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.