A key decision investors face when they are growing a portfolio is whether or not they diversify into different locations.
There are many different reasons why an investor might focus on a single area or purchase in different locations. Aside from the investment thinking behind the decision to diversify or not, there are also financing implications that you should consider.
Having a well-diversified portfolio means that your assets will likely grow at different paces at different times. Good finance structures allow you to borrow against individual assets, rather than your total portfolio position.
This means a well-diversified property portfolio can provide a more consistent source of equity growth in your portfolio, making it easier to release equity over time and helping investors grow their portfolios during slow markets.
The key to this is ensuring that your loans are not cross-collateralised, a common financing problem for investors. A cross-collateralised loan is a loan secured against more than one property.
Having each loan only secured against one property means your properties are separated in financing terms. This allows you to release equity from one property if it has grown in value, regardless of how the rest of your portfolio is performing.
A case, for example, of diversification below can help you release equity:
- John and Sarah are best friends and have decided to make 2017 their year to invest in property;
- John’s strategy is to buy what he knows. He buys seven investment properties in his local area;
- Sarah takes a diversified approach and opts to buy seven investment properties in seven different locations;
- Both John and Sarah use all of their funds and will be relying on equity to make future purchases;
- They have both set up a good finance structure and ensured their loans are not cross-collateralised;
- Fast forward to year one, and 2018 happens to be a rough year for property. That said, both want to invest again and take advantage of the opportunities presented in the slow market.
In John’s case, he finds that prices in his area have dropped 5 per cent. He goes to his broker who runs valuations and finds he has no equity to withdraw. As such, he cannot continue to grow his portfolio in the current market conditions.
Meanwhile, Sarah also finds her portfolio has also dropped by 5 per cent overall. However, Sarah’s broker finds that six of her seven properties have fallen in value, but one in Tasmania has performed strongly. This property has grown $100,000 in value and has $80,000 of available equity in it.
While their overall asset position is the same, Sarah can release $80,000 and use that as her deposit for the next purchase.
Why is this possible?
- Our finance system allows Sarah to release equity because banks will value each asset individually. While banks do look at her overall asset and liability position, she is still able to release equity from her Tasmania investment as its financing arrangements are not tied to her other properties.
- Houses prices move at different rates across the country. While house price movements between cities are closely correlated with each other in general terms (macro environment dictates this), they do rise at different paces at different times.
What do you need to do to take advantage of this situation?
- You must ensure that your financing structure is not cross-collateralised. In doing so, you ensure that each asset is valued independently. This provides options if any of your assets grow in value, rather than your whole portfolio having to grow in value.
- Your portfolio will also need to be leveraged at an appropriate LVR. Portfolios on very high LVRs (over 80 per cent) have limited options to release equity unless asset values grow very significantly.
- Finally, you’ll also need to buy in different locations to have a diversified portfolio. It’s highly unlikely one street will grow and the one next to it will get a substantially different result. By owning assets in different locations, you increase the chances that at any given time one of your properties will be in a growth phase.
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