The 7 Harsh Realities of Negative Gearing
Just when it seemed as if we had seen the top of the market in Sydney and Melbourne, buyers came out in full force for the March Super-Saturday auctions. With winning bidders offering up clearance rates well above 70 percent in most areas, many investors were left scratching their heads.
Only time will tell whether this level of buying activity will continue, but the broader economic picture is indicating an environment ripe for asset price inflation. Central banks seem to be consistently painting a picture of low interest rates for the foreseeable future.
Japan and Europe are already in negative territory. China is loosening lending restrictions while printing money, and the U.S. Federal Reserve has indicated a slower than expected path to higher rates. These currency wars have added strength to the Australian dollar, which is up approximately 11 percent on the year.
The RBA ideally wants to see the Aussie in the mid-60’s, to provide a boost to our exporters and maintain a moderate degree of inflation. This makes a rate cut in the coming months highly likely. If the Fed shifts further toward a dovish stance, we may even see a second rate cut before the year is out.
The dark side for the RBA of a lower cash rate is falling mortgage interest rates. This could attract more homebuyers and send house prices soaring even higher.
While APRA has already forced banks to tighten lending restrictions, giving the RBA some wriggle room, we must remember that bank profitability depends upon ever-increasing household debt levels. Banks need a steady stream of borrowers, while also carefully balancing the risk of a market correction.
What does this mean?
We shouldn’t be surprised to see more investors entering the market to buy expensive, low-yielding rental properties, which means more negative gearing. With the typical perma-bull mindset of the average Australian towards real estate, it seems that few understand the risks of such a strategy.
In the hope of saving some people from financial pain down the road, here are seven harsh realities of negative gearing. For some these will be reminders. For others, they may be revelation.
1. Negative gearing is a strategy guaranteed to lose money.
The immediate benefit of owning a negatively geared property is the tax deduction arising from a cash flow loss. By nature, negative gearing is all about losing money, like your rental income is failing to cover the costs of owning the asset.
In summary, it’s a strategy guaranteed to make a loss. In order for most people to offset this loss, they’ll need to dip into their personal cash flow by working longer hours or by diminishing their lifestyle. This might mean foregoing a family holiday or not paying down the home mortgage as fast.
Of course, no one purposefully invests in real estate to lose money, but the fact that so many people are happy to speculate on future capital growth reveals the power of effective marketing. Marketers convince investors of the future value of an asset, which ultimately justifies the purchase.
The only way an investor can build wealth through negative gearing is if the future capital appreciation far exceeds the cash flow losses incurred today. Even if the asset appreciates, once factoring in the loss in buying power of capital gain, the outcome may be no real wealth creation in the end.
Negative gearing can be a valuable profit-making tool in a rising market. In certain suburbs over the past few years, some investors will have no doubt realised some gains far exceeding the inflation rate, but it is not a strategy for all seasons. There’s no guarantee the future will be like the past.
2. Buying a property based on depreciation benefits ignores reality.
Depreciation is an accounting term used to describe the wear and tear of an asset that occurs over time. In practical terms, depreciation on a property refers to the carpet wearing down, the walls being chipped or stained, and the appliances becoming dated.
In most new properties, the ATO permits an investor to claim a tax deduction for the depreciation of the fixtures and fittings within the dwelling. In certain circumstances, investors may also be able to claim a building write-off of either 2.5 percent, or four percent of the value of the dwelling itself, not the land.
Slick marketing companies sell the notion of the taxman paying off your property using depreciation and building write-off deductions. The truth is, this is a deceptive practice. You can never avoid paying tax with depreciation – you can only defer it.
Depreciating an asset may give you a tax deduction today, but you must repay the savings in the form of capital gains tax at the time you decide to sell. This can be costly when you realise the gain and end up being pushed into a higher tax bracket. The higher your income in a particular year, the higher your marginal tax rate.
Some say, “That’s why you should never sell.” Fair enough, but just because you hold forever, it doesn’t mean you avoid the loss. At a minimum, you must acknowledge your depreciation tax deduction represents the wear and tear on your asset that eventually you’ll need to repair and refurbish in order to continue attracting quality tenants.
Few marketers ever project an outcome that takes into consideration the investor’s maintenance and improvement budget.
3. The benefit of attracting premium tenants can be deceptive.
A major selling point of new properties is the supposed benefit of attracting the highest quality tenants. Investors assume that the more attractive the property, the greater the likelihood the tenant will be a high-income earner, and the longer they will want to stay in the property.
This may or may not end up being the case. Higher net worth tenants can, in reality, represent the most volatile segment of the rental market. When times are prosperous, premium tenants look for glamorous living in the newest properties with all the modern conveniences.
When the economy contracts and times are tougher, these same tenants with their higher salaries are at a greater risk of being downsized. In this instance, they may seek cheaper accommodation, leaving you holding an expensive property while competing for new tenants in a shrinking market.
In an economic recession, landlords may experience vacancies of three months or longer on premium properties. How would that kind of drop in cash flow impact your lifestyle?
A better strategy would be to attract a quality tenant who is willing to pay above market rent for a well-maintained property with a responsive landlord. There will always be demand for a house the average family can afford to live in. People must have a place to live, but it just may not be as nice as they want it to be.
The wisest, most forward-thinking property investors seek rental properties that are the least prone to economic ups and downs. Then, they find strategies for attracting long-term tenants who are willing to pay a premium, while treating the property as if it were their own home.
4. New homes are often sold using inaccurate growth comparisons.
Negative gearing is a strategy doomed to failure until capital growth exceeds the cumulative cash flow loss, plus any decrease in buying power. Those who sell new homes must seek to substantiate their assumptions of future capital growth to get people to buy-in to the idea. Unfortunately, the methods and comparisons used can be deceptive.
A common strategy is for marketers to point to the increase in the median house price in a particular area, and then apply that same expectation to premium real estate. These may not be fair comparisons, as home prices in different segments can rise and fall in the same market at the same time.
The point is this: Movements in the median property price may not be representative of movements in the higher priced segment of the market.
Marketers also often point to the story that real estate values double every seven to 10 years. This may have been true in the past at certain times and in certain places, but to apply this as fact across all types of property, in all states and at all times is grossly misrepresentative.
Finally, marketers tend to base their income projections on gross figures. They quote figures assuming full occupancy and at the highest range of a rental appraisal. There’s almost never an allowance for vacancies after the rental guarantee period has finished. They also never seem to speak in terms of after-tax net profit by excluding any allowance for capital gains tax payable, once the asset is sold.
5. Off-the-plan real estate is often priced to include a secret commission.
How do most investors choose an investment property? They seldom receive the training to systematically research and assess areas and properties, and then make an educated decision.
These investors find many properties after attending a free “educational seminar,” or after receiving a recommendation from a financial planner, accountant or mortgage broker, but do these investors stop to consider who is getting paid in this transaction?
Developers often solve their exit strategy problem by forming partnerships with industry professionals who market properties for them. Often behind the guise of another service, whether training, accounting or financial planning, these professionals receive commissions or referral fees to refer their investor clients.
A typical commission may be in the range of three to five percent of the sales price of the property. This fee is seldom paid from the developer’s profit margin on the land. Rather, it’s a cost typically added on top and paid directly by the duped investor.
Smart investors are always aware of who is incentivised in a transaction. Commissions are a normal part of many business transactions, but when they make property purchases unnecessarily expensive, it’s the unsophisticated mum and pop investors who lose.
Remember to always ask ‘Who gets paid when I buy?’
6. Investing to save tax is a dumb strategy.
Accountants commonly recommend negative gearing because one of their chief goals is to save you tax. Marketers are quick to jump on board your accountant’s advice and provide their solution to the tax problem.
Investing in negatively geared property to save tax is a double-edged sword. For every dollar you lose, you’ll only ever recoup a maximum of 48.5 per cent back as a tax saving. While you’re waiting for often-illusive capital appreciation, you may be forced to work long hours and cut back on lifestyle spending in order to fund the loss from your personal budget.
No one has ever become rich by saving tax. In fact, the notion of creating wealth assumes the need to pay tax, as all profitable investing leads to a tax bill. You would be wiser to shift your mindset to recognise paying tax is a necessary outcome of making money. Invest to pay tax, not to save it.
7. Buying negative cash flow properties diminishes your buying power.
Since negative gearing takes money out of your personal income rather than putting money into it, your cash flow diminishes further with each subsequent property purchase. Since you can only recover a maximum of 48.5 percent as a tax deduction, the remaining 51.5 cents on the dollar comes from your back pocket.
This puts a limit on the number of these types of properties you can afford to own. The more loss-making rental homes you buy, the more your real buying power shrinks. Eventually, you run out of surplus personal funds to offset the cash flow loss.
Final Thoughts on Negative Gearing
Negative gearing isn’t all bad. It’s a proven wealth-creation strategy during times of rapid price increases, for those who can comfortably afford the negative cash flow and are happy to continue working.
It is a strategy wrought with pitfalls. While negative gearing has worked out well over the last decade for some investors amidst near-perfect market conditions, the ongoing risks are far greater than most people realise.
If speculation isn’t your cup of tea and you’re looking for a better way, check out Steve McKnight’s Property Apprenticeship course. Through a 65-session, nationally-recognised training course, we’ll equip you with a winning mindset and a strategic system. We’ll empower you to make wise investing decisions no matter what the broader economic climate looks like.
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