Building a $5 Million Property Portfolio

After 20-years in the property industry analysing and providing advice on a wide variety of property portfolios, we have developed several risk adjusted property portfolio models. This summary gives an overview of our $5m net equity model portfolio.

It is important to acknowledge that this is not a comprehensive property or financial plan and investment decisions should not be made on this information alone as it does not factor in individual circumstances. This is a summary of a property strategy that we individualise for our clients and often compliments other investments and advice from an accountant and financial planner. Our role is to design the property strategy and build the property portfolio for the optimum risk / return ratio given a client's situation.

Our hypothetical client (our client) for this model portfolio is a dual income household who has a 20-year investment horizon until retirement.

We have set out three key objectives to achieve the portfolio goals.

Objective 1 - Manage Risk to Protect Portfolio Income
As the client will be relying on income from this portfolio in retirement, our first objective is to ensure the property portfolio has a low risk profile and will generate a consistent flow of income in all economic climates, including: pandemics, credit contractions, and recessions.

Objective 2 - Compound Annual Growth Rate (CAGR)
The second objective is to generate an average compound annual growth rate (CAGR) of 6% for residential assets over the 20 year strategy. This will ensure enough capital growth to help fund the strategy and allow the client to leave a significant inheritance for their children or bequest as part of an estate plan.

Objective 3 - Loan to Value Ratio (LVR)
The third objective is to reduce the Loan to Value Ratio to below 30% by Year 20 of the strategy so the client is not entering retirement with high levels of debt.

The accumulation period will last approximately 12-years where we will invest and leverage our clients' capital into the market. Staging the investment over a period of time will help mitigate risk by smoothing out market fluctuations and navigating events such as recessions that happen every 10-years or so. The accumulation timeframe may be longer or shorter depending on changing circumstances, including: household income & savings, lending criteria, and economic conditions.

To achieve both the income (cash flow) and capital growth objectives, this portfolio will include an initial target weighting of 50% residential and 50% commercial property.

Residential assets

The residential allocation (50%) will consist of five properties that are in established AAA-rated suburbs with A-grade quality homes. Due to the ongoing scarcity of quality property in high quality locations, these investments will help achieve the capital growth objective.

These residential assets will be purchased in different states across Australia within the first seven years, with a preference for markets in their value or momentum stage of their cycle. Two of the residential properties will be sold towards the end of the accumulation phase once they have achieved their growth targets. The sale proceeds will be used to reduce portfolio debt, reinvest in another long term residential asset, and continue investing in the commercial assets.

Commercial assets

The commercial allocation (50%) will consist of diversified quality commercial property. The exposure will commence in the second year and is diversified through investments into commercial funds and syndicates with multiple investors. This provides access to assets leased to A-grade tenants (i.e. defensive government, logistical, medical) in high demand locations which would otherwise not be achievable for our client at this price point. The diversification is achieved by investing the $1.75m allocation of commercial property across seven Performance Commercial Defensive Funds at roughly $250,000 per investment.

At Year 20, the portfolio will consist of approximately 60% commercial and 40% residential.

Cash Contribution

Our client will contribute $50k into the strategy each year for 20 years, with a total investment of $1m.

Using conservative growth assumptions we expect the contributions in this model property portfolio to achieve approximately $5m equity after 20 years.

To compare this with other investments, if our client invested the same funds into a term deposit that compounded at 4%, those funds would appreciate to roughly $1.5m over a 20 year period. If they invested into a diversified share portfolio compounding at 10% those funds would appreciate to roughly $2.85m over 20 years.

Leverage

Much of the additional performance above term deposits and shares comes from the ability to leverage into property assets. This increases the risk as well as the expectation of a higher return. How we manage this risk is of paramount importance.

We do this by ensuring our client always maintains an agreed cash to debt ratio for their circumstances, adequate income protection insurance, as well as monitoring various different risk metrics on an annual basis.

At the start of this strategy, leverage is high. From year ten we see a dramatic reduction in the LVR as the portfolio becomes cash flow positive.

Risk

Managing risk within the property portfolio is at the core of every system and process within our business. Our risk management program covers but is not limited to: Ongoing Macro Research, Defined Property Strategies, Minimum Asset Quality Standards, Extensive Due Diligence, Diversification, Annual Inspections, Cash Flow Management (including Cash Buffers, Interest Rate Strategy, and Emergency Cash Flow Planning), Annual Portfolio Reviews (including General Property and Risk Insurance reviews).

Notwithstanding the above, this strategy does require our client to take on moderate amounts of risk, in large part due to the high levels of leverage in the first seven years.

Over a 20-year period, we expect that there will be periods of extreme uncertainty where property values will decrease. The 1990 Recession, the Global Financial Crisis, and the recent Covid pandemic are examples of this.

Because of these risks, this strategy is only suitable for our clients as they are a sophisticated investor who has the means and conviction to see out the strategy and the principles that underpin it for the full 20-year term.

Model Assumptions

While we don't publicise our full model, it is important to state the assumptions that we used to define our portfolio goals. The table below includes our assumptions that we feed into our model, which represent realistic growth rates, yields, and taxes.

When we consult with a client, we step them through the model and feed in variables based on their individual circumstances to ensure that we create a strategy and model specific to their circumstances.

Results

Based on the above assumptions, the table below displays the results from our model at Year 20. These results will differ for each client based on their circumstances and the way the market behaves over the duration of the strategy.

The key to a low-risk portfolio is the consistency of income despite all adverse circumstances. This would include extreme circumstances such as the current pandemic. This portfolio has 10 different income streams, roughly 40% - 50% coming from residential and 50% - 60% coming from commercial. Commercial investments are an essential part of the portfolio as the high net yields balance out the low net yields from the quality residential properties. Our focus when buying commercial assets is long-term, 'defensive lease covenants' - i.e. tenants that will still pay rent in economic contractions. These could include government tenants, supermarkets, medical centers, hospitals, or blue-chip, key supply chain businesses.

Economic contractions should be expected, recently in Australia they have occurred in 1972, 1982, 1989, 2001, 2007, and now 2020 - roughly every 10 years. These economic contractions have always been felt differently across the country and as such, geographic diversification ensures that if some rents fall, others across the country may rise. All our strategies have been designed to withstand these times, as well as other adverse circumstances, of which we can provide further detail upon request.

Finally, our view on land tax. Unfortunately, this tax you can't avoid if you want to have a $5m portfolio. You can, however, minimize it quite significantly through diversification, both in terms of asset location and ownership structures. Having a quality accountant with experience in property is crucial for advice on land tax and ownership structures.

This article is just a summary of one strategy to build a $5m property portfolio. We go into more detail and discuss the different paths our clients can take to reach a similar result in a portfolio review and strategy consultation.

Contact us to book a review of your portfolio and discuss a similar portfolio strategy for you.