How To Build a $160,000 Passive Income by Buying a Sub-Mill Commercial Property (Responsibly)

There are various factors that affect the return on your commercial property investment, but two of the most fundamental factors are capital growth and cash flow return - especially if you’re looking to expand your portfolio. 

Commercial property investors have a range of strategies they can use to grow their portfolios. One strategy that can be particularly effective is compound leveraging.

Essentially, compound leveraging entails taking the return on your current investment and reinvesting those proceeds into new investments, essentially increasing your earning power. 

This can help you rapidly grow your portfolio with relatively little up-front investment when done correctly. 

So, how do you get started? Let’s take a look.

How Does Compound Leveraging Work?

As I mentioned earlier, compound returns occur when you reinvest your current investment return into new investments. In other words, you are essentially adding the percentage income on the capital you’ve invested onto the amount you initially started with.

The new capital amount then earns more income in the next period, which accelerates the growth over time because you are earning ‘income on your income.’

For example, suppose you invest $100,000 at an interest rate of 7% per year, compounded monthly. If that is the case, in 10 years, your initial investment would have grown to $200,966. 

Property is one of the few asset classes where lenders allow you to significantly leverage, and when you combine leveraging with compound returns, you can achieve growth on a much larger scale. 

However, just like with any investment strategy, you need to be aware of the positives and the negatives before jumping in - compound leveraging is no exception. You need to be cautious not to take on large amounts of debt because, although you are generating positive returns, you’re also increasing your expenses.  

If you want to mitigate risk, you need to be sure to maintain a comfortable loan to value ratio (LVR). 

So, How Much Should You Leverage?

There are a few different factors you should consider when deciding on how much to leverage, including: 

• Your risk appetite: a high-income earner with no dependents and minimal commitments can take on far more risk than a low-income earner or an income earner with many commitments and family obligations. So, you need to establish how aggressive you can and are willing to be when deciding on how much you should leverage.

• Your goals: before you settle on an investment strategy, you need to identify your short-term, medium-term, and long-term goals. This will also give you an idea of how aggressive you want to be regarding your risk appetite. And a word of advice: don’t chase a number just for the sake of it - investing should be something that makes you happy. So be realistic and establish what you are willing to sacrifice to reach your goals. 

• Your time-frame and exit strategy: at what point do you want to achieve your desired cash flow? The time frame in which you hope you achieve your goals significantly impacts how much risk you are willing to take on. You also need to think about your exit strategy. For example, will you need to sell one or more properties to obtain cash or to pay off a principal place of residence at some point?

Remember to always err on the side of caution because how your property performs is also dependent on market conditions that you can’t necessarily predict. While you can implement practical strategies to minimise your risk, not every property will perform as per your expectations.

One practical strategy you can implement is a stress test: check how your portfolio would perform at higher interest rates or with longer periods of vacancy and see if you can financially handle one or both of these situations. 

Another thing you should consider is having enough cash reserves for unexpected expenses. Unfortunately, this is one of the most common mistakes I see investors make. So, have some kind of buffer available that aligns with your risk tolerance, the number of properties you own, the typical vacancy rate and your income and financial obligations. 

An Example: Generating $160,000 Passive Income Over 10 Years

The best way to explain the benefits of compound leveraging is to look at a sample portfolio. This particular example is based on commercial real estate and steady rental growth. It doesn’t however include personal circumstances and other factors that are out of an investor's control such as vacancies, interest rate changes, valuations and capital growth rate. 

So, for illustrative purposes, suppose you are looking into buying a commercial property worth $900,000, using a 30% deposit. You also have an extra $30,000 per year that you can invest straight back into your portfolio. If that is the case, the following details would apply: 

• Interest rate on mortgage: 5% (with interest-only repayments)

• Rental Increases: 3% 

• Cap Rate: 7% 

• Additional Yearly Contribution: $30,000. 

Now let’s look at what this would look like over 10 years: 

You can see that within three years you would be in a position to buy a second property worth $650,000, using the cash flow from the first property, the capital growth from the rental increases, and your $30,000 of annual savings. 

This is achievable by using the savings plus refinancing the first property back up to a LVR of 70% You’d then have two properties growing in value and a higher cash flow that could enable you to buy a third property in year seven, and a fourth in year nine.

You can see that after ten years, this investor ended up with a portfolio worth $4,5 million, and a passive income of $160,000 (without depreciation). 

Key Takeaways

I often hear that the biggest regret that investors have is not buying soon enough. The more properties you accumulate in your early stages, the larger your portfolio will be and the quicker you can start earning passive income from those properties. 

My advice to you would be to focus on the long-term benefits and accelerate expanding your property portfolio by securing a property below market value, adding value to that property and increasing rents. 

Sure, you need to consider the market you are buying into and what your long-term approach is, but “the best time to plant a tree was 10 years ago and the second-best time is today.” 

If you would like to know more about how I have helped thousands of clients successfully source and purchase quality commercial property across the country, get in touch today.