CHAPTER THREE:
Building a Growing Income Stream
"You only have to do a very few things right in your life, so long as you don't do too many things wrong".
—Warren Buffet
To achieve true financial independence, it is necessary to build an income stream independent of your employment income. At that point, you can leave your job and continue to receive an income stream, which will allow you to continue to maintain your existing lifestyle. Unfortunately, there is no short cut to achieving this goal, and many do not ever attain this position. Often when people cease work their lifestyle is immediately affected. As a consequence of this, some people simply continue working for as long as they can. This is a phenomenon that is likely to become more common in the future, as the eligibility rules for government benefits are tightened.
Building an independent income stream takes time, patience and persistence. When we commence life in the workforce, we are highly dependent on our salary to live, usually living on a week-to-week basis.
What this diagram shows is that, as you gradually build an independent income stream, the reliance which you have on your salary decreases. Hopefully, over time, you reach a point where you are no longer reliant on your wages or salary, as your investment income is sufficient to meet your day-to-day income needs. At that point, you would meet the definition of being financially independent. What constitutes as being financially independent varies with each person, depending on how much income you need.
There is no magic answer as to how the growing income stream should be created. It can be achieved in a number of ways:
• Buying a rental property with borrowed monies and using the rent to assist in paying off the mortgage. Once the mortgage is paid off, the rental income can then be used as a passive income stream
• Renting out your shack when you are not using it
• Building a business and selling off shares in the business to the employees or a third party and taking a regular dividend from the profits of the business
• Buying a diverse portfolio of Australian shares and using the dividends to assist in meeting your day-to-day needs
• Taking in an overseas student on a short term basis
• Buying a fishing licence and allowing another party to catch your quota for you in return for a fee
• Investing in a managed fund
Thinking Outside the Square
When looking at how to build your asset base it is important that you think outside the square. In a developed country there are opportunities everywhere that can be used to your advantage. However the average person does not see these opportunities despite being right under their nose. Let me give you a few examples:
1. I had a friend who worked on a ship which meant he worked for three months on, three months off. However he found that it was difficult leaving his house vacant for prolonged periods from a security point of view and it was expensive to hold a house he only lived in for half the year. After much discussion and debate he made the decision to live on his boat in the marina four kilometres away. The benefit of this was that he was able to rent out his house and still have somewhere in which to stay when he returned home from leave. The boat cost $80,000 and the marina fees were $1,500 per annum. Whilst his house was worth $540,000 and now generated an income of $475 per week. The boat costs less to operate (heating, power, no rates or land tax etc) and he also now has a "lifestyle asset" that he can enjoy. What's more he has now become a minor celebrity at the marina as the de facto security guard and has negotiated a 50% reduction in his annual marina fee. I suspect there would not be many people who would consider living on a boat as a money making venture
2. A client was transferred to Melbourne for work and by coincidence they rented a unit next to the Salvation Army Op Shop close to the city. Whilst her husband was at work the spouse visited the Op Shop and noticed that there were many "designer label" clothes being sold very cheaply. These items had been donated by the wealthy owners of the surrounding suburbs (Port Melbourne, Brighton, Middle Park, St Kilda etc). After a number of visits and many discussions with the shop attendants Mrs X was told that the new arrivals were sorted out on Sunday and put up on the shelves every Monday. As a consequence Mrs X now visits the store at 8.30am every Monday and makes a bulk purchase of around $500 on these clothes. The items are then placed on eBay for sale. The average mark up is over 300% or in other words $500 every week is converted into $1,500. This is a pretty solid return in anyone's language and is effectively the equivalent of earning around $90,000 per annum. Not a bad effort for a hobby job
3. After receiving a redundancy from his job Mr C was unsure what to do with himself as he still wanted to work but at sixty-four he had very limited prospects on what he could do. As he had some time on his hands he went and visited the local Lifeline Charity store and purchased a bookcase for $20. He asked the attendant if he could deliver the book case for him and they said unfortunately they couldn't as that was his responsibility. After making some enquiries he found out that this was the case with all of the Lifeline Charity stores. As a result of this he purchased a delivery van for $8,000 and now earns around $20,000 working approximately 10-20 hours per week. A great job for someone in semi-retirement mode. The job didn't even exist, he simply created this through thinking outside the square
4. Another colleague had a passion for motor vehicles. Given this passion and knowing the value of motor vehicles, he looked for small fuel efficient vehicles in the $8-$13,000 price range. When he was able to buy one of these motor vehicles at what he considered to be a reasonable price, he purchased the vehicle and then put it up for sale. To sell the motor vehicle, he would park it at various locations at the local university with a "For Sale" sign on it, as he figured that these were ideal cars for university students—cheap and reliable. He added on an average of $2,000 margin to the price and in most years he generated an additional income of $20-$30,000. Many of his friends laughed at him buying and selling cheap cars, but what they did not realize was that his side activity was the equivalent of
a) Having $500,000 invested in a term deposit at 6% or
b) Saving $30,000 from a salary each year
5. I had another client who went to the liquidation auction sales to look for bargains. He often attended these auctions and bought multiple numbers of the same item to resell gradually over a period. In one instance he purchased 10 used lawn mowers for $500. The lawn mowers looked as though they were on their last legs. However he checked the mowers to ensure the engines worked, and the frame was secure. He replaced any blunt blades at a cost of $10 for each lawn mower, cleaned them and then sold these via the newspaper flea market section for $150 each. Once again his friends laughed at him having 10 old lawn mowers at home. He was the one laughing as he made a profit of nearly 200% on his initial outlay
6. I have a friend who enjoys boating and going away for long periods on his boat. One problem he always finds is that it was difficult to find a secure anchorage when you are not familiar with the waters. When he returned from one trip he came up with the idea of buying moorings and renting them for short term use. An existing mooring at the time cost approximately $1,000 and to install a new mooring was around $2,000. He now has a portfolio of over 60 moorings which would be valued at around $60-$70,000 and each mooring generates an income of approximately $400 per year. His income is around $24,000 per year. His friends think he is mad by owning the moorings. They tell him repeatedly that it is dead money and to use an anchor. Little do they realise what he has been up to and how much he has increased his income
In life, the focus for most people is on reducing their home mortgage. This objective is admirable and should be encouraged. However once the mortgage has been repaid most people stop and relax. Unless you are careful and prudent, the amounts that were previously used to pay the mortgage will simply become part of your normal day-to-day living expenses and you will wonder how you managed to pay off your mortgage in the first place. It is at this time that you need to continue that discipline and redirect those savings into another asset which will provide you with an alternative income stream.
Let us assume for a moment that you have paid off your mortgage and on the 12th September 1991 you purchased Commonwealth Bank shares in the initial public offer. At the time, you could have purchased one share for $5.40 and the forecast and actual dividend was 40 cents per share for the 1992/1993 financial year. Look at what happened to the share price since then.
From the chart, you can see that your initial $5.40 investment was worth $62.16 on November 1, 2007. The price fell heavily during the Global Financial Crisis but, as inevitably happens, the price recovered a short time later. Since your original purchase of one Commonwealth Bank share for $5.40, you have received $26.79 in dividends. For the 2009-2010 financial year, you received a dividend of $2.35 on your original $5.40 investment alone. This represents a yield on your original investment of approximately 44%! This is how a growing income stream should work.
In retirement, it is the income that matters—not necessarily the asset value—as a general rule. The phrase of being asset rich and income poor is commonly used to describe the situations of many retirees. Unfortunately, this often means that their wealth is tied up in their residential property or land, which generally does not generate a yield. I have always struggled to understand why a farmer with large parcel of land works from dawn to dusk seven days a week for a meagre salary that results in a net yield of approximately 3% on the property.
Easier options would be to:
• Sell the property and invest the proceeds and live off the interest
• Rent out part of the property and focus on a smaller area of the land
• Rent the entire property out and obtain an alternate job
This very simplistic statement obviously does not take into account the lifestyle benefits of living on the land or the emotional attachment that many people feel for the land. The secret is not working harder but working smarter.
In planning for the future it is important to turn the assets into income-producing assets as we all need something to meet our day-to-day living needs.
The Financial Life Cycle
As we get older, our needs, objectives and priorities change and it is important that you adjust your strategy to suit these changes.
A typical financial life cycle involves:
1. The accumulation of wealth (twenty-five to fifty-five years)—during the accumulation phase the main focus is on repaying the mortgage, managing debt and cash flow and trying to build an independent income stream from your salary
2. The consolidation of wealth (fifty-five to sixty-five years)—as a person's wealth accumulates and the period to retirement decreases, most people adopt a lower risk profile to ensure that their wealth is preserved. In other words, as we get older we adopt a more conservative approach to how we manage our financial assets. This is understandable as if a business fails at 65 and you end up bankrupt this will have a far greater impact than if this occurred when you were 20 years of age
3. The spending of wealth (sixty-five or more years)—this phase involves using the accumulated wealth to meet your retirement needs and generally results in the reduction in the capital value of most people's retirement nest egg over time
4. The gifting of wealth—the older we get, the less we need and, as a consequence of this, during this phase many people prefer to make gifts to their children and grandchildren, to assist them in securing their financial future
This book will focus on the accumulation of wealth, which is the most important phase in determining whether a person will be financially secure.
Using the Concept of Time to Your Advantage
Throughout your life, time can either be your friend or your enemy. When you are younger, you have more time on your side so you can afford to adopt a different approach to your life than a person who is older. For example, when I was twenty-five, after working for a year I took off overseas for a year, not knowing where I was going or how I would support myself. At the time I had no financial commitments, no dependants and a general idea to see the world. During the twelve months I lived in a house with twenty-five others, slept in bus stations, squatted on a building site with a few friends, and lived off $15,000 in savings over the year. This was supplemented by a number of very casual and stress free jobs, including at one stage working in a sausage factory. It is highly unlikely that a person at forty with children and a mortgage would do the same. The younger you are the more risks you can take and the lower the potential consequences for you. It is important to use time to your advantage.
At my first after-work drinks function in the finance industry I asked the most financially successful person in the organisation what the secret was to being financially comfortable. His response to me was to go hard, to which I responded fairly naively, "What do you mean?" He said when you are young you have time on your side, but very few young people use this to their advantage. He went on to explain that his most financially successful friends used this to their advantage by borrowing as much as they could when they were young and taking serious risks at a time when they could afford to. As we get older, we are less likely to take significant risks. For example, if you have a wife or husband, children and a mortgage, you are less likely to bet the farm on a new business venture; however, if you are single with no commitments, there is a limited downside in taking such a risk.
The concept that time is your friend can be illustrated by the case of Bill who was twenty-six, single, and on an income of $100,000 when he purchased a residence in 2010 in Northcote in Victoria for $650,000. He needed to borrow $600,000, which was guaranteed by his parents and to service this loan he rented out a number of rooms in the house to his friends and paid the minimum home loan repayments. Over time, the value of Bill's loan will decrease even if he pays interest only on this amount. This is called the inflation effect, as over time the real value of money decreases. In other words, as a general rule everything goes up in price every year. For example the price of a carton of beer in the early 1990s was approximately $24, whilst today the price is over $45 for the same product.
Let us have a look at the impact of inflation (assuming a rate of 2.50%) on Bill's loan over time, assuming that all he has done is pay the interest on the loan.
From the above table, you can see that the real value of the loan has decreased over time with inflation. At the end of year one, for example, the capital value of the loan has been reduced in real terms with inflation to $585,000. This is despite the fact that Bill has only paid the interest on the loan and has not made any capital reductions. After 20 years the total amount owed in today's dollars is $380,395 assuming just the interest has been paid! This is the power of inflation and allowing it to work for you. It is worth remembering that debt is only your friend in rising markets.
What appears as expensive today often turns out to be cheap in the future. For example, the impact of the 2008 Global Financial Crisis on the ANZ Bank was as follows:
• Share price fell from a peak of $31.74 on the 15th October 2007 to $12.06 on the 23rd February 2009. This represents a fall of over 60% in the share price
• Profit fell from $4,143 million in 2007 to $3,273 million in 2008 and $2,910 million in 2009. The profit had fallen 21% in 2008 and a further 11% in 2009
• Yield on the 23rd February 2009 when the shares touched their lows was 9.95% fully franked and at the time the cash rate was 3.25%
What is noticeable about these statistics is that:
• The profits fell around 30% yet the shares fell over 60%
• The income was over three times that offered by term deposits
• At the time the bank was ranked amongst the top fifty safest in the world and the term deposits were covered by the government guarantee
Guess what? No one was interested in buying ANZ shares, as investors prefer to buy in boom and sell in gloom. This is a human trait, but successful investors do not follow the crowd. They do the opposite—selling in boom and buying in gloom. The greatest buying opportunities can be found in the eye of the storm, when the outlook is bleakest.
It happens in all areas; for example, in Hobart, Tasmania during the 1990s, property prices were very depressed yet no one was buying. At the time, you were able to rent out a property with a 16% yield and borrow the monies at 9%. This was an investment that in effect paid for itself, but very few people took advantage of this opportunity. If you can find an investment that pays for itself, the actual downside for the investor is generally minimal. However, when property prices in Hobart doubled and the market was moving upwards, buying an investment property became a common wealth creation strategy. Unfortunately in many cases, the horse had already bolted.
Achieving financial independence involves undertaking a series of small steps at regular intervals over time. The more time you have, the more steps you can make and the greater the level of your difference can be.
The Beauty of Compounding Interest
Compounding interest occurs when interest is added to the principal and then re-invested. This, in turn, results in the interest earning interest in addition to the principal. The nature of compounding interest is that the capital sum accelerates quickly, having the additional sums added to the original amount. If you are an investor, it can work to your advantage.
If you have a term deposit of $1,000, the following diagram shows the benefits of how compounding interest can work in your favour, assuming you invest this at 8% for twenty years:
From this table you can see that your original $1,000 grew to $4,316 over the twenty year period.
Compounding interest can also work to your disadvantage when you allow the interest on a loan to be capitalised (i.e. added onto the original amount). This would occur, for example, in a reverse mortgage situation.2
2 A reverse mortgage is a loan available to older Australians, and is used to release the home equity in the property as one lump sum or multiple payments. The homeowner's obligation to repay the loan is deferred until the owner dies, the home is sold, or the owner leaves (e.g. moves into aged care home).
The impact of compounding interest depends on the frequency in which interest is compounded and the periodic interest rate which is applied to the capital sum.
Having Some Luck?
The notion of luck is one factor which is often neglected when financial commentators talk about attaining financial security. We all need an element of luck to give us some momentum in building our asset bases. There are many examples of being in the right place at the right time, giving a person a kick start financially. The only way you can maximise your chances of getting lucky is to consistently practice the right behaviours over time and the luck will come your way. Persistence and patience are the keys to making your own luck.
For example, I had a friend who was interested in buying a property and he asked if I could assist him in the process—given my legal background. The first thing we did was get a valuation of the property—the valuation came in at $640,000. That then became the upper limit of what we were prepared to bid at the auction. The next step was to contact the agent and arrange an inspection. At the inspection, we asked the agent a number of questions and he advised that it was an estate sale, the deceased had no children and the beneficiaries lived overseas. Upon hearing this, we realised that at the auction there would be no emotion involved and the property would sell. At the auction, bids opened at $490,000 with very little interest. We made a bid at $510,000 and secured the property for this price. This was discount of over $130,000 on what we would have otherwise paid. He sounds lucky, but he looked at over twenty properties and undertook extensive preparation before he got lucky. In this case you can use the sporting analogy proper preparation prevents poor performance.
Everyone has a story about a person who got lucky and some of the more common examples are an inheritance, an employee with a share purchase plan (for example, Cadbury's or Microsoft), marrying a person of means or a lotto win. However, more often than not a person did not just get lucky, the luck occurred as a result of years of persistence. It may, for example, be as simple as a farmer buying a farm and working the farm as a continuing concern. Over time with the urban sprawl moving out of the cities the farm may become residential land which can be subdivided. Obviously, residential land is more expensive than rural land, so, all of a sudden, the battling farmer has made a windfall. However, if you ask the farmer about this, he will no doubt tell you that at the time of buying the farm it was a big risk and it could have gone either way. This relates back to a point I made earlier: what often appears expensive today appears cheap tomorrow.
The world is changing rapidly and opportunities which existed in the past often no longer exist; for example, a printing business. The good news is that there are just as many new opportunities opening up. Fifteen years ago you could not advertise your shack on a website like Stayz.com.au for short term accommodation, you had to go through a real estate agent. However, technology has given you, as a shack owner, greater control and the opportunity to make a substantial return at both minimal cost and risk. As an example, we rent our beach house out for 8 x 1 week periods every year which effectively pays for the yearly running costs of having a holiday home. At the end of each rental period a cleaner comes in and ensures that the place is neat and tidy for when we use it.
Invest For the Future and Not the Past
When investing, it is important to invest for the future and not for the past. What once was a great investment may no longer be a great investment. As society changes and develops with technological advances, so do the opportunities and growth areas. Jobs that were once popular no longer exist: television repairmen, paperboys, milkmen, and assembly line workers. Some exist today that did not exist in the past: pay TV technicians, wind farm engineers, distance learning co-ordinators and computer technicians. It is the same with investing. One common mistake many investors make is falling in love with an investment, which was great in the past but is no longer great.
One area which is facing significant challenges going forward is the traditional retailer as the internet has created an uneven playing field. As an example a group of colleagues and I at work order our work attire from an overseas retailer arriving within a week and leading to a saving of over 60% on the price in the traditional retail store. The world is changing and we need to change with it.
One additional problem we now face is that a person or board of directors in charge of a listed company can destroy what was once a great business through their conduct; by loading the company with debt (Centro Property), misappropriating investors funds, expanding into markets that they do not understand (ABC Learning), or making acquisitions at the peak of a market (Babcock and Brown Infrastructure). Many investors over history, as a consequence of this type of behaviour, lost confidence in listed companies and turned to family and friends for advice on how to build their wealth. Advice from family and friends needs to be considered carefully. Although they are well meaning, if they do not have knowledge and experience in financial matters and are not financially successful themselves, why would their advice make you financially successful?
An example would be where your parents purchased a property in 1970 for $40,000 with $20,000 borrowed from a bank. The interest rate on the loan is 4%. They had a combined salary of $10,000 and the property was rented for $50 per week. The property was four kilometres from the central business district. In this instance the:
• Loan to valuation ratio 50% ($20,000 loan against a property valued at $40,000)
• Salary to Purchase price ratio 25% ($10,000 salary against a purchase price of $40,000)
• Gross rental yield 6.50%
This is a very different purchase if for example you undertook the same strategy forty years later, where your circumstances could easily be as follows:
• Purchase Price $400,000
• Salary $60,000
• Loan (80%) $320,000 interest rate 6.50%
• Rent $320 per week
• Distance from the CBD ten kilometres
In the second instance the information would be as follows:
• Loan to valuation ratio 80%
• Salary to Purchase price ratio 15%
• Gross rental yield 4.16%
Although this is a hypothetical example, the strategy is the same in that both have purchased properties for investment purposes. However, there are significant differences that investors generally neglect to consider, including:
• The gross rental yield is lower
• The interest rates are higher and likely to increase, going forward in the current climate
• The income is now proportionately lower to the purchase price and, accordingly, it will take longer to repay the loan today than in the past
• The attractiveness of the property is likely to be lower as the property is further from the CBD
What worked in the past will not necessarily work in the future, so we need to be careful when listening to and trying to copy war stories from the past. When looking for a place to invest, we need to look for trends in the future. A number of these trends are fairly obvious, such as the ageing population and healthcare, and outsourcing for time-poor people. For example, there are now professional dog walkers—an occupation that was unheard of twenty years ago. There is growing use of the internet, and the importance of the environment.
One issue you also need to be aware of is that when someone comes up with a profitable idea in business, others usually copy it. Although the first business in a particular area or sector gets the first mover advantage, if it is profitable, others will soon follow. As others follow, competition increases and profits decrease. For example, coffee is a very profitable commodity to sell. It costs approximately 40 cents to purchase per cup and is sold for over $3.50 in most shops. Guess what? In any city or regional centre there are now a lot of places where you can buy your coffee. Why? The margins are fantastic.
Attempting to predict the future is fraught with danger but there are likely to be a number of themes that will dominate investment markets for years to come including,
• The management of sovereign debt
• The fear of a "peak oil" scenario
• The continuing demand to feed the growing population
• The growing gap between the "haves" and "have nots"
• Increased diversity within the population
• The ability to access workers across the world through websites such as www.freelancer.com and www.vworker.com. With the ability to access cheaper labour this will cause greater outsourcing in the developed countries
In any free market there will always be "winners" and "losers", you will need to adapt your thinking in an ever changing world. As Henry Ford once said, "If I had asked people what they wanted, they would have said faster horses". If he had listened to the general population he would never have developed a car.
Given these changes, it is important to review how, where and why you are investing on a regular basis, particularly when your circumstances change.
Useful websites
Savings tips from the Federal Government.
Australian Stock Exchange.