Why negative gearing still works for creating long-term wealth
Is negative gearing a strategy that still works?
It's a timely question.
Let's face it, property yields are low, capital growth is in question, the regulators want to slap limits on investor lending and the banks have responded with higher interest rates.
Throw in the changes to depreciation perks and the removal of the travel allowances and it's enough to make the 1 million or so Aussies who run a property investment at a loss - and those thinking of going down that route - to ask the big question.
I would argue yes, because ultimately negative gearing is not a strategy; put simply, it's a tax outcome that represents a moment in time.
Like a business owner who makes a loss in the start-up phase to ultimately make profits and build value over the medium to long term, so too does a property investor consider making a loss for only as long as it takes to build a big enough wealth base so that they too can move into positive-gearing territory, which will provide them with the self-funded retirement outcome they desire.
Negative gearing is a means to an end, not a permanent way of life.
So, in my view, the real question here is whether residential property still remains a good investment because the taxation benefits you receive through negative gearing are temporary but, if done correctly, the impact of the capital growth and rental income from building your portfolio will be lasting.
But before we ponder that question, let's look at exactly what headwinds property investors face.
Winter has come
The Australian Prudential Regulation Authority (APRA) this year introduced restrictions that have impacted lending for investment purposes.
APRA is the prudential regulator of the Australian financial services industry, overseeing banks, credit unions and building societies to protect the financial wellbeing of the community.
It is in this protective role that it has implemented new regulations as part of an ongoing response to what it describes as an environment of high housing prices, high and rising levels of household debt, slower income growth and historically low interest rates. As a result, the banks have adopted the APRA recommendations as follows:
Deposits - increased need for larger deposit as most lenders will no longer accept a loan-to-value ratio (LVR) greater than 90% for investors.
Interest only - for most lenders, for any borrowing above an 80% LVR, interest-only facilities are no longer available, regardless of loan purpose. Furthermore, the bank's loan book cannot have more than 30% in interest-only lending.
Investor lending - no more than 10% growth in investor lending year on year for each lender.
Interest rate - increased rates for interest-only lending to be higher than for owner-occupier lending.
New debt - tightened servicing requirements to increase assessment rates on new debts.
Existing debt - assessment rate on existing debt to be considered principal and interest even if paying interest only.
Postcode restrictions - some lenders have managed their risk by limiting lending on select postcodes.
Rental income - some lenders have further discounted rental income assessment from the standard 80% to 75%, and in some cases by as low as 60%.
Exceptions - if applications don't meet policy then it's simply unacceptable, with lenders unwilling to step outside strict lending policy to provide "exceptions". This is in contrast to owner-occupier lending where they're still happy to consider policy exceptions on a case-by-case basis.
No investor lending - some lenders are pulling out of the investment lending game altogether.
As well, the recent federal budget proposed the following changes that will affect any property investors who exchanged after 7.30pm AEST on May 9, 2017:
Depreciation - the government will limit plant and equipment depreciation deductions to outlays actually incurred by investors in residential real estate properties. Essentially, this means property investors can only claim depreciation on dishwashers, fans and other fixtures they've paid for themselves. Previously, investors who bought established properties could continue to claim depreciation on items they acquired as part of the purchase.
Travel claims - all travel deductions relating to inspecting, maintaining or collecting rent for a rental property will be disallowed. This applies within your own state as well as interstate.
Property investment is essentially a game of finance, just as much as it is a game of bricks and mortar, so these lending changes are significant. APRA will get what it wants as it achieves a desired slowdown in investor lending but I don't think that is a bad thing, as neither investors nor owner-occupiers want an unstable property market.
Equally, the hit to cash flow from the reduction in depreciation and travel allowances is not ideal. However, if Melbourne and Sydney were to keep on charging ahead as they have been over the past few years, then we would have set ourselves up for some pain in the future. Measures to avoid that are warranted.
Why invest in property?
But despite these speed bumps, investing in property remains an attractive proposition for building real wealth in the long term. There are many reasons but here are a few to remind ourselves why:
Big market - according to CoreLogic, Australian residential real estate is valued at $7.3 trillion, with over 9.8 million dwellings, an LVR of 23.4% with outstanding mortgage debt of $1.66 trillion. The opportunities to build wealth in this market are substantial with a very strong secondary market given it forms an essential human need. To put its size in context, Australian super is next biggest with $2.3 trillion and Australian listed stocks at $1.8 trillion.
Self-funded retirement - the growing awareness that superannuation alone will not be enough and the constant changes to the rules. As well, the uncertainty around the amount of government pension that will be available and the desire to be less reliant on the government makes it attractive to create a self-funded retirement through property.
Leverage - this is very appealing for a property investor, as the ability to control a larger asset and get the compounding benefits of the larger value is the single reason why we choose property over any other asset class. Combine leverage and compounding with an investment-grade property and the results are life-changing.
Low volatility - particularly in the capital cities and surrounding areas where the demand exceeds supply. While property performance is never consistent and linear, investment grade property rarely loses value quickly or in high proportions.
Simplicity - it's tangible and easy to understand. After all, it's an essential need: shelter.
Control - unlike other investments, you're in full control of your property investment; you can make all the decisions and have control over all your returns. You can add value to your investment without having to seek approval from a large company or fund manager.
Government backed - let's be honest, the collapse of the housing market would be a disaster for the government of the day at the ballot box, so protecting this very important asset class is not only in the national interest but politically underpinned.
Alternatives - they often appear harder to understand, are riskier or are perceived as a poorer return on investment. An investment-grade property offers better performance than money in the bank.
To build a portfolio that weathers any storm, it's important to ensure that you get the fundamentals right from the beginning. This enables you to positively plan your financial future while creating a safety net to defend your portfolio from external factors outside your control.
The first fundamental for any property investor is asset selection. Picking a poorly performing asset whose value doesn't grow or, worse, falls is by far the biggest derailer to any portfolio. So it's important to know that not all property makes for a great investment.
Therefore, knowing the difference between investment-grade property versus investment stock is a priority.
This point alone is what determines your ultimate success or failure as a property investor, as mistakes are often hard to recover from. I see too many investors who think it's simply about putting their name on a title and magically it will go up in value. The law of supply and demand exists in the property market as it does in any market, so ignore this fundamental at your peril.
The second fundamental is to correctly finance the property.
I mentioned earlier that property investing is a game of finance so getting a borrowing capacity is simply not enough. You must get a borrowing strategy that takes into account not only the current purchase but also planning for any future purchases. Providing a buffer as well as ensuring that the banks are not dictating the terms through crossing the security will give you the agility to navigate whatever the market throws at you.
Third, investing in property is all about time in the market. Savvy property investors see short term as being 10?years and long term as being 20-plus years. The power of compounding is brilliant but only if you give it time to work its magic.
The most successful investors we've ever interviewed on our podcast or met in person are those who have been investing for more than 20 years and navigated through many cycles, and their portfolio size reflects the patience they've shown to accumulate. The interest on the original purchase price is now equivalent to their kids' lunch money! If you hold for the long term, your reliance on the negative-gearing benefits well and truly diminish over time.
And, finally, to the common question of "When should I buy my next investment property?" The answer is the same no matter what the market sentiment is. Assuming you're a long-term investor (not a speculator) then it's simply "when your cash flows allow".
If you have planned your cash flows appropriately, taking into consideration your medium-term needs (growing family, changing jobs, 12-month sabbaticals, job security), not just the here and now, then if you have surplus cash flow above your needs then you should consider adding a property to your portfolio. It's as simple as that.
The growth of median house prices in the capital cities for the past 35 years has not been a straight line - and in some cases it goes down - but the overall trend is up and this further reinforces the benefits of playing the long game.
This too shall pass
When we ponder the question of whether investing in property and negative gearing are still worthwhile in the current market, it's important to keep all this in perspective.
A quick history lesson will remind us that there have been speed bumps in the past that we have faced and withstood.
Negative gearing was abolished in 1985 and reintroduced in 1987, the GST was introduced in 2000 with huge uncertainty for investors following the major change in tax scales, we weathered the Asian financial crisis of 1997 and of course most recently we were faced with the GFC.
It may be winter now but it doesn't mean that summer will never come again, and if you have an investment-savvy mortgage broker to help you navigate the finance waters as well as a long-term strategy, then it's simply part of the constant "white water" that is property investing, as it's never "clear water".
But now could be a terrific opportunity to acquire great assets while the market is uncertain. If anything, hopefully the changing landscape will discourage short-term thinkers and encourage people to have a long-range perspective.
So when faced with the ever-present white noise of the markets, I often find comfort in the words of the greatest long-term investor of our time, Warren Buffett, who tells us to be fearful when others are greedy and greedy when others are fearful.
While repayments on the mortgage are set at interest-only, all surplus cash flow goes into offset accounts.
Ultimately the offsets will have equal cash reserves to outstanding loans and each investor has the choice to keep the cash in offset or eliminate the loans entirely.