'Negative Gearing' - changes are inevitable!

March 21, 2016

Negative Gearing is a hot topic right now.  It’s been making headlines (yet again), however this time both sides of politics are weighing in on the argument.  GST debate move over, it’s now about tampering with negative gearing!

 

Negative gearing as we know it today will change.  The Labor government outlined their intent (if elected), however the Liberal government are tight lipped until the May budget is revealed.

Here’s a quick summary of the proposed changes under a Labor government:

  • From 1 July 2017 negative gearing will only be available on newly-constructed homes

  • The changes won’t affect investment properties purchased before 1 July 2017

  • The Capital Gains discount will reduce from 50% to 25%

Why the changes? 

 

Under costings released from the Parliamentary Budget Office, the measures could save the budget $32.1 billion over 10 years.  Mr Shorten said this…“we’re doing this because 30 years ago, houses cost around 3.2 times average income – today it’s 6.5 times average income”.

 

Let’s assume the changes proposed by Labor are implemented.  The question begs…

 

Is property still a viable investment?

 

The short answer is YES… BUT buying the right property will become even more important than ever before. AND buying and holding the right property will be key!

 

You’ve heard me say this before.  To make money from property in a predictable way, one must buy the right property asset and have a long-term view! Capital growth and the power of compounding is the secret.

 

To quantify my answer, I ran the numbers for a $500k investment property purchase and worked out if it’s still viable without the usual negative gearing benefits.

 

Analysis revealed that you need to invest in an asset that produces at least 17% per annum (compounding) in order to beat property as an investment.  Let me know if you find such an investment!

 

The assumptions of my financial analysis are as follows:

  • Purchase a $500k (established) property without negative gearing benefits

  • 7% interest rate on borrowed money (being the long-term average)

  • Rental yield of 4%

  • Tax rate of 39%

  • Purchase costs include Stamp duty 5%, and Buyers Agent fee of 2.75% (GST inclusive)

  • Capital growth 8% pa (conservative if purchase made by a professional Buyers’ Agent)

From a cash flow perspective, my analysis reveals that to break even you need to hold the property for 20 years.  In the first 10 years the investment would cost you $139k in cash outflow (i.e. Expenses > Income by $139k).  However, over the following 10 years, the property would generate $144k in cash inflow which reverses the initial $139k cash outflows (i.e. Rental income > Expenses by $144k).

 

Under the current tax environment, the government would contribute towards the $139k, which is where negative gearing comes into play.  However under the new ‘proposed’ rules, you would have to find the cash to invest which equates to $1,158 per calendar month (on average).

 

If the Investor holds the property for 20 years, the net capital gain will be $1.1million (cash in your pocket), after accounting for selling costs, 25% capital gains tax discount, and personal tax at 47%.

 

If you chose to invest the $139k (cash outflow in the first 10 years) as opposed to purchase a property, your $139k investment would need to return 17% pa (compounding) to provide you a similar net capital gain of $1.1million.

 

How?

 

From a cash flow perspective, rents go up but your loan amount doesn’t.

 

From a leverage perspective, compounding a $500k investment versus a $139k investment will obviously generate a much higher return over the long-term.

 

To illustrate cash flow, here’s a real life example (a client property):

  • 2 bedder in South Yarra, Melbourne

  • Purchase 10 years ago for $292k, market value today $650k

  • Rental income at time of purchase $260 pwk, today rent received is $440 pwk

  • Initial loan $308k (inclusive of purchase costs), interest expense $21k pa (@ 7%pa)

10 years ago the property generated annual rental income of $13.5k.  Today it generates rental income of $22.9k pa.  That’s an additional $9.4k in rental income per annum, yet the interest expense hasn’t changed (the truth is that interest rates have fallen to low 4’s however my analysis is based on 7% being the long-term average).

 

Can you see the point?  The rent went up, but the ongoing expense commitment didn’t.  In fact if our client pays down the original $308k loan, then the ongoing expense commitment will reduce even more.

 

Right property.  Right location.  Long term strategy.

 

What are the ramifications if the proposed negative gearing changes are implemented?

 

Opinions are plentiful at present.  Like anything, there will be winners and there will be losers.

 

Here’s my take on what may occur:

  • Rents will increase.  Perhaps not right away, however investors will want to recover lost cash-flow currently received from negative gearing

  • Scarcity of rental properties (due to possibly less property investors around)

  • Investors will be lured by clever marketing from Developers to buy brand new properties (a brand-new shiny apartment is seldom the right investment property)

  • Established properties currently owned (or purchased by 30 June 2017) will increase in value as these properties will be tightly held by Investors given the grandfathering provisions proposed by Labor

Whichever way you look at it, change is inevitable!

 

If you’ve been considering buying an investment property and find yourself sitting on the fence waiting for the right time, then the bell is ringing loudly.  Now is the time to act!

 

One could argue that the property you buy today will be of less value to a potential buyer down the track as you will be selling an established property.  My take on this point is that the property you buy today will be worth more in the future so long you buy the right property, for the reasons outlined above.

 

I hope the above provides you a perspective of negative gearing and how the proposed changes may play out.

 

Whatever changes are introduced to negative gearing, property will remain a viable investment asset providing you invest in the right property asset and providing you hold a long-term view.

 

Interesting times ahead!!!

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