The ALP announced on Friday (29/3/19) that it will ban negative gearing from 1 January 2020 if it wins the election next month. I wrote an article for The Australian newspaper over the weekend which addresses the steps property investors can take to fortify their investments (which I list below). A number of people have asked me whether they should invest in property prior to 1 January 2020. I discuss this too.
We still have a long way to go
Of course, the ALP has to win the election before it can ban negative gearing. I acknowledge that virtually every poll predicts an ALP victory. But John Howard didn’t poll very well leading up to his 1996 election win. And who would have thought Mr Trump would become President of the USA! So, anything can happen.
Secondly, it will depend on how strong their win is and whether they have a large majority or not. If it’s a tight win, they may have to negotiate with minor parties to get its law enacted and, as a result, water down its change to negative gearing e.g. limit it rather than an outright ban.
And finally, we have not seen the draft legislation yet. All the ALP has said is they will be negative gearing if people invest in established property or shares after 1 January 2020. Back in 1985 when the Hawke government banned negative gearing, people used unit trusts to invest in property. They borrowed to buy the units and as such were able to continue to negatively gear the property. So, there could be workarounds.
What should (existing) property investors consider doing?
There is a risk that the ban on negative gearing will put further downward pressure on property values in 2020. Owning an investment property in a falling market can be a double-whammy. Not only is your asset value falling, but you have to put your hand in your pocket each month to contribute towards the holding costs (if the net rental income isn’t enough to meet the loan repayments). Here are some of the steps you can consider taking:
1. Reduce holding costs – fix your interest rate
Many lenders are offering 3 years fixed rates at levels below variable interest rates, particularly if your loan repayments are structured as interest only. This may help reduce the monthly holding costs and you could still be better off on a fixed rate because, even if the RBA does cut rates this year, there’s no guarantees the banks will pass it on. See more from my blog a few week’s ago.
2. Make any changes to mortgages prior to 2020
If values do fall further as predicted, now might be a good time to lock in access to available equity. This involves increasing your loan’s credit limit to up to 80 percent of the current value of your investment property. This will give you access to additional credit for emergencies (i.e. a financial buffer) or future investment purposes. This equity may not be available in the future if bank valuations fall after 1 January 2020.
3. Divest of underperforming properties in 2019
I expect that some property types and locations will be more exposed to changes in negative gearing. For example, locations or buildings that are dominated by investor-owners could be at greater risk compared to locations with a more normalised number of owner-occupiers. In addition, the types of properties that have historically been marketed to investors primarily because of the tax benefits they generate (such as depreciation and negative gearing) will almost certainly be negatively impacted.
If you own a property with these characteristics, you might consider divesting of that asset before any changes to negative gearing are confirmed. Of course, you must consider this in context of the property’s past investment performance, likelihood for future returns, divestment costs such as Capital Gains Tax, real estate agent fees and the like. The point is that if it’s a dud investment today, its likely to be an even worse investment if negative gearing is banned.
4. Prepare to increase your rental income
SQM Research predicts that acquisition rental yields will rise by around 1% if negative gearing is banned. This is what many professionals said what happened when the Hawke Labor government banned negative gearing between 1985 and 1987. They reinstated negative gearing to take pressure off rents. If rents do rise, you should ensure that your assets are well positioned to benefit from this.
To achieve this, you could consider doing two things. Firstly, avoid any lengthy rental agreement terms with your tenant. This may allow you to review rent levels to meet the market. Secondly, consider making cosmetic improvements to your property that will enhance its rental demand. Things like installing air conditioning, giving kitchens and bathrooms a facelift, recarpeting or painting can have huge appeal to tenants. These improvements don’t have to cost a fortune, you can use a mortgage to fund these expenses and you can depreciate these improvements (i.e. get a gradual tax deduction for them).
Another way to increase a property’s income is to consider furnishing it and letting it out on a short-term basis via businesses such as Airbnb, stayz or corporate let. You can potentially more than double the amount of income produced by a property (compared to having a permanent tenant) thereby transforming its overall cash flow from a negative position to neutral or even positive. There are risks associated with this including ensuring you have correct insurance cover, getting approval from Body Corporate managers if it’s an apartment and preparing for the likelihood that income receipts may be lumpy. If abolishing negative gearing does put downward pressure on values, then hopefully you can offset some of the impact by maximising your property’s rental income.
5. Maybe it will create opportunities?
The impact of these proposed negative gearing changes could also create investment opportunities too. My analysis has demonstrated that, in the long run, the abolition of negative gearing will only have a small impact on overall investment returns in investment-grade locations (see here).
In the long run, the immutable laws of supply and demand in the face of strong population growth will continue to generate substantial capital growth. A strong level of capital growth will, over time, dwarf the lost tax benefits as a result of banning negative gearing. Therefore, if banning negative gearing does temporarily depress prices in quality locations, it might create an opportunity to buy investment-grade property at a level below intrinsic value.
Should you invest in property prior to 2020 to ‘lock in’ negative gearing?
Of course, the answer to the above question depends on your individual position and goals. However, as a very general rule, I would say that if your retirement strategy was to invest in property over the next 5 years then, yes! I would bring forward the implementation of that and try and invest prior to 1 January 2020. However, if for whatever reason that is not possible, I would not be too upset. Investing in the right asset is far more important than negative gearing benefits.
Remember, a negative gearing benefit diminishes over time. It is typically material over the first 5 to 10 years of ownership. After 10 years, the benefits of negative gearing have typically evaporated. So, if you intend to hold the property for many decades, the initial negative gearing benefits become less material over time.
Therefore, if you decide to try and invest in property before negative gearing is banned, don’t cut any corners and invest in just any property. A quality property without negative gearing will always produce better returns (in the long run) than an average property with negative gearing.
I would caution anyone from being driven by the Fear of Missing Out (FOMO). Don’t invest in property just because you feel that it’s a once in a lifetime opportunity to enjoy some negative gearing benefits. Making investment decisions purely in the pursuit of tax benefit is a recipe for disaster (i.e. mistakes).
Stay calm and focus on the long-run
These potential changes to negative gearing generate a lot of noise. The media and politicians love it. But in reality, in the long run, they are relatively meaningless. Its just noise.
Focus on the fundamentals (it’s exactly why I wrote Investopoly). Invest in quality assets. Have a plan and stick to it. I’d bet in 2030 we’ll look back and laugh at all the negative gearing hyperbole and be thankful it didn’t distract us from making important decision.