A few months ago, a reader of this blog asked me to analyse two options. Option one is to borrow more money to fund an upgrade of your family home and consequently enjoy tax-free capital gains. The second option is to invest in property. The reader wanted to know which is the best option, net of all taxes such as capital gains and land tax?
Widen the scope of the question
I’d like to widen the scope of this question and add one more option – investing in shares. I have concerns with investing large amounts of borrowed funds in the share market, which I will discuss below. However, as an independent financial advisory firm, it is important that we always provide a balanced view – even if some of the options we are comparing are more of an academic comparison, than a practical one.
Interest rate assumption
One of the key assumptions in my financial modelling is interest rates. Normally, I like to adopt a conservative long-term interest rate assumption of 6.5% p.a. However, I realise that this might be less appropriate when interest rates around the world are making their way to zero (or are already there) and central banks are pursuing quantitive easing. It is very likely that interest rates will remain persistently low for an extended period of time. That said, it’s also not impossible that interest rates will rise sometime in the future too.
As such, in this analysis I have assumed that the variable interest rate is 3.7% for investment loans and 2.9% p.a. for home loans and will remain at this level for the next 3 years. I have then assumed rates will rise by 3% p.a. over the following decade (on a straight-line basis) and remain at that level.
What is most important is that I have used the exact same assumptions when comparing all options.
The quantitative analysis
I financially modelled three scenarios:
Option 1: Borrowing $1 million to fund a home upgrade from $1 million to $2 million. This allows you to move to a superior location thereby enjoying a superior capital growth rate.
Option 2: Borrow $1 million to invest in a property that generates gross income of 2% (rental yield before expenses) and capital growth of 7% p.a.
Option 3: Borrow $1 million and invest in shares which generate 4.0% p.a. in dividends (40% franked) and 5.0% p.a. in growth rate (so that the overall return is the same as the property option i.e. 9% p.a. – to ensure the comparison is fair).
As you will see from the chart below (click to enlarge), option one is superior ($4.65m) as it results in a higher net worth in today’s dollars. Options 2 and 3 are broadly similar ($3.69m versus $3.64m respectively), after all taxes including CGT.
It is interesting to observe that the higher expenses associated with property (e.g. maintenance, land tax, etc.) do not have a material impact. One might expect that the higher expenses associated with property investing compared to the higher income from share investing (particularly franking credits) would result in the shares option being superior. But the higher (compounding) capital growth from property more than offsets its lower income and higher expenses. The key here is investing in the right property i.e. investment-grade.
Home loan debt is less of a problem whilst rates are low
One of the problems with a strategy that gives rise to high amount of non-tax-deductible debt (i.e. home loan) is that it can be very expensive. That’s because the interest is not tax deductible – so repayments are made from after tax dollars. In a high interest rate environment, this can absorb all cash flow thereby retarding your ability to make material loan principal repayments or invest in other assets.
For example, a $1 million loan at 7% p.a. will cost you $70,000 in annual interest. You need to generate approximately $150,000 of additional pre-tax income to fund this interest cost (i.e. $150,000 pre-tax amounts to $70,000 after-tax). That is expensive.
However, in a lower interest rate environment, non-tax-deductible debt becomes less of a cash flow burden. This allows borrowers to (1) repay this debt at a faster rate and/or (2) divert a portion of their cash flow towards other wealth accumulating activities.
I would almost never recommend investing $1 million in the share market in one hit
From a practical perspective, I would not recommend anyone invest a large lump in the share market in one tranche, particularly borrowed funds. Instead, I would prefer to invest the money in smaller tranches over a period of many years. This spreads your timing risk as the share market is twice has volatile as the property market.
I only assumed the $1 million was invested in one lump sum for academic purposes – to make sure I’m comparing like for like strategies.
Home strategy will only work if you downsize
Whilst the ‘home upgrade’ strategy produces the best result, it is will only help you fund retirement if you sell your home in the future (i.e. downsize) to crystallise the additional equity.
I caution people about relying on crystallising home equity as a primary strategy. It is okay as a ‘plan b or c’ but typically not as a primary strategy. The reason is that often people become attached to a certain location due to its amenity and community connections. They might like to downsize in accommodation size but stay in the same area. That does not always translate to a commensurate downsize in value. That is, selling a family home and buying a new, low-maintenance townhouse in the same location may not generate as much “cash” (to fund retirement) as you may initially anticipate.
Tax benefits associated with property are far less compelling
In the past, one of the benefits of investing in property is that it would reduce the amount of tax the investor paid i.e. due to negative gearing. This was true in a higher interest rate environment, but in a low interest rate environment, tax benefits are far less compelling.
For example, the rate for a 3-year fixed investment loan is currently only 2.70% p.a. Rental yields tend to range between 2% and 4.5% i.e. often higher than current interest rates. Therefore, it is possible a property’s rental income will be enough to pay for all its expenses including interest – thereby not providing an investor any tax savings.
Your home can be a good investment
The key message I would like to convey is that your home can be one of your best investments. For some people, it is practical and possible to purchase a home in a location that possess investment fundamentals. I always counsel my clients to do this, where possible.
Of course, the primary reason to purchase a home is for lifestyle purposes, and I understand that. But sometimes it is also possible to do both i.e. buy an investment-grade property and occupy it. And doing so can materially aid wealth accumulation efforts.
Therefore, don’t be too quick to discount a potential home upgrade purely as a lifestyle decision. There can be some important financial considerations too, which may or may not aid your wealth accumulation efforts.