Treasurer Scott Morrison kept his word last month and resisted calls from economists and Labor to remove or water down negative gearing, handing a gift to the one million Australians who run a property investment at a loss. Or did he?
For properties purchased after budget night, investors can depreciate new fixtures and fittings, but subsequent owners are unable to claim deductions unless they buy these fixtures and fittings themselves.
It isn’t just the Treasurer who is trying to spoil the property party for investors. The banks are too. Forced by the prudential regulator to curb property lending to investors, the majors have lifted rates on investment mortgages as a deterrence.
Data from comparison website Canstar shows that, in the case of the major lenders, over the past year principal and interest loans for investors have risen 0.2 percentage points to 5.81 per cent, while rates charged by the majors on interest-only loans have climbed 0.34 percentage points to 5.94 per cent. That means on a $750,000 interest-only loan, an investor will need to come up with an extra $212.50 a month to service the loan, or $2,550 a year.
It is enough to make the army of investors who negatively gear â€” and those who thinking of going down that route â€” wonder if the strategy still works.
“There is risk on the capital growth side,” says Scott Farmer of Bravium Financial Planning. “The Reserve Bank has signalled that there is a risk rates will be higher and there is evidence that house price rises are slowing down. You would want to be careful about negatively gearing into property today.
“In Sydney there are significant risks around potential growth. In Sydney and Melbourne you would want to be careful about what you are buying,” Farmer adds.
Other experts are of the opinion that negative gearing into property works in today’s climate as much as it ever has, although they concede that much care needs to be taken to ensure all the proverbial ducks are in a row.
“It is more important than ever to do a lot of research,” adds Farmer. “What are you buying? Why are you buying it? What are the risks? Too often we fall into the trap when the markets go up and we think we don’t need to do much research.” Investors need to ask themselves if they are looking to negatively gear into property simply because they are worried they might miss out.
Negative gearing does still work, says Patrick Canion, chief executive of ipac Western Australia, “but the free kicks probably aren’t there anymore”.
“It is not the lay down misere it used to be,” he adds. “People think it is easy and they just need to tick a box. But you need a back-up plan for the back-up plan for the back-up plan.”
Ben Kingsley, chief executive and founder of Empower Wealth Advisory, doesn’t view negative gearing as a strategy. Rather, he says, it is a means to allow the investor to buy the best property they can afford and make a handsome return.
He likens negative gearing to setting up a business. “Negative gearing is like forecasting losses in the first few years of starting a business. The data shows that the best properties are usually in better locations with good amenities. Those properties come at a premium and you will have to fund the earlier stages of the investment,” Kingsley says.
Paul Nugent, director of Wakelin Property Advisory, says his firm has not changed its property strategies despite rising interest rates and surges in prices in Melbourne and Sydney.
“We are not changing anything about the types of properties. We are buying and selling at the same rate,” Nugent says.
When it comes to property prices, most advisers are sanguine about the long-term outlook, even in the major centres on the eastern seaboard.
“History has shown that we have had many down periods over many years, and over the longer term property prices have still gone up. GDP will increase over multiple decades. Property prices will rise with it,” says Mark Fenech, a director of Profectus Financial Group.
Nugent agrees that the positive fundamentals in terms of GDP and population growth still exist. “The outlook [for property prices] is strong,” Nugent says.
Kingsley predicts that house prices in established suburbs, close to the CBD in the major cities with strong amenities and proximity to schools, will double in the next 12 to 15 years.
The lesson is that property is a 10-year investment. “You shouldn’t be going into property thinking it is a two- or three-year, or five-year investment,” Fenech says.
“You buy a property not when someone at a barbecue tells you to, but when you have got the available cash and you are prepared to take a 10-year view,” Nugent adds.
This is not to say that property prices will go up in a straight line, with experts unwilling to forecast movements in the next couple of years. Western Australians understand the vagaries of house price movements only too well. The average Perth property lost 4.5 per cent of its value in the 12 months to February.
But even over longer periods, investors need to understand what they are buying.
Hefty price gains, even over the next decade, are far less likely to occur for properties where the majority of buyers are investors â€” which is often the case with off-the-plan apartments â€” rather than owner-occupiers.
“You don’t want to get caught out with an off-the-plan apartment,” Kingsley says.
In regional centres where yields tend to be higher, the trade off will inevitably be more subdued price increases.
As they say, location, location, location.
Investors wanting to gain exposure to the part of the market that is most likely to appreciate in price will probably need to spend about $1 million, Kingsley says.
But he acknowledges that Sydney “might be a problem”. A townhouse in Melbourne is still possible. In Adelaide an investor can expect to buy a period home in a convenient location for that price. Ideally investors want to be buying in areas where owner-occupiers account for 70 per cent of purchasers.
Depreciation and travel claims
The budget measure to disallow depreciation on fixtures and fittings by subsequent landlords â€” in other words, landlords who have not purchased the fixtures themselves â€” has no or little impact on the negative gearing equation, say the experts.
The ability to depreciate fixtures and fittings was always, says Kingsley, the “cash flow cream”. “When we do the planning, we never assume a depreciation benefit,” he adds. “Smart investors should never invest for the tax benefit.”
Nugent agrees: “If you are buying a property based on depreciation benefits, you are barking up the wrong tree.”
Another reason advisers are unperturbed is because investors in new properties can still depreciate fixtures and fittings. For many existing properties, it is not worth having a depreciation schedule as potential claims are minimal. This is particularly the case for older properties, given that items such as carpets, air conditioners, ceiling fans and curtains are considered to have an effective life of anywhere between five and 15 years. After that, the assets can no longer be depreciated.
And, as Richard Wakelin of Wakelin Property Advisers wrote in the AFR this week: “Consider yourâ€“ an older style single-fronted two-bedroom cottage. Typically, the capital and plant is replaced in a drip-feed rolling manner. Say a new hot water service one year, the dishwasher three years later and the oven three years after that. And given most smart investors hold property for the long-term, they can expect to receive most of the depreciation benefit they enjoyed before May 9.”
Likewise, the ban on landlords claiming travel expenses for inspecting their properties does little to the negative gearing equation, say advisers.
“Travel costs associated with inspecting a rental property should be very much peripheral to the rationale for selecting and holding a particular investment property,” Nugent says.
“There are many Investors who for years have claimed a deduction for holding such an asset in a regional or interstate location, many of whom may have added a few days R and R to the tax-deductible investment inspection, and they will no longer be afforded this benefit,” he adds.
“If the intent has been to benefit from a semi-tax-deductible break at the same time, then I would suggest that the criteria employed is completely wrong and chances are that the asset is compromised and therefore unlikely to achieve optimal capital growth.”
Mortgage rates for investors have risen in the past few months as the Australian Prudential Regulation Authority (APRA) has slapped limits on the amount of investment home loans lenders can make.
In the latest move, and place strict internal limits on the volume of interest-only lending at loan-to-value ratios (LVRs) above 80 per cent. Figures from Canstar show that an investor with a $1 million interest-only loan has seen their monthly repayment rise to $3,713 from $3,500.
Kingsley says rising investment mortgage rates may well mean that investors need to temper their expectations of the type of property they buy.
For a mortgage of $1 million, with a cost of borrowing at 4 per cent and a rental yield of 2 per cent, an investor’s net loss a year would be $20,000, disregarding all other costs and the tax benefit of negative gearing. If rates rose to 5 per cent, the annual net loss would increase to $30,000. If the investor was unable to cover that loss, they might need to move down the price curve.
“The sacrifice is buying a more run-of-the-mill property and for that you sacrifice some of your capital gain,” Kingsley says.
Nugent argues that rising mortgage rates place more pressure on investors to find properties that are increasing in value, assuming they can afford to carry the extra costs.
To illustrate the impact of rising rates, Wakelin Property Advisers takes a $500,000 mortgage and assumes that interest rates rise to 5 per cent from 4 per cent, while the yield falls to 3 per cent from 3.5 per cent.
After accounting for expenses (such as agency costs, repairs and land tax and the tax benefit from negative gearing), the model shows that the investor’s annual cash cost would rise to an average of $4000 a year from $420 a year. But, says Nugent, that extra $3600 of carrying cost is, in theory, enabling the investor to buy between $35,000 and $50,000 of annual growth, depending on the rate of house price inflation.
“Provided you buy the right asset, it still works. For a first-class asset, you are buying 7 to 10 per cent of growth a year,” Nugent says.
The rise in the cash cost is hefty, amounting to an extra $300 a month. But before investors embark on a negative gearing strategy they should, in any case, assume that the carrying costs will vary over time. “In the context of owning a property for 10 years, at some stage you will encounter this sort of differential in holdings costs. The carrying costs at the moment are deceptively low,” says Nugent.
It is also worth noting that before the tax benefit kicks in, in this example of using someone on the highest marginal tax rate, the average annual net loss would rise to $9300 from $2800, underlining the point that negative gearing works well for savers in that highest tax bracket.
Much has been said about stagnating rents, but Kingsley insists that for the right properties, even in Melbourne and Sydney, they are still rising â€” but perhaps not as quickly as they have done in the past.
“Real rents are increasing. We are able to put rents up,” Kingsley says.
For properties worth between $400,000 and $500,000, landlords in Melbourne and Sydney can expect to be able to push up rents by between $5 and $10 a week each year. For $750,000 properties, rents are rising by between $20 and $30 per week each year, while on a $1 million property, rents are rising by between $50 and $75 a week each year. Rental growth in Brisbane, however, is far more muted, and for apartments may be flat or negative.
And while on the rental front, investors should never assume 100 per cent occupancy. Kingsley assumes 92 per cent.
Outlays on property, such as maintenance and agents’ fees may not be rising, but the risks of running an investment at a loss are as prevalent as ever.
Fenech says it is crucial that when investors are thinking about negative gearing, they should stress test their finances to ensure they can weather challenges, such as long periods of no tenants, unemployment, cyclical price declines, divorce, illness and other unexpected events.
Checking whether the strategy will still work if interest rates rise to 7.25 per cent is not enough. “You need to check that you can weather the storms,” he adds.
Sally Patten, The Australian Financial Review (online), 10 June 2017