Housing construction is an important injection into the circular flow of income in the Australian economy – it is an essential driver of employment.
Construction contributes approximately 8% of GDP and employs more than 1 million people.
Indirectly, many more workers are employed to provide the complementary goods and services that housing (both residential and commercial) necessitates.
To stimulate housing starts and the economy through the multiplier effect of construction, the government provides generous INCENTIVES and CONCESSIONS for those investing in a brand new property.
A depreciating asset is one that has a limited effective life and can reasonably be expected to decline in value over time.
Property investors can claim depreciation as a non- cash deduction as a cost of owning the property and renting it to a tenant. Non- cash refers to the fact that the money doesn’t have to be paid out by the owner first, it is merely an allowance made by the Australian Tax Office for investors to reduce their taxable income.
There are two categories of depreciation allowances available to the property investor:
CAPITAL WORKS – (the constructed building) can be claimed as ‘losing value’ (even though market value increases) at a rate of 2.5% pa for 40 years. (2.5% x 40 years =100%) This concession applies to both new and resale property (under 40 years old)
FIXTURES & FITTINGS –
You can claim for new assets; not second-hand or previously used.
This allowance includes where you purchase a newly built or substantially renovated property, for which no one was previously entitled to a deduction for the decline in value of the depreciating assets, and either:
No one resided at the property before you acquired it, or the depreciating assets were installed for use, or used at this property, and you acquired the property within six months of it being newly built or substantially renovated. Following ATO guidelines on the ‘effective life’ of the asset, your accountant will typically claim depreciation of the fixtures and fittings in a new property such as carpets, window blinds, oven and hot water system etc. over 5-10 years.
This is a significant deduction and since 1 July 2017
is only available on new properties
or substantially renovated ones
This policy change is an example of a targeted change to the tax system to influence the allocation of resources and to encourage investment in new properties given the employment and welfare effects of new construction.
Think of how significant and beneficial new housing starts will be to the recovery of the economy post-COVID-19. The government will be encouraging new builds, which via the multiplier effect will contribute significantly to production, employment and incomes in the construction industry and the retail sectors.
Update as of 4 June: “The Federal Government will give eligible Australians $25,000 to build or substantially renovate their homes, in an effort to boost demand in the construction sector and keep builders employed.” ABC News
Brand new properties are often part of master-planned estates with attention to open space and attractive streetscapes. Consistency of housing and covenants (building and design guidelines applicable to a new estate) means that it is unlikely you will end up next to an ‘eyesore’!
New property normally requires minimal maintenance with no renovation expenses. The building carries mandatory warranty periods as do the new appliances installed in the property.
A new property is appealing to tenants.
New properties are built with changing demographics and trends in mind, enhancing the market appeal for tenants and on resale. For example, the trend towards open-plan living is making outdated the formal living areas that don’t match changing lifestyles and preferences. Changing family compositions can be deliberately catered for in new designs. Duplex and dual-key designs are catering to the growing demand for accommodating elderly family members as an alternative to assisted living options.
Consider the impacts on the workforce as a result of work from home orders. Prior to the pandemic, only 5% of workers were in home offices. During COVID-19 it increased to 45% and the new normal is expected to settle at around 15%. This is an example of a structural change to the way we work. The suburbanisation of work will have flow-on effects for the demand for housing in middle to outer ring suburbs and well resourced regional areas. It will also influence the design of housing.
The home office space will be a priority for many. New builds afford the opportunity to meet the changing demands of work expectations and arrangements. Then consider the rise in homeschooling and the need for separation and quiet. Some new multi-dwelling constructions are providing dedicated, communal workspaces for residents to access away from interruptions and the demands of family or other cohabitors.
If the property is a house and land contract to be built, stamp duty is only paid on the value of the land and not on the contract price. This offers the investor a considerable saving. There is, however, interest to be paid on the loan during construction. This, combined with the stamp duty on the land, can equate to stamp duty on a completed package. Both of these costs can be offset against any capital gains tax liability when the property is eventually sold.
Profit is the return to risk
but ‘bricks & mortar’
is relatively predictable,
safe and reliable
“Australian residential property outperformed all asset classes for the 10 and 20 years to 31 December 2017”
Source: ASX/Russell Investments
1. Inflation favours tangible assets – inflation is a sustained general increase in the prices of goods and services over time. Unlike real assets such as property, the value of bank deposits can diminish over time due to inflation. Not only do the dollars in the bank potentially buy less than when you put them in, but the interest earned may not compensate for the higher prices over time.
The ‘real interest rate’ = interest minus inflation.
Think of something you bought from your childhood, perhaps at the school canteen, what did it cost? What would it cost now?
An example of the time value of money effect is demonstrated when lottery winners are persuaded to accept regular monthly payments’ for life’ (read 20 years) rather than a lump sum now, which is customarily a bit smaller.
For example, what would you rather have? $25K per month for 20 years which equals $4.8M or $4.25M now???
Take the money NOW! The $25,000 will buy you less in 10 or 20 years than it does now.
2. Low volatility over time – records have been kept in Australia since the 1890s. During that time, the overall trend for house prices has been positive, despite variations around the trend.
Aussie 25 Years of housing trends
3. Real estate ranks between fixed income and equities on the risk-return scale – housing doesn’t provide the lowest risk, but it also doesn’t carry the highest.
4. The ‘power of leverage’– Being able to borrow a large proportion of the funds required to invest means that lenders are comfortable with the property as an investment, and you use other people’s money!
A property makes your money work harder.
$30,000 invested in the bank at 5% pa = $1500 capital gain (which is then added to your gross income and taxed)
$30,000 deposit on a $300,000 house at 5% pa = $15,000 capital gain (and costs of ownership reduce your taxable income and CGT can be deferred until exit and at a more tax suitable time)
5. Government Legislation that allows limited recourse borrowing within a Self Managed Super Fund for a property is an endorsement of the strategy as a defence against the unexpected and sudden erosion of retirement funds.
6. Favourable tax treatment. Back in the first Lesson, ‘market failure’ was introduced as an essential concept to understand. In a free-market economy such as Australia, goods and services are produced according to demand and the ability of supply to respond to that demand, in other words, via market forces. While the market is generally efficient, it is not always equitable.
Government modifies the free market by compensating for its ‘failures’ (remember the business cycle)
It provides some goods and services that the market can’t or won’t and restricts the supply of some that it would if it could, such as illicit drugs.
Rather than crowd out (entering the market and increasing competition for funds and resources that the private sector may be competing for) more productive private sector activity, the government provides tax incentives for individuals to invest, thereby encouraging the supply of housing.
New builds, in particular, are promoted because of the multiplier effect on the economy and employment specifically. Building new properties has a ripple effect on consumption that is hard to replicate.
The public sector is typically not as efficient as the private sector. Resources are wasted by big bureaucracy that has social welfare as its agenda rather than self-interest. Consequently, there are some goods and services that the government outsources to the private sector to provide. It also offers incentives to others to do what they cannot do in sufficient numbers or with optimal efficiency – a prime example is housing!
7. Tax breaks in the form of Negative Gearing and Capital Gains Tax Discounts are strong incentives for investors to enter the housing market. Negative Gearing allows investors to claim all the costs of property ownership against their taxable income and provided the property is held for at least 12 months, the CGT payable is discounted by 50%. (dependent on the legal structure)
Depending on rent yields, prevailing interest rates, personal tax brackets and government concessions, it is possible for a property investor to own a property predominately paid for by the tenant and the tax office:
Conditions like these promote the entrepreneurial spirit, the building block of the market system, and are an incentive for individuals to create wealth for their retirement, thereby reducing the burden on future generations of taxpayers.
(Remember the ideas about building a business for the future)
8. Tax on any capital gain is deferred until the asset is sold. This is when ‘timing’ becomes more relevant.
9. Rental income is reliable, it isn’t subject to individual’ management performance’, the returns are contracted in a tenancy agreement and are protected by Landlord Insurance, AND they are
NOT a DIRECT TARGET OF MONETARY POLICY
As we approach retirement, we are encouraged to take less risk, and cash is typically favoured as the least risky asset class of all, but is it really?
Given the RBA’s recent lowering of the official cash rate to a historic low of 0.1%, the returns on fixed-term deposits have fallen to levels that make it impossible to survive on. Self-funded retirees depending on interest on safe, secure bank deposits often disproportionately bear the impact of Monetary Policy adjustments to the cash rate.
Could you survive on current returns to cash?
The consistent demand for housing along with the susceptibility
of cash to lower returns due to interest rate manipulation
is a powerful recommendation
for having rental income in any investor’s asset mix.
10. Interest rate rises usually mean fewer people buy their own homes and therefore demand for rental properties rises. All things being equal this should translate into higher rents.
Monetary Policy is the Reserve Bank action designed to influence both the availability and cost of finance in the economy. Interest rates are pushed up to slow the economy and curb inflation, and they are eased to boost spending and activity and therefore, employment. So, as economic circumstances change so will the prevailing cost of credit.
The upside of a rate increase is that your tax deductions increase and more people may delay buying their own home and continue to rent and put upward pressure on rents. Remember, ‘profit is the return to risk’ so you do have to take some risks if you are to build wealth for the future but make it a calculated risk.
In really low-interest-rate environments, retirees with assets dependent on bank earnings are adversely affected. When interest rates (and particularly real interest rates, taking inflation into account) are almost negligible, as they are currently, earning your retirement income from rent, even in part, is a very appealing and sensible alternative.
It is relevant here to examine the role of exogenous factors currently influencing the global and Australian economies.
Globalization means there is no escaping the effects of the COVID19 epidemic, both physically and economically.
The following excerpt from the RBA’s media release illustrates the role of the government in managing the economy to moderate the effects of an exogenous ‘shock’ such as a health pandemic.
The RBA has reduced the official cash rate to a record low in the hope of stimulating consumer spending and investment borrowing. (C, I) and the government is prepared to provide stimulus through fiscal policy (G) to maintain employment. It is classic macroeconomic management.
11. Investment in property is socially beneficial. Private sector activity is supported through negative gearing and results in a more efficient allocation of resources and the creation of jobs.
12. Risks can be mitigated through insurances
There are always trade-offs, and with property as an investment vehicle they are:
- It’s a long term strategy – property investment is not a strategy that you should come in and out of on a short term basis. That approach amounts to speculation and relies on investors being able to second guess what is going to happen or implementing a ‘crystal ball’ approach which is very risky. Property investment requires a long term commitment.
- It is a relatively illiquid asset. Liquidity refers to the ease at which an asset can be transferred into cash at will. (But this also helps to reduce volatility)
- It is an asset that you cannot divest from in part! Property is largely an indivisible asset. You can’t sell half a house (assuming it’s not a strata-titled duplex in which case you might be able to or as you will see later in the course, you have individual shares in a property).
- Costs such as land tax (a state-based tax levied on land ownership that applies beyond a threshold value that is different in each state) is another reason to diversify.
- Capital gains tax is levied on any profits on exit. (can be minimized through expert advice and timing your exit in a lower marginal tax rate period).
- Management of a real estate asset also requires ongoing involvement to a greater degree by the investor than it would in other cases.