Gearing is borrowing
to buy an asset
with a small personal contribution and
borrowing the rest from others
Property investors aim to earn income from the property in the form of rent in the short term and a capital gain, long term.
Property investment is negatively geared when the rental income doesn’t cover all the costs associated with owning the property.
The Australian Tax Office allows property investors to reduce their taxable income by the amount of the shortfall.
It is also important to note that property can be positively geared, where the income received exceeds the holding costs. Neutrally geared property exists where after all income and expenses are calculated, the property ‘breaks even’, that is the rent covers the expenses but no more.
Any property can be positively or neutrally geared depending on the LVR and the size of the investor’s contribution.
Typically though the idea of a positively geared property relates to the concept of the rent exceeding the holding costs with only a minimum deposit, this is more likely in rural areas where prices are low and rents typically much higher relative to the purchase price. The trade-off may be lower capital growth long term.
Why negative gearing is here to stay
= “Why negative gearing is here to stay…”] Once again the idea of changing the tax benefits afforded to investors via negative gearing has been floated in the context of broader tax reform.
Australia is a market economy and, in a perfect world, freely operating markets are efficient and deliver maximum satisfaction for all. But it isn’t an ideal world. Sometimes market solutions are inadequate, inequitable and lacking in social responsibility- you only have to look at the causes of the GFC to see a classic example!!
There is a role for government to redistribute income and resources in ways that enhance market solutions and compensate for market failure.
Tax benefits for negatively geared investment property are a perfect example of government policy designed to achieve a desirable market outcome. The government provides tax incentives for individuals to invest in property, especially new property, thereby increasing the stock of available housing and delivering significant employment opportunities as a byproduct. The stimulus to private sector property investment through tax concessions helps to redress the housing imbalance and reduces pressure in the rental market.
It also importantly promotes entrepreneurial spirit, the building block of the market system, and is an incentive for individuals to create wealth for their retirements, thereby reducing the burden on future generations. Shifting the goalposts to be eligible for the age pension to 67 after 2023 is in direct response to the looming crisis in the economy’s ability to support an aging population that no longer contributes to the public purse.
We all need to become proactive now so that we don’t end up reliant on the overstretched welfare system in the future. It is also essential to understand why tax benefits are maximized on a new property through depreciation.
Depreciation means that you are allowed to claim a proportion of your property’s value, the building and its fixtures and fittings, for wear and tear over time as another cost of ownership. This claim is most substantial in the early years of a property’s life and so building a new property is the best way to take advantage of the ATO’s concessions.
A healthy building industry is vital for economic growth and employment. The multiplier effect of construction means not only work for tradespeople and suppliers, but it has a ripple effect on the retail industry for white goods, carpets, blinds, turf, fencers, landscapers, moving companies, and the list goes on! No wonder the government considers ‘housing starts’ a leading economic indicator.
Policy changes involve trade-offs and disincentive effects, both intended and unintended. Removing tax advantages for property investment would reduce the supply of housing and put the onus back on the public sector to provide more public housing.
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?
(I provided my classes with much amusement when I’d tell them what their favourite canteen items cost in ‘my day’)
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 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 0.25%, 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 relatively inelastic demand for housing and the rapidly
growing population coupled with the sensitivity
of cash to lower returns due to macroeconomic management
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 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.
Monetary Policy Decision Number2020-28 Date3 November 2020
Media Release Statement by Philip Lowe, Governor:
At its meeting today, the Board decided on a package of further measures to support job creation and the recovery of the Australian economy from the pandemic.
With Australia facing a period of high unemployment, the Reserve Bank is committed to doing what it can to support the creation of jobs. Encouragingly, the recent economic data have been a bit better than expected and the near-term outlook is better than it was three months ago. Even so, the recovery is still expected to be bumpy and drawn out and the outlook remains dependent on successful containment of the virus.
The elements of today’s package are as follows: a reduction in the cash rate target to 0.1 per cent a reduction in the target for the yield on the 3-year Australian Government bond to around 0.1 per cent a reduction in the interest rate on new drawings under the Term Funding Facility to 0.1 per cent a reduction in the interest rate on Exchange Settlement balances to zero the purchase of $100 billion of government bonds of maturities of around 5 to 10 years over the next six months.
Under the program to purchase longer-dated bonds, the Bank will buy bonds issued by the Australian Government and by the states and territories, with an expected 80/20 split. These bonds will be bought in the secondary market through regular auctions, with the first auction to be held this Thursday for Australian Government securities. Further details of the auctions are provided in the accompanying market notice.
The Bank remains prepared to purchase bonds in whatever quantity is required to achieve the 3-year yield target. Any bonds purchased to support this target would be in addition to the $100 billion bond purchase program.
At today’s meeting, the Board also considered an updated set of economic forecasts. The global economy has been recovering from the initial virus outbreaks, with the recovery most advanced in China. Even so, output in most countries remains well short of pre-pandemic levels and recent virus outbreaks pose a downside risk to the outlook, particularly in Europe. In Australia, the economic recovery is under way and positive GDP growth is now expected in the September quarter, despite the restrictions in Victoria.
It will, however, take some time to reach the pre-pandemic level of output. In the central scenario, GDP growth is expected to be around 6 per cent over the year to June 2021 and 4 per cent in 2022. The unemployment rate is expected to remain high, but to peak at a little below 8 per cent, rather than the 10 per cent expected previously. At the end of 2022, the unemployment rate is forecast to be around 6 per cent. This extended period of high unemployment and excess capacity is expected to result in subdued increases in wages and prices over coming years.
In underlying terms, inflation is forecast to be 1 per cent in 2021 and 1½ per cent in 2022. In the most recent quarter, year-ended CPI inflation was 0.7 per cent and, in underlying terms, inflation was 1¼ per cent. The Board views addressing the high rate of unemployment as an important national priority. Today’s policy package, together with the earlier measures by the RBA, will help in this effort.
The RBA’s response is complementary to the significant steps taken by the Australian Government, including in the recent budget, to support jobs and economic growth.
The combination of the RBA’s bond purchases and lower interest rates across the yield curve will assist the recovery by: lowering financing costs for borrowers; contributing to a lower exchange rate than otherwise; and supporting asset prices and balance sheets. At the same time, the RBA’s Term Funding Facility is contributing to low funding costs and supporting the supply of credit to the economy. To date, authorised deposit-taking institutions have drawn $83 billion under this facility and have access to a further $104 billion.
Given the outlook for both employment and inflation, monetary and fiscal support will be required for some time. For its part, the Board will not increase the cash rate until actual inflation is sustainably within the 2 to 3 per cent target range. For this to occur, wages growth will have to be materially higher than it is currently. This will require significant gains in employment and a return to a tight labour market.
Given the outlook, the Board is not expecting to increase the cash rate for at least three years. The Board will keep the size of the bond purchase program under review, particularly in light of the evolving outlook for jobs and inflation. The Board is prepared to do more if necessary.
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 which 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.