In my experience, one of the most common mistakes made by property investors is that they do not have a clear idea of what they are trying to achieve, and as a consequence, they do not really have any sort of a plan or strategy. As the old saying goes “if you don’t have a destination in mind, any road will get you there”.
If you were to ask a random sample of investors what they are trying to achieve, you’d probably hear answers like “security”, “income” or “increased net worth”, but if you pressed further and asked for details such as “how much income or how much net worth” or “by when do you want to achieve that figure”, the chances are they’d not be able to tell you.
The truth is that many property investors I meet and mentor don’t have a clear idea of what they are trying to achieve. They have a vague idea that they’d like to be successful in property or that they’d like an income from property, or that they’d like to own a few properties so that they can have some capital growth and something to look forward to in the future. But it’s all a bit vague and wishy washy. The problem is that if you’re not really sure what you’re trying to achieve then buying any old property will do, so…. which, happens all too often.
The answer to this is to set ‘clear and focused’ goals what I see time and again is that most investors don’t set goals, and even those property investors who do set goals (and I think there’s not that many of them) set fuzzy, unfocused goals. Then they wonder why they can’t, or don’t, achieve as much as they’d like to.
It’s true that there’s a lot of information about goal setting in a general context but I’ve never seen any material that deals with the subject specifically from a property perspective.
Why does this matter? Simply because study after study has shown that those who set clear and focused goals <em>always </em>outperform those who don’t, and by a significant margin. So it makes sense that if you want to succeed that you take this seriously.
Now, before I start, you might be thinking, “Not more stuff about goals. There’s loads of material available about goal setting”. But please, don’t switch off because what I want to tell you about IS important.
Here’s why most investors property goals don’t work. Here’s an example you might be able to relate to; I certainly know that I set goals like this in the past before I discovered how important it is to be totally clear and focused.
“I will buy 10 properties this year” or “I will own 10 properties by 31st December 2016”
This is the problem, it’s all too vague. Look at it this way.
What does owning or buying10 properties mean?
Does it mean owning 10 large luxury detached, executive houses or 10 2 bed terraces?
Does it mean buying 10 properties for cash which are free and clear of mortgages, or buying 10 which are mortgaged to the hilt and have no equity?
Is it 10 properties with a significant positive cash flow or 10 properties which barely break even, or perhaps are even cash flow negative?
Perhaps 10 properties let to tenants on benefits, or 10 properties let to working tenants?
I could go on and on but I won’t, I’m sure you get the idea. It’s all too non-specific and makes setting the goal meaningless.
It’s a shame because if you set the right goals, and then follow-up with the right plan and actions, you are pretty well assured success.
By the way, I’m not knocking or criticising anyone who sets goals like this, the fact they are setting goals at all is highly commendable, but it’s a shame it won’t help them to achieve what they want to achieve.
The solution to this is simple. Think about what you want to achieve and why, and when you want to achieve it by. Then working backwards, construct a plan to get you there. In modern self-help talk this is called goal setting.
Having a plan and a long-term approach to property investing are only part of the answer. You need to know whether your plan for achieving your goals is working and on track, and so you need to be able to apply some kind of ‘measurement’ to your property activities. Another mistake is not knowing whether you are on course to achieve your goals because you either aren’t measuring your progress or you’re applying the wrong type of measurement. Often this goes hand in hand with setting the wrong types of goal.
For example, you may set a goal of owning 15 investment properties. This in itself is meaningless. It tells you nothing of their value, whether they are increasing or decreasing in value, the income you need them to produce etc.
A better goal would be to add financial value to it and a time limit for it’s achievement, such as “within 10 years I will own 15 investment properties with a total capital value of not less than £xm”.
However, I suggest that a much more useful measure would be to combine the concepts of gearing and compounding, and set a goal for achieving a certain level of equity. Equity in this context is the balance left when the amount of any outstanding loan is deducted from the capital value of the property. This is, in effect, the net worth to the investor.
Now your goal might be to achieve millionaire status. At the moment you might think this seems a bit fanciful, but with property, because of the effects of steady and compounding growth, it isn’t. Especially when you give the compounding enough time.
So, the question isn’t “If I become a millionaire?” but “When will I become a millionaire?” In fact £100,000 will compound to just over £1m in around 10½ years at 25% annual growth.
The next question is “Is 25 % per annum a realistic target?” The answer is yes because we are compounding the equity, not the capital value of the properties, and we can use gearing to do it. So, if we have 5 properties each worth £100,000 and they increase in value by just 5% per annum the total value will increase to £525,000 in the first year. This extra £25,000 is all yours and your equity will now be £125,000, an increase of 25%. So far, in the first year at least, we are bang on target. And that’s using a relatively conservative growth rate. The figures could be different depending on whether you’ve opted for a repayment mortgage, or an interest only mortgage. We’ll look more at that later.
The bad news is that in year two the figures aren’t so good. Again allowing for only a conservative growth rate of 5% the value of the five properties will now total £551,250, an increase of £26,250. However, as the equity at the beginning of year two was £125,000, this extra £26,250 represents an increase of only 21% on the equity. Each successive year the return on the equity will decrease.
However, don’t panic, this doesn’t mean that the goal is unachievable, we just need to help the growth along a bit. There is a simple solution. At the end of year two all we need to do is refinance, and take 80% of the increase in the equity as a deposit for our next property purchases. To keep things simple, and assuming we continue to buy properties each worth £100,000, you should have funds to use for the deposits to buy three more.
So from the beginning of year three you will have 8 properties with a total capital value of £851,250, each compounding at 5%. At the end of year three the total value will be £893,812, an increase of £42,562. As the equity at the beginning of the year was £151,250, the return on equity will be 28% and so we are now ahead of target. Of course, 5% is a rate I used purely to illustrate the point. In reality property values don’t grow consistently, some years are better than others, and I some years they don’t grow at all or even go down.
The key to achieving your goal is to keep in mind that the important statistic to study is the ROE, the <em>Return on Equity</em>. In this example, every time it dips below 25% (your required growth rate may be more or less, depending on your goal and your starting point) the portfolio should be refinanced and more property purchased. In reality, using actual historic growth rates, the chances are that this goal will be achieved quicker than 10½ years.
So make sure that from the start you know how you are going to measure your progress, and just as importantly, decide how you will know when you’ve arrived at achieving your property goals.
This is still only part of the story as increases in capital value are only one way by which your equity can grow. Another way to add to the equity is to progressively pay off your loans during the mortgage term. This is a natural consequence of financing using a repayment mortgage. However, there is a school of thought that taking out a repayment mortgage isn’t always the right way to fund property purchases.