrinsic value = £7,020 / 8% = £7,020 / 0.08 = £87,750.

So this is the target maximum price you are prepared to pay.

If properties in that area are selling for £75K, you know they are selling below your intrinsic value. If they are £100K, you know that they are selling above your intrinsic value, but you also know that you would not pay more than £87,750 for it, no matter how much Below Market Value you are offered.

This is the difference in approach from pure BMV to BMV qualified by intrinsic value.

In 2009, it is possible to purchase a property for £32K with an intrinsic value of £71,250 but before you go running off buying, bear in mind that the intrinsic value calculation assumes that your target gross yield is actually achievable.

If this property were in an area known to have social behaviour problems or likely to suffer from long voids, your gross yield target would obviously be somewhat higher than 8 percent.

What’s the £16bn government spend in August all about?

What’s the size of the government debt all about?

I like to put very big numbers in perspective. So the news says that the government borrowed £16bn in August, and £65bn year to date. What does that mean?

Well, apparently, there are still 29 million people working in the UK, so in August, the government borrowed £555 for every working person. At £65 bn year to date, the yearly run rate is £3,448 for every working person.

Total government debt is just over £800 bn, or £27,500 for every working person in the UK.

That is probably the size of a student debt after four years at university.

Is this a problem, and should we be worried? Debt now stands at 57.5% of GDP. it's the highest level since the 1970s, but before the 1970s, it was higher than this between 1915 and 1970,. peaking at over 200% after the second world war.

UK National Debt As Percent Of GDP for United Kingdom 1900-2010 - Central Government Local Authorities

And how does this compare to other countries?

https://www.cia.gov/library/publicat.../2186rank.html

Japan 178%
Italy 105%
France 64%
Germany 64%
USA 61%
UK 57%
Norway 44%
Syria 26%
Iran 20%
Australia 13%
Russia 7%
Libya 4%

I guess it doesn't seem so ridiculous as a measure of debt when you look at the world stage, does it? Would you rather live in the UK @ 57% or in Libya with 4%?

So if the government intends to spend it , that doesn't bother me. That's their job - to spend when they need to spend.

Back to the beginning. £3,448 per working person this year? Not an enormous amount considering the current financial crisis is, as they say, the worst since 1930.

Much of this supports why the bank base rate has not increased for six months, and is less likely to increase dramatically the longer it stays at this record low. You only have to look to Japan to believe that base rates COULD stay low for an awfully long time.

For property landlords fortunate enough to have reverted to SVRs based on pre-2007 mortgages, they are fortunate temporary recipients of unexpected cash flows.

Personally, I wouldn't care if the government continues to overspend to reach 100% debt as a % of GDP if that means we keep very low interest rates for a decade.

At these low rates, property prices would not have to rise at all to make a successful business out of property investment. Compared with one year ago, most investors are making 4% per year additional net income on the value of their portfolio stock because they are paying 4% per annum less interest than a year ago.

And if that is additional guaranteed income instead of perceived capital growth, I'm happier to take the income NOW instead of the capital growth LATER.

The fifty year wealth strategy in two decades

How does one go about creating the footprint to achieve financial independence within two decades?

Financial independence is, to an extent, a state of mind. I recently talked on the telephone with a friend of some thirty years. In fact he was my first boss after I left university, and though we did not get along too well in that relationship, we met after a decade apart, when I was much more mature, and forged a strong, if distant relationship. My friend had retired at the ripe old age of 54 and went world cruising on a 58 foot Oyster ocean-going sailing boat. He has recently become a land lubber after travelling around the world since the start of the Millenium, where I missed the trans-atlantic crossing to Bermuda for the celebrations. When I explained to my friend that I needed income generating assets of £4M before I was sixty, he retorted “you don’t need anything like that Jerry”. With all my detailed financial planning, I had neglected to account for a few facts like: no kids in private education, no mortgage repayments on the private residence, etc, etc. He was right. I had been calculating net income requirements based on our current personal outgoings, adjusted for inflation over the years, and not realizing that almost fifty percent of our outgoings would disappear within ten years. Stupid really.

I want to fast forward for a moment to exit strategy – how to assure that you have sufficient income in retirement to live within your means, yet preserve the real value of that income stream for the full duration of your retirement. I saw on the news that Harry Patch, the last remaining World War I hero, had died at the age of 111. It reminded me that we have hardly lived half of our lives, and it also reminded me that our plans for perpetual income generation would need to last for between thirty and fifty years. At least one of our presumptions for the last twenty years was correct, and that is that you can’t rely on spending capital as a substitute for income.

That’s applicable to very young investors these days, especially those who found the key to cash back investment in the heady days of big property loans, and what seemed for almost a decade to be unlimited borrowing. That has come to a short, sharp shock ending for most of us property investors who thought we could borrow our way out of an ever increasing debt pile whilst the property price inflation would take care of it all some time in the future. But when?

2009 has become the year of sober thoughts and sober financial planning. For those who remortgaged to fund lifestyle in excess of their net income, it’s become a sober reminder that you can’t always ride the wave of asset price inflation to surpass erosion of capital as a substitute for income. I refer; of course, to using cash back from borrowing more than 100% of the purchase price of property, or remortgaging property assets to more than 100% of original purchase price and spending the proceeds on non-investment activities.

The behaviour of any asset class is, by nature, unpredictable in the short term. But it is a reasonable assumption that, over time, the real value of property will not decrease. Like stock, the total return on investment of a property is the sum of the capital gain (or loss) and the rental income (net of all costs). So a sustainable investment strategy involving real property really has to treat the capital value as a component that keeps up with inflation, and the net income after costs as a component that is short term income and can be spent perpetually. Just how much of that income can be spent without eroding the real value of the asset investment is a subject that requires detailed analysis. Whilst it’s true that great leverage can be applied to residential property investment, the leverage comes at a price. The price is that if medium term cost of letting exceeds income from letting, the property portfolio becomes a liability, not an asset. And as some investors will no doubt experience over the next few years, an uncontrolled and rapid increase in ownership of highly leveraged residential property will result in bankruptcy.

Balancing leverage with ability to cope with short term market fluctuations (from all sources of income) is a subject worthy of further analysis.

What is wealth?

Since the ripe old age of 9 I realized that to have choice in life, you need to have money. By the time I was 17 I realized that having money one week and spending it the next week is like a perpetual motion machine. You keep having to earn it to be able to spend it. By the time I was 22 and in professional work, I realized that an education gives you the opportunity to earn so much more money than without, maybe there is a light at the end of the tunnel. I thought back to my mother who always quoted Mr Micawber from Charles Dickens “Income one pound, expenditure nineteen shillings and sixpence, result happiness. Income one pound, expenditure one pound and sixpence, result misery”. Perhaps what we misunderstood about Mr Micawber’s famous statement was that income does not have to be earned income.

If we add up all the earned income over all our working life, simple arithmetic doesn’t seem to make sense. I know we have accumulated wealth in plain old Pound Sterling terms equivalent to almost all the income we have ever earned. That doesn’t seem fair does it? How can we have accumulated, albeit on paper, a sum of net wealth equal to all the money we have ever earned in our life?

Around 20 years ago, I learned that Jewish people had a philosophy of teaching their children that they should never spend more than 90% of the money they earned. I looked back over the first ten years of my working life, when my net assets were less than zero, and back-calculated what position I would have been in had I saved (invested) exactly 10% of my earned income. Had I just put that money in the bank it would have been about the price of a semi-detached house at the time I would have started saving. However, had I put the first years' saving as a deposit on a house and rented that house out to a tenant, and continued to put 10% of my income into paying off the mortgage of that house, I would have owned that house outright in the first ten years. But the value of that house had just about doubled by that time. So I would have had net assets equivalent to around 20% of all my net income over that 10 years.

I vowed at that time, though still in debt, to make sure that I "saved" (I later corrected that to “invested”) 10% of my net income, in five decades, I would have a net wealth equal to my entire net income over the 50 years. Surely enough to retire on? So how much is enough?