Asset Protection and Your Property Portfolio
Creating a substantial property portfolio can be a lifetime's work, so serious investors need to know how to keep their assets safe.
You've lovingly accumulated your property portfolio, investing and borrowing while you're working, using capital growth and rental returns to build your empire. But there are a few storm clouds on the horizon, including an increasingly litigious society. The issue for you now as you contemplate transitioning to financial independence is not how to build wealth, but how to keep it.
Here we'll look at 10 ways to protect your wealth and keep your prized portfolio safe. As many investors know, property investing is as much about managing cash and liquidity as it is about choosing properties, managing tenants and arranging finance. You need to ensure that you're able to access the cash needed to feed your portfolio and enable it to grow: this is a key wealth-building skill. The first few tips deal with your ability to manage cash so your portfolio can continue to appreciate and generate ongoing wealth for you.
1. Take out income protection insurance
If you're a negatively geared property investor who's self-employed or you work on contract, your salary doesn't have the same short or medium-term stability or security as a wage earner who's a permanent employee.
One risk-management strategy you can put in place to maintain the stability of your income is to take out income protection insurance. This ensures you continue to receive a certain amount of income if you suffer a decline or inability to work. Income protection insurance covers you for such things as illness or disability. It'd be hard to cop building a large, geared portfolio and then having your ownership of that portfolio threatened because your ability to service the loan repayments was undermined by a long illness. You want your property portfolio to be able to support you but until it does you need to be able to continue to support it!
A helpful aspect of income protection insurance is that the premium is deductible for tax purposes.
2. Take out landlord's insurance
We've all heard horror stories of tenants who trashed rental properties, were months behind on the rent and skipped the premises while still heavily in arrears. This not only causes costs for the investor in repairs and lost rent but also causes delays in collecting future rent because of the time required to get the property in order.
While prevention is obviously better than cure, in that good tenant selection is paramount, landlord's insurance offsets the cost (and some of the pain) of a bad tenant. This can mean the difference between a bad tenant causing only a minor disruption versus a huge cash hole.
As with income protection insurance the premium for landlord's insurance is tax deductible.
3. Keep a cash buffer
The most straightforward means of ensuring you can get cash quickly is to have some on standby.
Don't part with cash if you don't have to when making a property acquisition. To the greatest degree possible, let a bank or lender be satisfied with equity in the form of hard assets rather than cash so you can have cash on standby and under your control.
You can still have the cash working for you if you have it sitting in an offset account or line of credit. There's no substitute for cash – it's the most liquid asset – and a ready supply is one of your best risk management measures.
4. Borrow more than you need
This may sound counter-intuitive since higher borrowing increases risk (other things being equal) but here we're just talking about an extension of number 3: when you buy a property, if your loan-to-value ratio (LVR) allows, your financing may permit taking out a few extra thousand dollars on top of the cost of the property and associated legal and purchase costs to keep on standby.
These extra borrowed funds don't need to add to your repayment costs: you can simply keep them in a line of credit, to be drawn down if you need to meet a sudden or unexpected expense.
5. Lock in your interest rate
It's something of a game for geared investors to try to beat the market by second-guessing future interest rate movements by locking in a fixed interest rate. The gamble is that the fixed rate you lock in will be lower than future variable rates for the period for which the rate is fixed.
Usually, long-term rates (i.e. those at which a rate is fixed) are higher than variable rates, with the longer the term the higher the rate. If you plotted interest rates from short term to longer term the line would slope upwards – this line is called the yield curve. The time to lock in a fixed rate is when you believe the yield curve will invert (i.e. the yield curve will slope downward rather than upward).
Betting on interest rate moves is a highly fraught (some would say speculative) venture. Trying to forecast future interest rates is far more difficult than choosing a good property investment. Really, the benefit of fixing your interest rate lies in giving you certainty about your loan repayments for a given period of time – this is where its risk management value resides.
6. Make your loans stand alone
The usual means for a working property investor to accumulate a portfolio is by using the equity generated by the capital appreciation in one property as the security, or collateral, for a loan that is used to acquire another property.
This process, known as cross-collateralisation, means that the liabilities from one asset are in effect woven in with the liabilities from another. There's a whole tapestry of debt supporting the portfolio of assets.
This is fine in and of itself, and is a critical means of structuring finance to build a property portfolio for many investors. The problem arises when there's a cash shortfall in meeting the repayments on one loan, which then ripples through the debt structure, endangering the portfolio as a whole. Then, the tapestry of debt turns into a house of cards and the whole thing can collapse, meaning you lose the lot.
You can owe on a property loan even after assets are repossessed and sold if property values dropped below their purchase price and the bank didn't recoup the value of the loan. You'll be liable to pay the difference – a scary prospect.
How can you avoid a cash shortfall rippling through your whole liability structure? By releasing security and de-coupling your loans. Growth in equity enables this to happen because there may be sufficient value in one property that enables it to meet the loan to value requirements of the original loan, free from the requirement for equity from another property.
The loan structure would then be segregated: an asset that was tied to another would instead stand on its own. In effect the liability structure would be divided up and the (possible) house of cards subdivided (pardon the pun) into smaller, independent entities.
De-coupling a loan in this way means the liabilities are spread and dispersed and can therefore be more effectively managed because they’re quarantined in smaller lumps. The usual considerations would apply where security is to be released: bank valuations (or more correctly, revaluations) would be conducted, with mortgage insurance required if the 80 percent LVR requirement isn't met.
At first blush this strategy conflicts with what we noted earlier (in number 3) about using hard assets rather than cash to secure an investment loan. However, these can be seen as different steps in the same process: a portfolio can be accumulated using cross-collateralisation, leaving cash free, and the loans can be de-coupled later once equity has grown.
The vigilant investor therefore has the ability to take advantage of the power of leverage to build a large equity-rich portfolio and to subsequently manage the liabilities used to finance this portfolio by splitting them up. It’s a nice facet of equity growth that it not only builds wealth for an investor but also enables an investor to manage their liabilities by splitting those liabilities up.
7. Use a trust
In the same way that you can quarantine liabilities by de-coupling debt into smaller entities, as we've just seen, a trust can be used to quarantine liabilities.
A trust is a legal entity that can own property: it has beneficiaries who are the people or entities to whom the returns of the investment owned by the trust are distributed. A trust will also have a trustee who, in a discretionary trust, will distribute the investment returns as he or she sees fit. The trustee can be a person or company.
The protective benefit of a trust for a property investor is that if you have debt enforcement action taken out against you or you go bankrupt, assets in which you have an interest via a trust (including of course, properties) will be sheltered from such action.
Robin Evans, of solicitors Evans and Wislang, notes that because of this, if your property assets are owned by a trust, only the creditors of the trust – not the creditors of beneficiaries or the trustee – can lay claim to those assets.
"Effectively this takes the asset out of, say, a debtor's pool of assets which would be available to a creditor. Similarly, creditors to the trust aren't able to claim against a beneficiary's assets for a debt of the trust. By the effective use of a trust a person can acquire assets which will not be available to his general creditors." Evans says.
The protective value of trusts was in the spotlight recently, particularly after the Westpoint case where the Australian Securities and Investments Commission was able to obtain injunctive orders in relation to assets in the hands of other legal entities (including trusts) in order to make the assets available to creditors.
However, Evans notes that where a trust acquires an asset for full value and there's no suggestion of any impropriety, that asset is protected under the trust from claim by unsecured creditors of the trustee or beneficiaries.
There are other benefits of a trust as well, most particularly the ability to distribute income on a basis to minimise tax liabilities. But from the asset protection point of view that we’re interested in here the value of a trust is that the risk associated with the debt or liability used to acquire an asset can be managed by virtue of being quarantined within a trust structure.
8. Get a pre-nup
It's never a happy topic to consider but if you're getting married or in the early stages of a long-term relationship and want to ensure your property assets stay in your hands in the event of the breakdown of the relationship, a pre-nuptial agreement (or pre-nup) may be for you.
A pre-nup stipulates how assets will be divided if the marriage or relationship dissolves, before that event occurs (if it ever does).
Many lawyers recommend that asset-rich investors get a pre-nup, also known as a Binding Financial Agreement. On the other hand, many people don't like the idea of a pre-nup because it appears to them to pave the way for a break-up rather than supporting the idea that the relationship will endure.
In an ideal world, pre-nups wouldn't be needed, or at least both people in the relationship would want one. But for many, this ideal is not a reality. The choice is yours. If you believe your relationship will last the distance and/or that your partner won't take you to the cleaners in the event of a breakdown, don't get a pre-nup. But if you want to ensure your ongoing ownership of your properties, push for a pre-nup.
According to the statistics, the probability of a marriage ending in divorce is increasing over time (from around 28 per cent in 1985-1987 to 33 per cent in 2000-2002) so if you're able to get one you'd be well-advised to take it. Just ask Paul McCartney.
9. Ensure you have an up-to-date will
This is as gloomy a topic as pre-nups but of even greater importance. No-one should be without a will – and this applies all the more so to property investors. You need a will to ensure your property and other assets are distributed after your death to whomever you've chosen. Give yourself – and your intended heirs – peace of mind by ensuring there's clarity around who gets what.
Hopefully you won't need to use it for a long time. But it would be a terrible irony if the property assets that were supposed to bring you security and freedom brought your intended heirs conflict and insecurity.
Hope for the best but prepare for the worst.
10. Buy cheap
We're saving the best till last. It's an old investment cliché that you make your money when you buy rather then when you sell. However another aspect of this is that buying at a bargain price is also an excellent risk management measure.
This is for the obvious reason that you’re parting with less capital, accumulating fewer liabilities and setting up the cash return from the investment at a higher yield relative to purchase price. Also, if you're able to buy at a discount to market you have, in effect, created immediate equity which has its own risk management value.
This is an aspect of the value investing approach adopted by the richest person in the world, famed investor Warren Buffett. For Buffett, risk and return can sometimes be positively correlated (as conventional finance theory states) – but not all the time. While many investors associate risk with volatility and price swings, the fact remains that if you buy an asset (whether a property, shares or a business) at a discount to its true value because of a price drop there is both less risk for you and greater potential for reward.
So kill two birds with one stone: do the research and the number-crunching to buy properties which are trading at a discount to their true worth (understood as the sum of their expected future rental return and capital growth) and get the benefit of higher returns. You’ll not only be adding to your wealth, you’ll be better insulated from cost increases or interest rate rises.
Disclaimer: Please note that the above article should not be taken as a substitute for tailored financial advice for your individual circumstances. The information in this article is intended to be general in nature and should not be taken as personal financial advice.
SOURCE: AUSTRALIAN PROPERTY INVESTOR - www.apimagazine.com.au/api-online