(03) 9020 2905Bruce Brammall, The Australian, 16 January, 2022
I wasn’t even a teenager when actress and fitness “guru” Jane Fonda made famous the “no pain, no gain” exercise mantra.
Her thinking was that if you’re not in pain when working out, you’re not working hard enough.
(If I’m feeling pain when I’m exercising, it’s more likely I’m doing it wrong. I’ve probably injured myself. “Call a physio!”)
The “no pain, no gain” principle is actually far better applied to your personal finances. To get ahead, you should be doing something with your money, other than spending it all – not spending some (pain) to invest to benefit “Future You” (gain).
This is particularly so when it comes to buying property, whether it’s a home or investment.
When most people first buy a home, the mortgage is usually more than if they rented the same place from a landlord. That is, it’s usually more painful to buy a house than it is to continue to rent.
The financial success comes when the home is finally paid off, while renting is forever.
Negative gearing pain
When you buy an investment property, you’ll most likely pay out more to cover costs than you’ll receive in rent.
This is “negative gearing”. It occurs when the costs (including interest, agents’ fees, insurance, rates and general maintenance), outweigh the income from the rent.
And for almost all investment property – certainly that would meet my investment criteria – this will occur in the early years of ownership.
Negative gearing means you’re losing money on a cash basis. Your expenses are higher than your income.
Losing money doesn’t sound like a great investment. Why would anyone do that?
It’s related to the “no pain, no gain” way of thinking, but adds in an element of investment risk.
Only one way it works
Negative gearing only makes sense if the asset appreciates at a multiple of what is being “lost” on a cash basis.
That is, on a cash flow basis, you’re losing, say, X dollars a year. But the investment has increased in value by 2X, 3X or more.
Let’s put some more realistic numbers around that.
We’re purchasing a $650,000 property. Rent is $19,500. Interest is $22,750 (3.5 per cent). Other costs amount to $6800, for total costs of $29,550.
The cash “loss” is $10,050. (See negative gearing tax implications below.)
Note I’m using current interest rates, which are ridiculously low. Rates will rise from here, possibly later this year. If rates rise by 1.5 per cent, the yearly cash loss nearly doubles to $20,000.
For an ongoing cash loss to make sense as an investment, the property would need to be rising multiples of that figure. For now, let’s assume it’s going up $30,000 a year.
Lose $10,000 here, gain $30,000 (on paper) there, which is a rise of 4.6 per cent.
It never works that smoothly. Gains aren’t guaranteed, particularly for poorly picked properties.
And ignore the utter rubbish spouted by some that property prices never fall. They do. Property prices largely fell across Australia in 2020 and 2018. And those who buy (generally bad) property can watch their investment go backwards for years.
Occasionally there are years like 2021, where CoreLogic says average prices for the five largest state capitals increased by 21.34 per cent. On our $650,000 investment, that’s a gain of $140,000. Don’t count on that happening often.
Just gambling?
This is the risk that those using a negative gearing strategy are “punting” on. Gains outweighing holding costs. But while not as volatile as stock markets, property rarely does the same capital growth/loss rate two years running.
Property can stagnate, or fall, for long periods.
But Australians love property because they’ve watched what it’s done over the long term. It always seems to bounce back.
In recent decades, when falls have occurred, it has generally been for periods of less than two years.
There are a couple of notable examples. Take Perth’s property prices in the roughly 6.5 years till near the end of 2020. They fell year on year. And Melbourne and Sydney had falls, then flatlined, for as many as seven years going into and coming out of the 1990s recession.
The risks “seem” small. Memories are short. And there’s always a fresh crop of gung-ho newbies coming through. Cue developers rubbing hands.
Biggest dangers
From too much studying of the numbers and too many horror stories, I know the biggest drivers to copping huge losses in property are buying from developers, buying in the wrong areas, and the wrong type of property. (Sometimes all three combined.)
This leaves “poor timing” not even on the podium.
Too many investors do their dough on property from breaking those rules, effectively handing over tens of thousands of dollars to others while on a long, horrible, journey of painful losses.
Tax – the crucial helper
Back to our example on the $650,000 property. With current rates, the investor made a $10,050 cash loss for the year – the difference between rent and expenses.
What are the tax benefits of negative gearing?
When “assessable” income such as rent is earned, taxpayers can deduct tax losses against their regular income.
The result therefore depends on how much you earn.
Someone earning an “average” salary of $80,000 a year will get back 34.5 per cent of the $10,050. That means a tax return of $3467, cutting the net loss to $6583.
An income of $150,000 comes with a marginal tax rate of 39 per cent, cutting the net cost on $10,050 to $6131. On the highest tax bracket (over $180,000), they will receive 47 per cent back, reducing the net loss to $5327.
Obviously, for those earning lower incomes, it becomes difficult to afford those ongoing losses. And the tax benefits for those earning less than $45,000 is minimal.
Negative, neutral, positive
Can you afford to keep losing money on a cash basis forever? No. But you don’t have to.
Over long periods, geared properties will move from negative, to neutral, to positive. This is mostly because rents will rise faster than the other costs associated with ownership, such as rates, insurance and agents’ fees, etc. (Interest rates go up and down, but the size of the loan becomes less important over time, if equity grows.)
How long does that take? How long is a piece of string? It will depend on economic factors beyond your control.
Safety first
If you’re starting out looking at the numbers, always build in buffers and prepare for things to be worse, or take longer, than you’d expect, particularly around interest rates.
Mortgage brokers and banks (believe it or not) assist here. For example, banks don’t use current interest rates when assessing your affordability. They add 3 per cent and test you against that.
State of the market
And the million-dollar question … where to for property markets?
There are a million different answers. Like the individual companies that make up stock markets, properties are not homogenous.
Markets aren’t even state-based, or city-based. They are suburb and even street-based.
Melbourne and Sydney seem to be showing some early signs of this latest bull-run having run out of puff. But that doesn’t necessarily mean falls. And other major capitals and rural regions? As individual as the town or suburb itself.
In a very broad sense, the current bull-run for property seems to have a little more to go. A major reversal seems unlikely in the next six months and there are probably more gains to be had. But factors such as interest rates, elections and omicron’s path of destruction are included in the unknown column as of now.
Property, whether a home or an investment, involves both pain and risk. At the very least, putting off spending money now to try to build wealth and security for later.
And it involves risk. Don’t be stupid enough to believe those who don’t talk about the risks of property. Geared property simply isn’t right for some. Get advice.
Bruce Brammall is both a financial adviser and mortgage broker and author of books including Debt Man Walking. E: bruce@brucebrammallfinancial.com.au.