This transcript was generated automatically and may contain small errors.
Cross-collateralization. This big word can actually have some consequences for property investors. In this episode, I'm going to help you understand why investors that build larger portfolios almost never cross-collateralize their properties. There are a few small exceptions to this rule, so stay tuned to the end of this episode to learn more about them. By the end of this episode, you're going to understand what that big word is, what the downsides are, and why you want to avoid this as a serious property investor.
I'm Arjun Paliwal, CEO of InvestorKit. Let's get into it. So when it comes to cross-collateralization, firstly, I have an honest admission to make here. I probably did like 20 takes on that intro, and for the fun of it, we might just insert like five seconds of me mucking up that word. So get ready for that now.
Cross-collateralization. Cross-collateralization. Cross-collateralization. Okay. All right.
And we're back. So now it's time to get serious on what this topic is. So yeah, when it comes to this particular big word, because I'll just stop it there, this is a killer for portfolios, especially if you're trying to diversify across the country and you have markets in different cycles. And so let me give you an example of a real case study we've seen. A customer of ours bought a property just over $400,000 almost two decades ago in the suburb of North Melbourne.
That property is now worth just over $330,000. It's actually gone backwards by $70,000 plus in just over a decade and a half. So coming close to two decades. Now, fortunately, they came to us to fix up that portfolio, and we've purchased them a high growth property now in Adelaide and in Toowoomba, both that have crushed it since owning them and shown them what really opportunity cost looks like by seeing the impact of that particular property. Now, that property example isn't the example of cross-collateralization.
That property example is to show you that if you have a diverse portfolio and you have one property moving the other way and then two other properties moving in another direction and you tie them together with one bank and secure them against each other, when it comes to getting that equity out, you might not be able to get out as much as you'd like because you've got two values that have increased, one that's decreased, and as a result, the net value is not as big as if each asset was treated individually because they're coming together. Let me give you a working example here to go through this scenario that I've just mentioned for the North Melbourne. Let's just say that property A has performed well and increased $100,000. That means there's $100,000 in equity that you can look to tap into. Property B has also increased by $100,000, totaling now $200,000 in equity.
And then property C has actually decreased in $50,000. So whilst you've seen $200,000 in these two properties, because of that $50,000 decline, your total equity gain now is not $200,000, it's only $150,000 in equity gain. So that means 80% of $150,000 is $120,000 equity removed. Now let's go to scenario two where the properties aren't cross-collateralized. Property A has increased $100,000.
Property B has increased $100,000. Therefore, you take 80% of each of those, which totals to be about $160,000 in equity because $80,000 from the first and $80,000 from the second. That $160,000 in equity is $40,000 more than that first scenario because in the second scenario, you know that property three is down 50, so you're not touching it to take equity out. You're leaving it there, and as it's separate, you can take out equity from the first two. This already has increased the asset growth that you can have and the equity you can pull by $40,000 in just this scenario.
Imagine this in bigger portfolios, bigger equity growth, or even worse declines. You don't want that happening when you tie properties together. You want that separate scenario where you take out more equity. So that's just one example that shows that when you diversify markets across the country, if one's not going as well, you're now tied to it if you did that cross-security structure in your banking, which is the bad part, right? So that's the first thing you really want to avoid.
Now, that's just equity releasing. What happens if you have to sell? Now, you may not have a choice. You may have to restructure loans with other banks. You may have one bank not so happy to let it go until you pay it down to a certain amount.
And what happens if you don't have that cash handy to pay it down to a certain amount? So the key thing that you're noticing as a theme is you're getting stuck. Now that you know you don't want to be stuck in a portfolio, let's talk about some of those exceptions where people do do it and what those scenarios look like when investors get around to actually structuring it in this way. The first reason is that it can be cleaner in lending. So to give you an example, if you took out 80K equity from a property that's gone up 100,000, most people will create a separate equity loan.
So you see the loan that you originally had, say it's 400,000, and you see a second loan of 80,000. And you can tell your accountant, hey, the 400,000 loan is where I'm living. The 80,000 I'm taking out for the purchase of an investment property, just as an example, that's going towards my deposit. Now, because that purpose is investment driven, your accountant may say after you get advice from them that that's tax deductible. Now, if that's the case, that's the scenario that you're using.
But it's not clean because you've now got two loans. And what happens if you don't use all that 80K? Maybe you use 60K, and then maybe you use 10K for a deposit on a boat, right? So now you're mixing purposes, personal with investing. Now you've got multiple loans.
How do you factor the interest calculation? Things get a bit messy, and you make mistakes with your accounting. And come tax audit time, you're now not able to claim the things you thought you could claim because of this lack of structuring. So some people I've noticed did do cross-collateralization to be able to have that loan structured in a way where they just get one loan for the whole purchase price plus the deposit costs, the stamp duty, the professional fees, and then they can just tell the accountant straight away, here's my one loan for that investment property, and my 400K loan for my home is still 400K. So that is that one advantage.
But unless you're really flush with equity, unless you're in a strong income position to move around, unless you're in markets that aren't likely to go in two different directions and really impact the dangers here, and unless you have the cash that's sitting there to make sure if the bank weren't happy, you could make some payments, you shouldn't be doing this. But did you notice how many unless you're I said during that whole time? Which means like, do you really want to even consider this if you don't have even the half-perfect scenario? You really need the full-perfect scenario to make sure you're fully covered for when that time's right of expanding your portfolio further. So that's one of the core things that you don't want to do, but also when I've seen the exceptions why people have got into doing them.
And lastly, if you're wondering why this happens so much without people realizing, it's because it's just easier for that banker to process it. Now, it's most commonly done by bankers, not brokers, and that's because all the loans are with them. They can just give you one contract. They tie up the things in the back end, and it's just easier paperwork, less processing, faster speed. So why wouldn't you, right?
If the game is business for them, it's speed, efficiency, process, and for you, it might be comfort and easy too. But is that the right thing to do when you're scaling a portfolio? That's what you need to look at. So that's why many of the big investors avoid it, and that working example, do rewind back to that if you really want to grasp that one more time, because that's the key example that will show you how you can have less equity as a result of mixed valuations within your portfolio. And the truth is, if you've got a really good portfolio, you need to have a mixed portfolio in terms of different markets, different states, and not all your properties should be killing it all at the same time.
And so it's likely to happen to you then, that impact, if you do have the cross-security done. So consider splitting it up, consider getting separate loans, and guess what? You'll actually also be able to scale your portfolio further because you're taking equity loans out, and now you can shop around for multiple banks to see where you can get that next property in case your current bank says you can't get any more. That's the key, because you've got your deposit released, it's in your offset account, the few hundred thousand that you pulled out in equity is sitting there, so now you have full freedom to go to different banks and go, well, I don't want to go to you if you're not going to give me any more lending other than the 200K equity release, I'm going to go to bank B because they're going to give me an extra 500K in lending, I've got the deposit for it, I can purchase another property.
