Negative Gearing Doesn’t Work Anymore

NEGATIVE GEARING DOESN'T WORK ANYMORE ……..except for Sydney which has gone crazy…remember the higer the prices go, the closer it is to the top of the market and the inevitable pain that follows.

How it’s supposed to work and why it no longer does:

 

Have you ever been to a property investment seminar? No? Well, I’ll describe what usually happens at a typical seminar and those of you who have been, see if you are familiar with the script that follows

Here’s how it goes:

The presenter is usually pretty entertaining, a good communicator and does a good presentation, having done it umpteen times before. The script tends to follow this pattern.

1.            The presenter presents a bunch of statistics showing that the vast bulk of the population has pitifully inadequate superannuation and how at least 90% of the population will end up on the pension. Now you can survive on the pension but you can’t LIVE on it. About the only entertainment you will be able to afford will be to go down to the local RSL and play bingo.

Unfortunately the above situation is accurate. Most Australians are woefully under prepared for retirement (also woefully under insured, but that’s another topic). It is the presenter’s job to paint a grim picture of an underfunded retirement. His job is to DISTURB the audience and get them to realize that they have a major problem looming in retirement.

I have no qualms with this at all. People need to be confronted with the truth even if they find it painful. It is better to face the problem early when you still have time to implement a plan to provide for your retirement, rather than sleepwalking to the pension.

2.            The presenter by this stage would have all the audience agreeing with the proposition that their superannuation will be inadequate and that they need to get some additional investments working for them. What follows is an outline of the merits of the three classes:

  • Cash
  • Shares
  • Property

CASH:  It’s not too had to do a demolition job on cash. We all need it, but as an investment medium it doesn’t stack up.

SHARES: In the current climate? Only for the brave.  Historically, shares and property have appreciated about the same rate, but for me, where property stands out is LEVERAGE or GEARING.  With shares, the bank will only lend you around 50% of the value of the shares you wish to purchase in a loan they call a margin loan.  Say you want to buy $400k of shares. The bank will only lend you $200k and you have to come up with the remaining $200k. This means that you have a gearing ratio of 50%. If the shares rise 10% to $440k you have made a gain of $40k or 20% of the money you outlaid.

On the other hand, with a margin loan, if the shares drop to $300k in value, the bank will require you to pay a margin call. Remember the bank will only lend you 50% of the value of the shares. The shares are now worth $300k which means that they will only lend you $150k and will issue with a margin call of $50k with as little as 48 hours to pay, or they will sell down your portfolio! Gulp!

You can see why shares are not for the faint hearted.

PROPERTY:  If you want to buy a property the bank will currently lend you up to 95% of the value of the property. That means that you have to put in $20k for a $400k property. For the sake of this exercise, I will ignore LMI (Lenders Mortgage Insurance) and purchase costs at this stage.

If the property goes up by 10%, it will have increased in value by $40k. You will only have put in $20k of your own money, so you have made a gain of 200% on the money you outlaid!  The fact that banks will lend 95% + LMI  on property and only 50% on shares speaks volumes about which asset class the banks think are the most secure investment.

So, to my mind the outstanding advantage of property over shares is that it can be leveraged much more than shares. In other words you can control a $400k asset with $20,000 not $200,000. The next major advantage of property is its lack of volatility. It doesn’t have the wild swings that shares do.

So having decided that property is the way to go the next question is:

NEW or OLD?

NEW : New properties have major advantages over old properties, some of which are:

  • Depreciation benefits.
  • Greater rental returns result in better tenants.
  • Structure covered by warranty.
  • New homes tend to be more energy efficient.
  • Very low maintenance.
  • Stamp Duty concessions

Depreciation: The government will allow you to write off 100% of the construction cost over 40 years. In other words: 2.5% per annum for 40 years.  On a $200k construction cost, that amounts to a $5000 deduction for 40 years. In addition, the fixtures and fittings (value $25000 say) can be written off over around 10 years, giving you an extra average deduction of $2500 pa for 10 years.  So for the first 10 years of a new investment property (construction $200k) you will be able to claim an extra $7500 in deductions on top of your normal expenses. Remember, depreciation gives you a deduction where you haven’t actually incurred an expense!  All the other deductions you claim have to be backed up by invoices and receipts. A property more than 40 years old will have minimal depreciation benefits and depreciation is the biggest single factor that steers me to new investment properties rather than old.

New properties also command greater rent.  Given the choice, a tenant will always choose new over old.

The building structure is covered by the builder's warranty for six years.

There is very low maintenance in new homes as all appliances are covered by warranty.

Stamp duty concessions in some states. In NSW at the moment there is no stamp duty for brand new investment properties.

 

3.                      The third stage of the seminar is where the presenter presents figures demonstrating that property values double every 7-10 years!

Now this used to be true and negative gearing used to work really well but in the last 5 years, Australian house prices have generally stagnated or actually gone backwards in value but at property seminars all over the country, presenters are still preaching that property values will double every 7-10 years, and this is where I disagree.

 

NEGATIVE GEARING

In a nutshell, negative gearing works like this:  An investor buys an investment property for a certain price. His expenses are the interest on the loan as well as rates, insurances, and depreciation. His income is the rent received.  Usually the rent received does not cover the expenses so a loss is incurred. Because the investor makes a loss in an income producing venture, the loss is able to be offset against other income and so a tax saving results.  This tax saving decreases the loss made, but a loss still occurs.

Why would anyone go into a transaction knowing that a loss would be likely?

Simple: The investor is expecting the property to increase in value thereby off-setting any negative gearing loss.

The strategy depends solely on one factor to be successful……. increasing property values!

BUT WHAT  IF PROPERTY VALUES DON’T INCREASE, OR EVEN GO BACKWARD?

 

WHY NEGATIVE GEARING DOESN’T WORK ANY MORE, AND WHY IT WILL COST YOU A MOTZA

The simple answer is that the sole factor that makes negative gearing work, increasing property values, no longer holds.  Most properties, including my own, have actually gone backwards over the last four years.  This will vary from location to location, but most of my clients have had no growth or negative growth in their property values over the last 4 or 5 years. A very astute investor from Melbourne told me recently that he bought a unit in Melbourne ten years ago for $500,000. He had it valued recently and ten years later it was worth $600,000. This didn’t even cover inflation.  He is losing money day by day on this property but can’t sell it in the current market.

Falling or stagnant property values will totally smash a negative gearing strategy and cause big losses.

There is no point in saving some tax to make a loss!

A loss is a loss whichever way you slice it.

Negative gearing worked well in the past and it may do so again in the future, but for the moment it is a sure fire way to lose money.  I’m not saying that property values will not go up in the future; I’m saying that you can no longer RELY on them going up. Most property analysts agree that the days of property doubling every seven years are over.

So if there is no point in borrowing 100% of the purchase price any more as we are only going to lose money, does that mean that investing in residential real estate is no longer viable?

Short answer….NO!   Read on and all will be revealed, well……….. almost all.

 

THE ANSWER

POSITIVE CASH FLOW is the ANSWER

Last year a game changer took place with hardly anyone taking any notice. Investing in residential real estate is now even a better proposition.  With the latest changes by the NSW government, you can now own a $400+k property in 13-16 years, which will pay for itself WITHOUT any increase in property values!

What was this change?

In 2011, under the NSW Government's policy on affordable housing it was decided that home owners could now be allowed to build secondary dwellings (granny flats) on their properties and rent them out.  This means that a property investor could now collect two lots of rent of each block of land, and it meant that in virtually every case, properties that would have been negatively geared with negative cash flow would now have positive cash flow. In other words an investor would get more money back than they had put in, regardless of whether the property went up or down in value.

When I talk granny flats, I am not talking about a converted garage or basement, rather I am talking about purpose-built two bedroom studio apartments with separate lock-up garage and full depreciation benefits.

Clairmont layout

32A design

There is only one builder that I am aware of that is doing this successfully. The Clairmont 32 pictured above achieves rents of $360pw for the 3 bedder and $260pw for the 2 bedder. Gross yield is 7.08% on a purchase price of $455,000. Comparative yields in SE Qld for single dwellings would only fetch a paltry 4.3% gross yield.

Now, I'm a very loyal and parochial Queenslander but these figures speak for themselves. NSW, and in particular, the Golden Triangle has the best non-mining returns in Australia. I will always go to where the best deals are located and right now that's in the Golden Triangle.