For most people, retirement conjures up images of lazy walks along the beach interspersed with endless rounds of golf. For others, retirement spells the financial independence that moves them from the ‘rat race’ to the ‘fast track’, and the choice of whether to work or not.

What rounds out the picture for property investors is an empire of houses that throw off large amounts of cash to finance the whole set-up.

Regardless of how financial independence looks and the fact that it’s most investors’ goal, the emphasis in much of the property investing literature is on how to start investing, how to choose a property, how to get financing, whether you should choose fixed interest rates or variable interest rates, cheapest renovations, and so on. Very few deal thoroughly or in-depth with how to achieve financial independence, or the mechanics of retiring on property.

We’ll be looking here at how many properties it takes to retire. In future articles we’ll look at how long it takes, different methods to get there, superannuation and property, pitfalls and traps, plus much more.

How to retire on property – a first pass

Now… down to brass tacks: how do you retire on property?

There are actually several ways to retire on property, but for the moment let’s look at the fundamental model of an investor’s retirement being supported by the rental income generated by a portfolio of properties.

The first step is to calculate what your desired or required annual income is in pre-tax terms, in today’s dollars. If you want to retire on an income equal to your existing salary, then your current gross salary is a good starting point. Divide that figure by the annual rent on a typical property: this will give you the number of investment properties required to support your level of income. Don’t forget to add a little bit to your desired income figure to account for property management expenses, repairs, rates etc. before you divide by the rental figure. Remember also to take vacancy rates into account in your estimate of rental income per property.

For example, say that my required annual pre-tax income in retirement, in today’s dollars, is $80,000. I add a notional amount of $5000 to account for rates and management expenses to arrive at an income level of $85,000 per annum required income. If the annual rent I could reasonably expect from a property is $12,000 then I will require around seven properties (85,000 divided by 12,000 comes to a little more than seven).

So, seven properties is my goal in order to retire – that seems easy enough to understand and calculate. But can you see the fly in the ointment? For the vast majority of investors, accumulating properties means borrowing large sums of money. As most investors know only too well, the loans used to finance property acquisitions bring with them repayment obligations that outweigh the rental income generated by the properties.

When we talk of needing seven properties to retire, in fact what’s required are seven unencumbered properties, that is, seven properties without any loan obligations attached to them.

This is where it gets interesting. If you’ve used borrowing to accumulate your portfolio, you’ll need to pay down that debt. What do you use to pay down those borrowings? The answer is… more properties – because the properties are sold and the proceeds of the sale are used to pay down debt.

But how many more properties? This depends on whether your portfolio consists of high capital growth and low-yield properties, or high-yield but low-growth properties.

How many properties will I need?

Some investors are highly negatively geared and have relatively low-yielding but highly tax-effective portfolios. Others prefer positive cash flow properties. Still others accumulate a mixed portfolio of positively and negatively geared properties with the aim of striking a balance between income and tax-leveraged capital growth.

To answer the question of how many properties in total are needed to retire, we’ll look at two case studies: the Smiths – who are negatively geared investors with a handful of properties, and the Jones who own a lot of cheaper cash flow positive properties.

The negatively geared Smiths

The Smiths have a handful of median priced properties that are relatively low yielding, but highly tax effective. The properties have been growing in value at the average long-term rate of 8 per cent and the Smiths have used the equity built up in their portfolio as the security for their property acquisitions.

After 10 years of regular investing the Smiths have accumulated five properties. The gross value of their total property assets now is $1.75 million and they have $1 million in property investment loans. Their net worth is $750,000 ($1.75 million asset value minus $1 million in borrowings). Each of their five properties is worth $350,000, and the gross rental income they receive from these five properties totals $60,000 per annum (each property generates gross rent of $12,000 per year). They pay interest on their loans at 8 per cent and their annual interest bill is $80,000. Their before-tax out-of-pocket expenses are therefore $20,000 ($60,000 rent received from their five properties minus $80,000 in interest payments on the loan).

The Smiths have decided that their desired retirement income is $80,000 in today’s dollars.

At an annual rent of $12,000 per property, the Smiths will need seven unencumbered properties to retire. A portfolio of seven unencumbered properties will also generate a few thousand dollars extra for property related expenses. While they have five properties now, their portfolio has $1 million in debt associated with it, so they need to acquire more properties whose capital appreciation over time can be liquidated (i.e. the properties are sold) to pay off the debt so that the seven properties they require to support their retirement can be left free and clear.

After they’ve acquired two more properties to bring their total portfolio to seven properties, how many more properties do they need in order to pay down the debt and leave their portfolio unencumbered? In theory, only one!

After the Smiths have acquired the eighth property, they could rely on their first property to grow in value to the point where the equity in that property overtakes the size of the debt. Of course, that would take some time.

If they bought three more properties at, say $350,000 each and borrowed the total amount, their debt would stand at $2.05 million. If one of their properties appreciated at 8 per cent every year, it would take another 23 years for it to grow large enough to pay out all the debt (leaving aside the issue of capital gains tax)!

Of course, they could shorten this by buying two, or three or more properties to use to pay down the debt. The balancing act here is that the more properties they buy to use to pay down the debt, the greater that debt is, and hence the longer it takes to retire. The Smiths will also need to stop acquiring properties at some point to let their portfolio appreciate in order to generate extra equity and reduce the overall portfolio loan-to-value ratio.

So there are quite a few moving parts here:

·         the rate at which the Smiths continue to acquire more properties;

·         how long they want to taper off acquiring more properties and let their portfolio appreciate while their borrowing level remains constant; and

·         how long they’re prepared to wait until they retire.

Let’s back up to where the Smiths are now, with their $1.8 million, five-property portfolio. They’re determined to save and invest aggressively, so they buy a new property every year for the next six years. While properties now are priced at $350,000 and are typically appreciating at 8 per cent per year on average, the Smiths buy smart and are able to acquire properties at a 10 per cent discount to market value.

Having acquired a property a year for another six years, the Smiths’ portfolio now consists of 11 properties. Their properties continue to appreciate at 8 per cent per annum, and their borrowings – and interest repayments – also grow. Rents have been growing at 4 per cent each year, and at the end of the sixth year their gross rental income is $167,000. However this is far outweighed by a massive interest bill of nearly $280,000. The Smiths stop acquiring and let their portfolio appreciate for the next four years, during which time their rents rise, reducing the negative cash balance since their debt level remains the same.

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