Robert Allen, author and self-made property millionaire, in his excellent book Nothing Down for the 1990’s, suggests an interesting plan by which we can all retire early and live off a plentiful supply of untaxed income. Does this sound too good to be true? Well, actually, it probably is, although there are some aspects that require a closer look and some careful thought. The plan itself is very simple. It goes something like this:
First, buy a property that you can let out at a high enough rent to cover your costs. Preferably take your time and, if you can, look for a bargain you can pick up substantially below market value. Next, repeat the process annually for at least the next four years until you have a minimum of five properties.
Here comes the clever bit. By year six, assuming past trends continue, property number one should have substantially increased in value, and with it your equity (the difference between what the property is worth and what you owe by way of a mortgage). In his example, Robert Allen assumes a 10% per annum growth rate (which isn’t going to happen any time soon).
So, does he now recommend selling and taking your profit? No, instead he recommends that you refinance.
Indeed, Robert, in this and other books he has written, strongly recommends that you never sell your property investments, and I concur. So, the investor should now re-mortgage, releasing the increased equity which he can pocket tax-free. The extra finance charges will be covered by the rent, which he speculates should also have risen over the five years.
In year seven, repeat the process by re-financing property number two, and so on until year eleven, when you will refinance property number one again. And so on and so on. Congratulations! By following this plan, you are now officially off the 9 to 5 treadmill.
Like all good plans, it is simple. And it seems relatively easy to implement. But is it realistic? And is realistic in this current market when prices are flatlining, or only increasing slowly?
Actually, I think it is, but there are a few practical issues which need further thought and attention, if the investor is to stay on track.
Let’s have a look at these now under the following headings:
- Buy a property below market value
- Let it out at a rent that covers all costs
- Wait for prices to go up
- Pocket your tax-free lump sum
Buy A Property Below Market Value
There are many ways of achieving a bargain at below market value, and many of these techniques have been discussed in detail in this and other publications, including, of course, buying at auction.
Most of these techniques involve seeking a ‘distressed’ seller or a ‘don’t wanter ’ owner; often someone who is in a hurry to move, or going through a divorce, or someone who just needs their money out fast. There are many possible reasons why someone might want to sell in a hurry and will accept a lower price.
Then there are properties which require ‘work’, ranging from cosmetic tarting up to major structural repairs. The worse the problem seems to be, the more the price is likely to be discounted disproportionately to the cost involved. For example, a house which in good condition would sell for £200,000 might be on the market at £150,000 in an unimproved state, but the cost of the works and the improvements to get it back to a £200,000 condition might be only £30,000. So there is a £20,000 margin to be made.
If property prices are rising, or are expected to rise naturally through market forces, then buying below market isn’t so crucial. However, any equity you can gain at the point of purchase will allow you to take money out later.
As they often say in property, “the profit is made on the purchase, not on the sale”.
Let It Out At A Rent That Covers All Costs
This isn’t necessarily as easy as it sounds, because yields and capital growth often work against each other. It is generally true that the higher the yield, the less expectation there is in the market of capital growth. Conversely, the higher the likelihood of capital growth, the lower the yield.
You can try and guarantee a positive cash flow by purchasing high yielding properties, but inevitably you will be reducing the chances of benefiting from substantial capital growth. Obviously this negates the whole point of the plan. You will need to find the right balance between the yield and anticipated capital growth by researching the sales market and the rental market in your chosen location.
Don’t forget the unwritten rule that properties will always cost more to run than you think. Always make allowance for void periods (when the property is vacant between tenants), repairs, insurance, management fees, gas safety certificates, and 101 things you won’t be expecting. And you’d better to try to leave some slack for increases in interest rates.
Not achieving a positive cash flow, or a break-even position at worse, could make the plan seem unattractive. However, it’s worth bearing in mind that in many countries, the USA and Australia included, investors often opt for ‘negative gearing’. This is where the investor has put money in from other income sources to supplement the cash flow from the property. If capital values are growing quickly enough, or if the property was bought at a significant discount to market value, this additional payment will be worthwhile, and can be thought of as like a savings scheme.
An alternative solution is to set aside part of the tax-free lump sum, when you take it, to cover any shortfall on the mortgage payments.
All costs should be covered, but the mortgage must be a priority – the plan won’t work if your property is repossessed. There’s a lot of debate amongst the so-called property guru’s as to whether you should opt for ‘repayment’ or ‘interest-only’ mortgages. In this case I think the position is quite clear. If you are going to re-finance every five years to take the equity out then there’s not much point paying the mortgage down. You’d be better off having an interest only loan, which will be cheaper, and which will help you to increase positive cash flow. But having said that, interest-only loans are getting harder to find!
Wait For Prices To Go Up
This is the crunch part of the plan. If prices don’t go up, the plan won’t work (unless you bought substantially below market in the first place).
I’ve heard it said that house prices double, on average, every 7 to 10 years. Looked at another way, average house prices in the UK have increased by 10-11% per annum since 1948.
However, there are some areas which have traditionally lagged behind these averages, or have even decreased in value. And other areas have beaten these averages hands down. Hence the north-south divide. This is why solid research pays premiums.
Dolf de Roos, in his book Real Estate Riches, wisely counsels buying in areas that have consistently beaten the averages, on the basis that the chances are they will continue to do so. This is a neat theory, and is worth thinking about. But be careful when you buy. Traditionally, London and the south-east has always outperformed the rest of the country. Predictions are that long-term this will continue.
Don’t forget that averages hide the fact that growth is never constant – some years will be better and worse than others. This means in practice, and depending on when in the economic cycle you buy, the equity in your property might not have grown sufficiently by, say, year five, for you to refinance it. All the growth might occur in year six.
Dolf de Roos also suggests looking at long-term socio-economic trends when buying. In addition to looking for areas where increases beat the national averages, he also advocates looking for properties with an aging population in mind, i.e. properties:
- in areas close to the sea.
- which will appeal to retirees, such as bungalows.
To keep things simple, Robert Allen suggests buying a property every year for five years, or, if you need double the income, two properties a year every year for five years.
Of course, depending upon where you are in the economic cycle, it might be better to buy multiple properties one year, and none the next, depending upon available finance and what you think is going to happen to prices in subsequent years.
This is relatively straightforward. Most buy-to-let lenders will allow you to borrow more if the rent is sufficient to cover the mortgage, plus a bit. They will stipulate that the rent is 130% to 150% of mortgage payments. They will also want a revaluation and administration fee.
The big proviso for the plan to work is: will rents rise in line with capital values and interest rates? Although capital values generally double, on average, every 7 to 10 years, rents double, on average, every 7 to 12 years. In other words, rents increase slightly more slowly than capital values.
If you started with some ‘slack’, this shouldn’t present a problem. But, ultimately, the rent receivable will limit the amount you can borrow.
There are limits, as well, as to how many times you can remortgage: lenders will pull the plug when you start getting near to 60 years of age.
Pocket Your Tax-Free Lump Sum
In theory, this cash lump will be tax-free. Because it is not strictly earned income, there will be no income tax. And Capital Gains Tax will only be payable on the disposal of the asset (and amortization etc can be deducted, plus allowances to reduce the liability, possibly to zero).
However, I have a sneaking suspicion that HMRC will want to look a little closer if they see this happening on a regular basis.
What I am sure about is that because the loan is not ploughed back into the ‘business’, you will not be able to offset that element of the interest on the loan against the rent as an allowance for income tax.
To sum up: With some thought, planning and careful research, I think that this is indeed an interesting and workable plan to use property as a ‘money tree’ producing regular crops of nice, juicy, taxfree cash. And there’s no reason why you should quit the day job just yet, because you can do this ‘on the side’.
Why not start today? Look around the auction houses for bargain properties that you can tuck away and harvest in five years time. And this plan is so simple, and so relatively easy to implement, just about anyone can put it into action, knowing that in as little as five years, this could become their full-time occupation.