Banning negative gearing will force you to become a better property investor

By January 23, 2019 Property Investing
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If the ALP wins the election in May and ban negative gearing on established property (as proposed), does that mean property is no longer a good asset class to invest in? The answer is no, if you do it right. In an environment of no negative gearing, capital growth becomes even more important.

The razzle dazzle of tax savings is too tempting for some people to ignore 

Too many people have been seduced by tax benefits when selecting a property investment. Potential tax savings distract investors’ attention away from an asset’s poor quality (lack of fundamentals). The problem is that you have to live with the asset’s quality long after the tax savings have evaporated. And the asset’s quality will dictate whether you will enjoy adequate investment returns (mostly in the form of capital growth) or not. 

Tax benefits can come in two ways.

Steer clear of depreciation benefits

Firstly, there’s ‘depreciation’ which is a measure of the reduction of a dwellings value over time. If you are the first owner of a property, you can claim a depreciation deduction in respect to the building and its fittings and fixtures. The problem with depreciation is that it actually happens. It’s like driving a new car off the lot – they say it immediately depreciates by 10%! A new building will depreciate substantially in the first decade of ownership. Therefore, for the investment to work, the land value must appreciate at a much faster rate to (1) offset the building depreciation and (2) contribute to the property’s overall value appreciation (if there is to be any). The problem is that new-build properties typically have a smaller land value component so that doesn’t happen. The existence of a depreciation benefit is a red flag that a property isn’t investment-grade and therefore should be avoided from an investment perspective.

Negative gearing should help you generate capital gains

Amazon is worth over $USD830 billion according to the stock market. However, it makes $USD3 billion profit per year – which is not a lot for a company that is worth so much. Therefore, the reason that people invest in Amazon is because they think that the businesses will be worth a lot more in the future. Amazon shareholders are clearly investing for growth, not income (it’s never paid a dividend to shareholders). 

The same concept is true for investment-grade property. Smart investors don’t invest for negative gearing. Negative gearing is merely a positive consequence of their investment. Smart investors are targeting capital growth so that whatever they lose in income (net loss after tax benefits) will be dwarfed by the amount of capital growth in the long run. However, some investors have incorrectly focused on (or been seduced by) tax savings when making investment decisions. In reality, this is an unwelcome distraction from what is ultimately going to make-or-break an investment in the long run. 

In the future, you’ll have to be more picky 

If you agree that the primary reason we invest in property is for capital growth, then, when considering any prospective investment, we must consider its future capital growth prospects. That is, we must be sure that a property’s future growth will more than offset any income losses to the extent that the net investment returns are still very healthy. 

The existence of negative gearing means that an investor needs a lower amount of capital growth in order to generate an adequate return. However, if negative gearing was to be abolished, I would argue that all investors must become even more focus on future capital growth prospects. 

The chart below sets out the projected cash flow of a $750,000 property investment with and without negative gearing. Over the first 20 years, the difference is approximately $131,000 in today’s dollars. You must generate a higher capital growth rate of 0.40% p.a. (on average over the 20-year period) to offset the impact of having no negative gearing.

negative gearing

How do you become a better property investor? 

In short, by nailing asset section. That is, few properties in Australia have a high probability of generating strong capital growth. Put differently, you must only invest in properties that have the highest probability of doubling in value every 8 to 12 years. That knocks out probably 95% of properties. 

Here is a blog which outlines the three characteristics that an investment grade property must have, being:

  1. Strong land value component – more than 50% of the total value of the property must be land value. 
  2. Scarcity. The land must be located in a position that enjoys excessive demand and fixed supply. This means there’s no available vacant land within a 20 to 30 minute drive (i.e. fixed supply). The location must be well serviced by amenities (e.g. schools, shops, medical facilities, parks, public transport, arterial roads and so on). The area should be dominated by owner-occupiers, not investors. Secondly, the dwellings architecture and type must be scarce. Take an art-deco apartment for example. Typically, a block will consist of 6 to 8 apartments on 1,000 sqm of land. So, there few apartments (compared to a high-density development) and no one’s building double-brick, art-deco apartments anymore. The imbalance between demand and supply will cause capital growth.
  3. The property must have demonstrated its capacity to generate strong capital growth in the past. That is, when you review past sales over the last 2, 3 and 4 decades, the average growth rate is impressive. This is a core tenant of evidence-based-investing. That is, only invest where there’s strong evidence that doing so will generate quality investment returns. 

If negative gearing gets abolished 

There are two key benefits of investing in property compared to shares:

  1. Investment-grade property provides most of its return in capital growth. Typically, an investor could expect say only 2% income after expenses and therefore say 8% p.a. growth. However, with the share market, you are likely to receive 4-4.5% income and therefore 5.5-6% growth (in Australia). If you are more than 10 years from retirement, you should prioritise growth over income because it will (1) reduce the tax you pay and (2) allow you to benefit from compounding capital growth. 
  2. Most people feel more comfortable borrowing to invest in property compared to shares – probably because property has half the rate of volatility compared to shares. Mathematical, borrowing to invest more sooner will have a dramatically positive impact (compared to not borrowing, or borrowing less – holding all other assumptions including returns constant). 

These two benefits are important to people who need to grow their asset base. However, if you already have a significant asset base (i.e. close to or in retirement), then these attributes will be less (not) important. 

You will note that these two benefits have nothing to do with negative gearing. Therefore, if negative gearing gets abolished, investing in property will still be a smart thing to do. The only thing is that there’s less margin for error with respect to asset selection. That is, you must get it 100% correct. And the best way to do that in my opinion is to engage the services of a reputable and experienced buyers’ agent.