If you think the best investment in Australia is property, you’d in fact be wrong because there are several asset classes that outperform it. But you would also be right if you said it was the best investment vehicle by which to generate long term wealth.
But why the oxymoron?
Australia’s banking system is addicted to using property as security, which means this low income asset class has to be used as security if you want low-cost bank capital. Low-cost capital is essential for being able take advantage of great investment opportunities with higher returns. Talk about a catch 22.
To solve this conundrum, some of the family offices and HNW investors we work with have created an investment strategy that ensures the system works for them. In short, it’s a combination of the right property acquisitions, low-cost bank capital and private market arbitrage investments.
This strategy allows them to simultaneously maximise borrowing capacity; double property yields and make higher returns through compelling investments. All of which we will share with you in this article, so you can do the same! We will also list some compelling investments you should consider to maximise your investment portfolio.
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The components of the family office investment strategy
You can’t be emotionally attached to property
Having equity is great, but having dead equity can’t be tolerated (equity not being put to active use).
Select the right properties to invest in
Not all properties are equal because they vary in returns, maintenance costs, tax concessions, tax charges and development potential, therefore it is imperative you select the right ones.
Select properties that banks love
Property is to bank loans, what pollen is too bees. Select property investments that banks would happily lend against at a high LVR and low cost.
Borrow to create liquidity
Instead of selling assets to take advantage of compelling investment opportunities and paying taxes on crystallisation, take loans instead.
Property tax benefits
Ensure you maximise the tax benefits of property maintenance items and the expense items of when taking loans against properties.
Find compelling investment opportunities
Compelling investments must have three components. Firstly, they must have an asymmetric reward to risk ratio (otherwise known as an alpha return- you can read our latest article here on alpha). In other words, you can generate higher returns without taking on additional risk. To do this though you need active control of your investments. Secondly, the return on capital must be at least 50% more than the cost of borrowed capital. Thirdly, there must be a high degree of security for your invested funds.
Wealth is made through private investments
Private market investments such as the creation or acquisition of private businesses that you control, private credit, property development and venture capital offer the highest chances of wealth building. Most family offices made the bulk of their wealth through private business that they founded or acquired. Very few did it through trading on public markets alone.
Determine your risk tolerance and concentration risk
You must determine what percentage of your portfolio will be invested into the new investment and your ability to service debts for the investment in the event it fails.
The family office investment strategy to boost your wealth
Property is used to store wealth
Family offices can’t afford to have their cash surplus eroded by inflation, so when they have excess capital they quickly deploy it into property acquisitions or some store of wealth. When they do finally find a compelling investment, some of them will borrow funds to take advantage of opportunities.
Sounds simple, it is but isn’t. The hard part is finding compelling investments. This is in part why firms like ours exist.
The investment strategy at play
The below strategy assumes the property or properties have a high degree of equity within them. We’ve modelled the numbers down from $50M to $1M so you can better see the potential for your situation.
The below numbers are for example purpose only.
The property
Assume the family office have a $1M property with a net rental income of 2.5% ($25k net income), no debt and a clean credit score.
The bank loan
The family office will then then borrow against the $1M property at 70% LVR, $700k at 6% p.a., costing $42k in interest per annum.
The private credit investment arbitrage strategy
In this example the family office will invest the borrowed funds into a first mortgage private credit investment, where they lend the money to a business taking property as security.
The investment will yield a minimum 10% return p.a. on their $700k ($70k). With a first mortgage security over a property asset worth $1M at a 70% LVR.
This profits the family office a 4% delta. The cost of bank capital at 6% vs the return on capital at 10%. Allowing them to make a net return of $28k on the investment ($70k less $42k).
What they have done is in effect a type of arbitrage. They are using their $1M property as security with their good credit file to take a cheap bank loan. Then selling that same money to a business borrower, taking the borrowers $1M property as security, but absorbing the higher credit risk of the borrower, and profiting the delta in return.
Doubling of property yield
That same $1M property now generates $53k in returns or a 5.3% instead of 2.5% ($25k from net property rental, plus $28k from the above-mentioned investment strategy).
Increased wealth over time
So, whilst property on its own is a poor income producer, as a vehicle to generate wealth it is second to none. The beauty of this strategy is six-fold. Firstly, it also allows you to evidence higher servicing with the increased investment income. Secondly you gain capital appreciation of the property. Thirdly, rental income increases over time. Fourthly, it allows you to borrow more against the asset as it increases in value over time. Fifth, you can reinvest those funds into more compelling opportunities. Lastly, tax benefits of property expenses and financing costs of borrowing.
Can this investment strategy be improved?
Yes, there are several legal tax minimisation strategies we are aware of that would greatly amplify the benefits of this model, separate to any property or finance tax deductions.
Compelling Investments to consider
What to consider
Before we give you a list of investments to consider, you first need to work out what your cost of capital will be, your portfolio construction, your concentration risk and your ability to actively manage investments.
These are a sample of investments we have on file, and we’ll update this further in the weeks coming.
Development of your own PPR
Whilst we initially thought not include this, it is a pet hate of ours that most people often ignore this strategy.
The current tax structures in Australia (I can’t stress enough the word current) give principal place of residence (PPR) owners ample tax concessions that make development and sale of their own home a mechanism to grow wealth. The problem is most people get emotionally attached to their home. In essence you would borrow funds to acquire land that you can develop a brand-new home on that would add significant value to the site. You would then live in this home for the minimum period to get the tax concession. It’s basic but if you have equity in your existing home, it means you need to borrow less money.
First mortgage private credit investments
The above strategy utilised first mortgage private credit investments. These typically net a return of 9% to 14% p.a.
US equities
US equities significantly outperform Australian equities. US equities have grown by 10.8% on average per annum over the past 30 years. There is a great article here by the AFR on US shares vs Australian shares.
Second mortgage private credit investments
Second mortgage private credit investments providing you can underwrite the first mortgage to mitigate risk are a good option. This is reserve for more experienced investors. These typically net a return of 18% to 24% p.a. You can read more here about this strategy.
Business acquisitions
This has to be one of our favourites due to the major wealth shift happening between generations. You can buy businesses trading at multiples of 3 to 5 EBITDA. Meaning your return on capital is 33% to 20% p.a with a business that is cashflow positive. In addition to the tax deduction benefits. The important part is that you stay in control of the business to minimise risk.
Conservative crypto lending
Lending against a crypto portfolio might sound high risk, but if you’re lending against a major crypto currency at 50% to 60% LVR, risk can be mitigated providing you have the right to liquidate the asset in event it drops below a certain price. Returns here are at least 12% plus p.a.
Emerging market government bonds
There a number of emerging market bonds that offer returns above 9% returns. The issue however is the currency and sovereign risk involved. You can see current bond yields here.
Specialist property acquisitions
In our article inside the portfolio we provide several property examples that family offices are actively pursuing. Most of these provide returns above 9% p.a.
Mid cap public equities
When interest rates are low, equities markets are buoyant. Buying equities at a discount when interest rates are higher, can mean you can experience strong capital growth when markets boom again. There are specialist mid cap fund managers, that have hit 14% p.a. annual returns, who specialise in a select portfolio of only 20 stocks.
To learn more about private credit investments click here.
If you'd like engage us in an advisory or investment capacity contact us here.
