By that we mean investment properties that don’t have a mortgage.

Why is this?

We mentioned before that a property with a gross yield of 6% might have 2% of operating costs, leaving you with a 4% net yield.

But if you are borrowing 100% of the purchase price of the property and the interest rate on your mortgage is 3%, then that leaves you with just 1% in cash each year after you pay your mortgage. i.e. 6% rent – 2% operating costs – 3% interest = 1% cash left.

On a $600,000 property, that’s just $6,000 a year, or $115 a week. It’s not going to change your life.

If you want an annual income of $60,000, you’d need to buy 10 of these properties. That is unrealistic for many Kiwis.

Instead, if you owned the property and didn’t have the mortgage against it, then you would earn $24,000 annually from the property after costs.

To make the same $60,000 of passive income, you’d only need 2.5 of these properties … that’s $1.5 million of debt-free assets.

That demonstrates that if you want a decent passive income, then you need to own properties with very little debt secured against them.

Said another way, you need to have a lot of equity in your properties.

If you own properties that are highly geared, then the interest costs will take away most of the income you would otherwise enjoy.

So, how do you calculate the level of assets you need?

First, take the annual passive income that you want to live on. Then divide that number by 0.04 (i.e. 4%, or the equivalent of multiplying the figure by 25).

That will give you the level of debt-free assets you need.

To give a worked example, let’s say that you want an annual income of $100,000 in today’s dollars (more on that below). Once you divide that by 0.04, you get $2.5 million of debt-free assets.

That means that after your $2.5 million of high-yielding property has paid rates, insurance, maintenance, body corporate and any other expenses, you make $100,000 every year before tax.

If you’re like most people, you’ll be thinking “OK, that’s great … but I don’t have $2.5 million of debt-free assets!”

That’s fine. That’s where you can use property investment to get to the point where you do have the assets you need.

Don't forget about inflation

Before we move on to how to build a portfolio that creates the assets you need, we have to talk about inflation.

Over time, the cost of most things increases.

Think of it this way, 40 years ago a 50c ice-cream was massive …. 20 years later it would be an OK size … today it would barely buy you the cone.

The point is this: the price of things go up, and what $100 can buy this year will be more than what $100 can buy in 20 years.

Why does this matter?

Because when you are trying to create a passive income for your future, you can’t just think in terms of the income you want today.

For instance, if you want a passive income of $50,000 to start 20 years from now, you can’t just divide $50,000 by 0.04 and be done with it. Because by the time 20 years have passed, $50,000 won’t buy you the same amount of stuff that it can today. In fact, based on the 2% inflation factor often used, it would only buy you $33,649 worth of stuff (in today’s money).

So you first need to figure out: “How much income do I need in the future to buy the equivalent of $50,000 worth of stuff in today’s money”. Once you’ve done that you can divide the new number by 0.04.

So how do we do that? To keep it simple, you can use an inflation calculator like the one below.

But, as an example, if you want to build a passive income of $50,000, and you want it in 20 years, then you need to aim for $74,297.

Multiply that by 25, and you will need $1.86 million of debt-free assets to generate that passive income.

Inflation is an odd concept for many people. It’s obvious when looking back … just think about how big a 50c lolly mixture was when you were a kid, and how puny they are now. But looking forward it’s harder to see the same thing happening in 20 years’ time.

That’s because it hasn’t happened yet. But that doesn’t mean it won’t happen. It’s vital that you factor inflation in now, because you don’t want to get 20 years into the future and realise you’ve aimed short of what you really wanted.

How to build a property portfolio to achieve the assets you need

To build a significant level of debt-free assets as a long-term buy and hold investor, you will likely want to focus on properties that go up in value quickly.

As mentioned, two types of properties are available to most investors – growth and yield.

A growth property is one that will increase in value more quickly over time, but will attract a lower rental yield.

On the other hand, a yield property is one that will attract a higher rental yield but will increase in value more slowly.

When you eventually start to enjoy your passive income, you’ll probably be using yield properties to get the 4% net we talked about above.

But to build the assets to create your passive income, most Kiwis will invest in growth properties first.

Let’s walk through a case study to show why this is true.

Within this example we’re going to assume that your goal is to build wealth through a buy and hold property investment strategy.

Let’s say you can purchase a property worth $500,000 and you’ll be borrowing at 100%. That means you’re not putting any cash in as a deposit.

On the one hand, you could purchase a growth property. This is expected to appreciate at 5% annually, but the property will be cashflow neutral (i.e. it will earn $0 a week).

On the other, you can invest in a yield property that is forecast to appreciate at 3% annually and will make $100 a week in cashflow.

Which will make you better off in 15 years?

Note: for the purposes of this example, we are going to ignore the impact of inflation on rent and expenses, and will ignore the fact that within this timeframe the profits from the properties would be taxed.

Well, in 15 years your growth property is forecast to be worth $1,039,464, and the yield property is forecast to be worth $778,984 with an additional $78,000 in cash saved.

In both examples, you still have a $500,000 mortgage.

So, once the mortgages are paid off, investing in the growth property will have earned this investor $539,464, whereas the yield property would have netted $356,984.

That means the growth property provided a 51.12% better total return than the yield property.

This is why, to create the assets needed to generate a passive income, it pays for a long-term buy and hold investor to focus on growth properties first.

These properties tend to be standalone houses or townhouses located in the main cities of New Zealand – Auckland, Wellington, Hamilton and Christchurch.

Case study: The building of a property portfolio to build a passive income

Let’s say that you and your partner are both 40 now and in 20 years you would like a passive income of $100,000.

That means that you can retire 5 years earlier than the current age of superannuation entitlement. You can live off your rental properties for the rest of your lives and still leave this as an inheritance for your family.

How do you do this?

Step 1 – adjust the income for inflation

Using the inflation calculator above, we see that the inflation factor is 1.49. So, you actually need to aim for $149,000 of passive income to be able to live the same life you could today on $100,000.

Step 2 – calculate the debt-free assets needed

Multiplying $149,000 by 25 shows that you’ll need $3,725,000 worth of debt-free assets to create that passive income based on a 4% net yield.

Step 3 – map out your property portfolio

In this case study, you’re looking to create a lot of equity. Generally, you might have other assets that would help you get to this goal, like shares or savings. But let’s assume you don’t have any of these and you’re just going to do it through property.

Step 3a – buy your first property

You might start by investing in a property in Christchurch. Let’s say you buy this for $500,000. Let’s forecast that this property will grow in value by 5% each year.

By the end of the 20 years we would forecast that property to be worth $1.32 million.

It would have $827k worth of equity in it, even if you used an interest-only loan and didn’t pay off any of the debt.

That means that this one Christchurch property is projected to create 22% of the equity you need to achieve your passive income goal. 

Step 3b – buy your second property

The next year you might decide to invest in an Auckland-based property that costs $800,000. Similarly, you might project that the property will increase in value at a rate of 5% (which is well below the historical average).

You’ll hold this property for one year less than your Christchurch property, although because it’s a higher value asset it will create more equity for you in the end.

Based on these numbers it’s projected to be worth $2.021 million by your goal date, creating $1.22m of equity. That fills 33% of your overall equity goal.

So between the Christchurch and Auckland properties, you’re projected to close 55% of the overall equity you need to create to hit your goal.

Let’s say that you then spread your next purchases over several years and use slightly lower growth rates to be even more conservative.

Step 3c – buy your third property

The third property you decide to invest in might be a Wellington apartment. This would be the sort of property that would produce excellent cash flow, which can help pay for any unexpected costs within your other properties.

The property you purchase in this case could be worth $750,000, and you are buying it another year after the Auckland property. That means that you’ve got 18 years of capital appreciation in the asset before your goal date.

But, since it’s a yield property, you’ll forecast that it will grow at just 3% a year.

That means by the time you reach your goal date, it is forecast to be worth $1.28 million and will have created $527k worth of equity for you.

This fills 14% of your goal and will end up producing the least amount of capital from any of your properties.

You buy it anyway, knowing that your risks are covered if interest rates rise, or unexpected maintenance costs crop up within your portfolio.

Step 3d – buy your fourth and fifth properties

So far you’ve filled 69% of your equity gap with property.

You’ve only got 31% to go.

But each property you purchase after this earns less and less of the total equity.

Why?

Because each additional property you purchase is being held for less time before your goal date. That’s because you’re making the decision to build your portfolio gradually in this example.

So, 3 years after purchasing your Wellington property, you invest in an $800,000 Hamilton property, and 5 years after that you invest in another worth $1 million, also located in Hamilton.

Remember, the values of the properties you’re investing in keep going up because of inflation – houses will be more expensive in the future than they are today.

To be conservative, you use a forecasted growth rate of 5% for your first Hamilton property and 4.5% for your second.

Your first property will fill 23% of your equity gap and the second, 15%.

Results of this investment strategy

If you had followed the strategy as set out here, in 20 years’ time you’re forecast to have properties worth a combined $7.84m, with total equity worth $3.99m.

That’s above the target you initially aimed for.

In fact, if you add up all the percentages mentioned so far, you’ll note that you’ve actually hit 107% of your total equity goal. That wasn’t by chance. The reason you want to produce more equity than you need is that while you’ve been building your portfolio, you will have primarily been focusing on growth properties.

But, to build the passive income you wanted to create, you need yield properties. By the time your goal date arrives, you’ll want to sell all your growth properties and purchase high-yielding properties instead.

These will generally be higher-yielding apartments or room-by-room rentals near universities, hospitals and significant employment areas.

So we need to allow for a buffer for sales costs and real estate agent fees.

In the above example, you’d budget for $235k of real estate agent fees (using a flat 3% rate), so you can sell the properties and purchase new ones.

That leaves you just shy of $3.76m worth of equity to invest, and based on the 4% net yield you’ll earn a passive income of $150,400 every year, which will go up as the rent of your properties increase.

In today’s dollars that’s the equivalent of earning $101,100 every year without having to work a single day.

You can retire at 60 and be sorted for as long as you live because you’ll own 3-4 high-yielding properties with no debt on them.

What are your next steps

What does it take to build a passive income?

No matter which asset class you decide to invest in, it’s going to take time. Time for your assets to build to the point where the return can make the passive income you want.

And while property investment may not be the highest yielding asset class, or be the most risk-free, it is the asset class that has an acceptable mix of both.

Write your questions or thoughts in the comments section below.