The Matthew Effect

We have talked about Pareto and the fact that 80% of the wealth ends up with 20% of the population. Superimposed on that is that those with wealth tend to increase that wealth and those with little tend to spend the little and end up with nothing. 

We have also discussed that to create wealth you have to put three elements together:

1. Budget well to create a capital base.
2. Structure your investments to mitigate risk and minimise taxation.
3. Establish and manage investments that provide your required rate of return. 

In this paper we are going to look at the three elements and then put them altogether in an exercise that shows how the rich get richer and the poor end up on the pension.

To put that in perspective the average graduate’s salary is between $55,000 – $65,000 per annum and the pension is $37,014 per COUPLE.

Budget.

There are huge resources available in how to budget. I suggest you find the one that fits you and make it work. Having said that, there are several elements to budgeting that are often left out.

Time.

There are 168 hours in the week. If we allow for 8 hours sleep, 2 hours for feeding, 1 hour for washing, 2 hours for commuting, 3 hours for play, 4 hours for study, that is a basic 20 hours per day leaving 4 hours a day or 36 hours a week, no weekend study, for producing income.

Many University courses allow for students to have full-time jobs. Some need to work fulltime to support themselves. The privileged are supported and therefore can make the decision to start building wealth or having a party and ending up with a HECS debt. Make no mistake this time of life creates opportunities. You have more time at your disposal than any other period in your life. Some use the time for sports, some to read, some to help others. It is a time to explore.

Don’t forget the holidays, what is it 4 months of the year? I met a young man that used holidays to turn a love for SCUBA diving into an underwater welding skill. As a teacher he makes more money from his hobby than he does teaching.

Outsourcing.

When you are budgeting you need to have a close look at your expenses. When does outsourcing make sense and when is it you just being lazy? 

I understand that you can no longer service most new cars, but having food delivered, really.

Structure.

As you build wealth the structure becomes increasingly important. Superannuation is a great example. It is easy to get another 1 – 2% return in an SMSF than you get in a default fund. For a start why would a 25 year old have a 20% cash holding, especially with interest rate nearly going negative. The return must be balanced against the administration costs. 

There are CGT and income tax differences with trusts, companies and individuals. You need to know where you are going before you can get the structure right to get there.

Rate of Return.

Your rate of return has to be measured in your bank account not on the glossy paperwork of a fund or any other institution. You can spend hours trying to figure out what your bank account doesn’t seem to match the rates of return quoted by institutions of one form or another. This is mainly because there are fees and there are fees.

The Rich get Richer.

I am going to work through an example here in Commercial property. You can do the same sort of analysis for residential properties or equities.

Before we start remembering that return is a function of risk, this example has a high level of return but also a high level of risk. It is not for the faint hearted especially in times of crisis.

Assumptions.

You go to University at 18 and realise that with 20 contact hours a week you have enough time for a job. You save $125 per week for 4 years and learn to invest it in equities.

You graduate at 22 years old with $29,000 in savings and get a job as a graduate for $55,000 per annum. ($55,000 = $9,422 tax = $877 per week) This allows you to save $300 per week. This means at 25 years old you have $87,000 in your investment account, which gives you a 20% deposit on a $435,000 home. On the mortgage of $363,000 after costs you move in with two mates who pay you $200 per week rent each. 

In 11 years’ time you have $260,000 left to pay on a property that is now worth $560,000, which means the bank will let you borrow an extra $200,000 against your property.

You find another person like you and put in $400,000 to buy a commercial property for $1,000,000. The property has an 8 year lease at $81,600 per annum plus GST increasing at 2.0% per annum. You structure this investment in a company with a 30% tax rate.

Together you have borrowed $675,200 and after paying income tax your loan is down to $292,184 after 8 years. Because the loan has come down the ROI has dropped from 38% in the first year to 14.2% in the 8^th year.  The property is now worth $1.369 mill and your co investor wants their money to go and buy a bigger house. 

You negotiate a new lease on the same conditions for the next 10 years, and then go to the bank and borrow an extra $538,408, which brings your borrowings up to $830,592, which is an LVR of 60%. That means you now have $538,408 to buy out the other investor, which gives them a 12.44% after tax return over the 8 years.

At the end of the deal you own a property worth $1.368,568 with borrowings of $830,592 and a return of 12.44%. Nothing spectacular and most people bail out there and go buy the bigger house or car or take the overseas holiday. But for those that hang into the same structure turn the  $538,408  into $2,191,123 over the next 12 years giving a return of 12% over the next 12 years.

$200,000 turned into $2,191,123 over 20 years a return of 11.8% after tax.

That leaves you with no debt. However, if you were to keep the strategy going and after 3 years into the new deal you borrowed another $300,00 against the first property and then buy another $1mill property and borrowed $700,000 against it. Then after the 19 years you would have equity of $3,120,460 at an annualised return of 14.5%.

Needless to say you get to the stage where you add a property each year and the annualised return builds and hence the rich get richer.

In addition to that as your income increases you have been able to pay off your mortgage and upgrade your house.

The Poor Get poorer.

The co-investor that bailed after the first 8 years with $538,408 had to pay CGT at company tax rates.

Investment $200,000 return $538,408 implies Capital Gain of $338,408 at 30% equals $101,522 in CGT. Therefore, they had $436,886 in cash. This relates to a return of 9.8% on the original investment.

This investor has done well, had good increases in salary and is bringing up a family. The original house is now worth $710,000 and they still owe $165,000 on the mortgage. 

It’s time to upgrade the house, buy a new car and take the family on an overseas holiday. So they sell the little house for $710,000 and but the upgrade for $1.2mill. They could get a loan of $960,000 but decide to use the some of the money from the investment and only borrow $700,000 which the new salary will handle nicely. Stamp Duty is $65,000 plus Real Estate fees of $10,000 and legals total costs $80,000.

Outgoings $1,200,000 + $80,000 + $165,000 = $1,445,000

Incoming $338,408 + $710,000 + $700,000 = $1,748,408.

This means they have $303,408 in cash to play with, so they buy a new $80,000 car, put $40,000 into new fixtures and fittings for the new house, and of course the $33,000 for the skiing holiday overseas. The think they are being conservative because that leaves then with $150,000 to invest.

After a couple of years with the children growing up, they realise they have signed up for $2,800 per month in mortgage payments for 30 years. The school fees start to grow as do the extra curricula school activities. They want another holiday the house needs painting, but what the heck they are wealthy they have their investment, so they raid the investment. Guess what? The same thing happens a few years later. 

They bottom out their investment for the big 50^th Birthday bash, but that’s OK the kids will be away in a few years, and then it dawns on them, another 20 years to pay off the mortgage, the house is run down and needs repairs, we need a new car. This can lead in two directions. The first is the middle age meltdown, the second being downsizing. We know where the middle age crisis leads with a new Porsche, a new partner and financial ruin.