When planning to build towards a passive income by investing, it’s critical to formulate a clear strategy from day one. Part of that strategy is calculating what your goals are and knowing what is required to achieve them.
The key factors to consider are how much you can afford to invest and the projected timeline.
By noting down a clear outline of your plan, you can avoid disappointment and have a better chance of reaching your goal. A good strategy combined with the tax-saving benefits of investing via a Stocks and Shares ISA make the perfect combo for optimal returns.
Please note that tax treatment depends on the individual circumstances of each client and may be subject to change in future. The content in this article is provided for information purposes only. It is not intended to be, neither does it constitute, any form of tax advice. Readers are responsible for carrying out their own due diligence and for obtaining professional advice before making any investment decisions.
Using the example of a £1,000 monthly passive income, how would an investor build a portfolio that delivers that kind of return?
Breaking down the numbers
With an aggressively income-orientated portfolio, an investor could realistically target dividend returns of 6%-8% annually. Let’s use 7% as a guide and an average annual growth rate of 3%. To bring in £12,000 a year (£1,000 a month) that would require a portfolio worth around £171,500.
With that target, we can break down the time it would take based on how much money can be invested a month. A well-off investor with an initial £10,000 lump sum and £500 a month to contribute, could hit that target in around 13 years.
With a £5,000 lump sum and £250 contributed a month, it would take almost 20 years. Even an investor in their 40s with a moderately decent income could use this strategy to hit their goal by retirement.
The high-yield portfolio plan
The trick to income investing is identifying companies with realistic and sustainable dividend policies. It’s best to avoid those with unmanageable debt levels, limited cash flow or no track record of payouts.
Take for example the major British real estate investment trust (REIT), LondonMetric Property (LSE: LMP).
The company’s combination of dividend growth, sustainability, and inflation protection suits a 10-20 year income investment timeframe.
Although the share price is down 19.2% in the past five years, it’s delivered a 10-year dividend compound annual growth rate of 7.8%. The most recent half-year results show dividends covered 111% by EPRA (the standard European method to calculate earnings), with a payout ratio of just 80%. While somewhat high, this is still sustainable. The company can still reinvest around 20% of earnings back into the business to fund growth without cutting distributions.
It operates a triple-net lease model where tenants pay property taxes, insurance, and maintenance costs. This creates a 98.5% gross-to-net income ratio — meaning 98.5p of every pound collected flows to shareholders as dividend income. Essentially, it’s more than just a rent collector — it’s a rent compounder supported by high occupancy rates.
Moreover, since 67% of its rental income is subject to contractual escalation clauses, it’s able to increase dividends inline with inflation.
The bottom line
Londonmetric is a compelling option to consider for dividend income but it’s not without risk. REIT valuations are highly sensitive to interest rate movements, earnings surprises and credit spreads. Subsequently, the share price can fall sharply during times of economic tightening.
However, when looking at a 20-year investment timeline, I believe the potential volatility is tolerable. By combining several similar stocks from a diverse range of sectors, an investor can reduce risk while targeting high and sustainable dividend returns.
