Ten rules to avoid getting blown up by CFDs
1 February, 2012Euromoney deals of the year, Asia, 2011
1 February, 2012Smart Investor, February 2012
As Australians, we’re probably among the world’s most voracious buyers of investment property. It’s entrenched in the national mindset as a tried-and-tested way to build wealth, through the reassuringly tangible method of bricks and mortar.
And why not? Though property markets have ups and downs like any other, the vast majority go up in value over the long term; and a well-chosen location, properly tenanted, can generate a reliable yield, pay down your debts and in some circumstances slash your tax bill.
The only problem is, so few of us think about the exit. How many of us who have bought investment properties have thought clearly about exactly how, why and when we’re going to get out again? We ought to have that in mind. There are tax issues, for a start, around capital gains; there are questions about your debt position, and need for cash, as you approach retirement. Ideally we’d think about this at the start, not just the end.
“Many people don’t think the investment strategy right through to its conclusion,” says financial planner Paul Moran. “Especially with investment property purchases, the end profit can be very large and hance there can be a significant capital gains tax liability. In fact, many investors don’t understand that there is no such thing as capital gains tax – rather, the taxable capital gain is simply added to your other income for the year and taxed according to marginal rates.”
To learn more, we asked Kim Wight at Smartline Personal Mortgage Advisers to model a few of the scenarios that commonly arise around investment property, and the exit strategies that would work within them.
“It’s an afterthought for many people,” she says. “When people come and see me wanting to buy property, a lot of the time they’re looking at it more for a tax deduction as a way of negatively gearing and reducing their tax. Their strategy in actually retiring that debt down the track is an afterthought. If they then look at selling it and cashing in, they’ve got to be aware of the capital gain.” Not that there’s anything necessarily wrong with paying capital gains tax; “As I say to people, capital gains negates the negative gearing effect you had on the way. You still made money.”
Part of it is about getting the right advice from the outset – and not just from mortgage advisors or property spruikers, but accountants and financial planners. And having a clear sense of what you want is helpful from the outset. Early on with a client, Kim says, “we sit down together and work out what we’re trying to achieve. If we’re trying to build a property portfolio, it’s important they understand it’s not just a matter of ‘he who’s got the most properties wins’, but he who has got the most equity in their property assisting them to build wealth. You need to be able to reduce debt, while building equity, if you want to keep buying more properties.”
We asked Kim to model three scenarios for us: first homebuyer; interest only versus principal and interest; and property for retirement. Here’s what she came up with.
SCENARIO ONE: FIRST HOMEBUYERS
One common approach for people getting started in property is to buy a modest home to live in, with the intention of upgrading to a grander place later, at which point they keep the first home as an investment property. It’s a straightforward ambition, and it usually goes like this: they’ll have the debt on the property for 30 years, and at the end of it all, they’ll own it outright.
It’s possible to be more ambitious than that. Kim cites the example of a $400,000 30-year loan taken out at 7%. The difference between paying $2,661 a month and paying $3,000 a month means reducing the loan term to 21 years – saving a cool $182,254 in interest.
No first home buyer is going to be able to make big payments above and beyond the required mortgage every month; there are a host of other demands on finances. But paying off as much as possible, as often as possible, helps to reduce the owner-occupier home debt. A redraw facility can be useful here, allowing borrowers to deposit extra money into the loan and withdraw it again when they need it; also worth considering is a 100% offset account, where a borrower’s income is paid into an account linked to the loan, which can be used for all the usual cheque, EFTPOS and internet banking transactions like any other bank loan. Since the two accounts offset each other, the more money is in the offset account, the more interest is saved on the loan. “Over time, these extra deposits can significantly reduce interest payments and the life of the loan,” Kim says.
BOX:
Owner-occupied value $ 450,000
Debt $ 405,000 P&I @ 7% pa
Property value 5 years later $ 521,672 based on 3% pa average growth
Debt 5 years later $ 381,233
Money held in redraw/offset $ 50,000
Available funds for next purchase$ 138,271 @ LVR 90% (plus LMI)
Another first homebuyer approach is to do things the other way around: investment property first, then owner-occupied home. They may purchase using benefits available to them, such as first homeowner grants, then rent the property out after a qualifying period (generally the owner has to live in the home for six of the first 12 months of ownership).
This approach is not without drawbacks – chiefly, that once you sell a property you’ve used as an income-producing asset, you will attract capital gains tax. As always, accounting and financial advice is vital.
If buyers do take this approach, Kim suggest a loan with an offset facility, rather than a redraw, to build up funds while reducing interest. That’s because you can use money in an offset account however you like, but if you withdraw from a loan redraw account, the ATO may take the view that you are increasing your borrowings, in which case the higher interest charges from the redraw might not be tax deductible.
After that, Kim suggests waiting until the funds in the offset, combined with your equity in the property, reach 20% LVR (the amount borrowed as a ratio against the value of the property) before purchasing another property – and don’t forget stamp duty and legal costs. Think, too, whether buying the owner-occupied property while keeping the investment property is really the right choice. “They need to consider if having a large amount owing on a non-income producing asset is the right strategy and if they would be better to sell the investment property and reduce the debt on the owner-occupied property,” Kim says.
BOX:
Owner-occupied home value $ 450,000
Debt $ 405,000 IO @ 7% pa
Property value 5 years later $ 521,672 based on 3% growth average pa
Debt 5 years later $ 405,000
Money held in redraw/offset $ 140,000
New property value $ 630,000
New property loan $ 516,000 purchase plus costs
Total security value $ 1,161,672
Total loans $ 921,000 LVR 79.28% (plus LMI)
In 15 years’ time (current security values)
Owner-occupied value $ 981,519 based on 3% growth average pa
Debt $ 381,937
Investment value $ 812,747
Debt $ 405,000
Total value of properties $ 1,794,266
Total debt $ 786,937
SCENARIO 2: Interest only vs principal and interest
Many buyers of investment properties take out interest-only loans to reduce costs. But should they? Investors may be able to claim deductions on interest and maintenance costs, which is good. But “there does come a time when an investment property held over a long period would become positively geared,” Kim says, at which point the rent would exceed the interest charges and the tax deduction would no longer be such a benefit. It will depend on individual circumstances, and so requires professional advice.
Investment property $ 500,000
Interest-only loan $ 500,000 over 30 years @ 7% pa
Principal & Interest loan $ 500,000 over 30 years @ 7% pa
Increase in value $ 1,213,631 over 30 years @ 3% pa
Sell property after 30 years
Cash from sale on IO $ 713,631
Total interest paid $ 1,050,000
Cash from sale P&I $ 1,213,631
Total interest paid $ 697,544
Total savings in interest with P&I loan $ 352,456
As Kim says, professional tax advice is vital in assessing this scenario possibly – so we got some. Peter Bembrick, tax partner at HLB Mann Judd Sydney, crunched those numbers for individuals on the 46.5% and 31.5% rate, for companies, and for super funds. The results can be seen in the attached table. The conclusion: P&U results in a better nominal return regardless of the marginal tax rate, but the degree to which this is true depends on your tax band – and the investment has to be balanced with what else is in your portfolio.
“Tax deductions and marginal tax rates are relevant, as the tax deductibility of interest reduces the differential between interest-only and P&I loans,” he says. But “all other things being equal, an interest-only loan will cost more than a P&U loan due to the higher interest paid, even after tax and regardless of the marginal tax rate.”
Peter has some important suggestions. Always pay off non-income producing loans, such as the home mortgage, before investment loans. “If there are any non-income producing loans owing then we would always recommend making extra principal repayments on those loans, and keeping investment loans interest only,” he says. “Therefore P&I only makes sense for investment loans once all private debt has first been repaid.”
He also counsels against seeing the P&I/I only decision on an investment property in isolation. “Investors need to consider the opportunity cost of funds that would be used to pay down investment loans, and whether they could be better invested elsewhere.” That should be part of a broader wealth management strategy with financial advice. “If the alternative investment options are more attractive it may still be preferable to keep investment loans interest-only, especially once the tax deductibility is factored in.”
SCENARIO 3: Property for retirement
In this area, Kim costed three common scenarios.
Marriage breakdown is regrettably frequent. As the former partners reach retirement, they may have to remortgage the property with one partner having to buy the home and pay a cash settlement to the other.
“I recently worked with a client who, at the age of 62, found herself in this situation,” says Kim. The property was worth $650,000 and she needed to refinance the existing mortgage, pay her ex-partner cash, and have access to more cash for minor home improvements.
She took an interest-only new loan for $363,000. “Her plan to retire the debt involved continuing in full-time work to the age of 68, longer if her health permitted, but then change to part-time work, which is an option in her profession.” Her daughter moved back home to live with her, assisting with loan repayments, and they agreed that after the repairs were done they would pay as much as possible each month to reduce the debt. At retirement, the superannuation money can be used to pay the debt down further, thus increasing equity in the property; at that point, it would probably make sense to sell and downsize to a small property.
Current property value $ 650,000
Current debt $ 363,000
Property value after 8 years $ 823,397 based on 3% average growth pa
Reduced debt $ 325,000
Clear funds from sale of property $ 498,397
A happier scenario involves borrowers looking to build wealth with investment property in order to create a reliable income stream in retirement. People do, after all, like the visible, touchable nature of bricks and mortar.
For this strategy to work, the property has to become self-funding, and the loan amounts must reduce in order to provide income later. Kim says clients often buy a mixture of properties in regional and capital cities: capitals give the best capital growth and rents but require high investment; regional centres are cheaper and become self-funding more quickly.
In the scenario in the box below, the investor plans to downsize to a smaller property worth $750,000, pay off all debt, and use the rent as their income in retirement.
Owner-occupier home (no debt) $ 1,300,000
Regional property (no debt) $ 250,000
Rent return (per week) $ 250
Regional property $ 300,000
Debt $ 120,000
Rent return (per week) $ 270
Capital city property $ 550,000
Debt $ 300,000
Rent return (per week) $ 530
Total property value $ 2,400,000
Total debt $ 420,000
Total rent return (per week) $ 1,050
Another common approach is to hold investment property until retirement, with a view to selling then to pay off debts. Once that’s done, the remaining proceeds from the sale can go into super, or another investment strategy.
Here’s an example:
Owner-occupier home (no debt) $ 1,300,000
Regional property (no debt) $ 250,000
Rent return (per week) $ 250
Regional property $ 300,000
Debt $ 120,000
Rent return (per week) $ 270
Capital city property $ 550,000
Debt $ 300,000
Rent return (per week) $ 530
Total property value $ 2,400,000
Total debt $ 420,000
Total rent return (per week) $ 1,050
“In this scenario, the borrower can sell either their city property or both regional properties to clear debts, and have funds to invest while still receiving rental income on the remaining properties,” Kim says.
CASE STUDY
Kevin Lee knows what it means to rebuild. In 1991, then a retail executive, he bought a business without checking it out properly; too late, he discovered it had been sold based on fraudulent numbers. Getting out of the situation and paying off the loan he had taken to buy the business forced him to sell his house. “I walked away with 40 grand, a second hand car and some furniture,” he says of his settlement in early 1995. “I had to start again at the age of 41.”
He did more than start again. Today he’s 58 and owns a property portfolio worth $5.5 million, just over half of it his equity; it brings in a total annual rent of $161,200. And getting from that miserable mid-life restart to here has not involved a windfall or an amazing job, but careful and prudent assembly of an investment property portfolio over time.
After getting out of his disastrous business, Kevin joined ANZ and became a manager for a small business unit tasked with finding new business for the bank. Doing so taught him a lot about what made clients successful, and many of them had investment properties. “I thought I would try to go down that path, but when I tried to get a staff loan the manager looked at me as if I had two heads and said I didn’t earn enough,” he says. “I couldn’t buy negatively geared properties because I didn’t earn enough to negatively gear it.” This would eventually prove something of a blessing in disguise, as it forced him to look at property investment from the perspective of cashflow rather than tax.
By 1996 he was able to buy a house in West Pennant Hills, Sydney. “It was the worst house in the entire district,” he says. “It was all I could afford.” But it was a start and was on a huge block of land. He and his family “lived in it, gutted it, renovated it from top to bottom. It was a tragic house. If I showed you a photo you’d laugh.”
In improving it, he was able to use it as collateral to buy an investment property, and he started out with two small studio units in Newfarm, Brisbane. Galvanised, on the plane back home he saw an ad for a house in Caboolture for $40,000, and bought it sight unseen over the phone. He made these apparently rash decisions for the quite pragmatic reason of income: the house in Caboolture was rented for $120 a week, yielding a 15% return, while the studios were yielding close to 10%. “They were cashflow positive from day one,” he says. “I used my calculator and my brain. I put my heart under the pillow so there was no emotion involved. That’s one thing I’ve learned.” He subsequently sold Caboolture but the two studios have never been empty and, having cost $153,000 between them in 1997, would probably fetch close to $600,000 now.
Other investments followed. He bought a townhouse in Kedran, another Brisbane suburb, in 1999, and by now was finally able to put down a deposit. He got a subdivision approval on the house in West Pennant Hills (which he moved out of in 2001, renting it out instead) and moved to a much bigger place in the same suburb. He bought two small two-bedroom units in Redhill, also in Brisbane, in 2002, then bought two properties in a single complex in Fortitude Valley, Brisbane, off the plan. The off-the-plan purchases, he says, “were more speculative, knowing full well that the income from them would rise quite rapidly. My knowledge of finance had grown: I’d been doing it for seven years by that stage.” (He sold one of them in 2008 as the financial crisis kicked in in order to pay down other loans.) He bought land in Airlie Beach – as yet undeveloped – and in Dalby, inland from Toowoomba, again as a more speculative play based on the expected growth of a coal seam gas field nearby. Along the way he sold out of the big house in West Pennant Hills after his daughter moved out, and downsized to a smaller place with his wife in Sydney’s Castle Hill. And on top of all that, through his super fund he owns a 5% share in nine other blocks of land in Airlie Beach, and a stake in his company offices (it’s perhaps not surprising that along the way he left ANZ and began property advisory).
How has all this happened? “I’m not the most special person,” he says. “But in 1995 I was looking down the barrel. 41 years of age, saying: what did I do wrong? What do I do now? But I live by the fact that you learn from your mistakes and you can certainly change your future. Head down, backside up.”
There have been a few principles along the way, among them not chasing negative gearing. “During the GFC people who were negatively geared and suffering through higher interest rates had one alternative: get rid at any price,” he says. “I didn’t have to.” Another is to leave the management of the properties to professionals; for example, his units in Newfarm and Redhill are managed by a group named Rental Express. And a third is not to overdo it on the gearing. Today his gearing is 49% – $2.7 million on that $5.5 million portfolio. His range of properties has helped whenever times have got precarious, as when mortgage rates hit 9%; then, the places giving a 14 or 15% yield covered the ones that were only getting 6 or 7%. “There were no rules in place except that the properties I bought had to be self-funding,” he says.
So what’s the exit strategy? Now 58, he expects to work for between two and five more years. At some stage he will sell the vacant block of land in West Pennant Hills – the one that came from the subdivision approval – and the block in Airlie Beach to pay down the debt, and if necessary his own business too, which might then clear debts completely. “That would leave us about $140,000 income to live off for the rest of our lives and an unencumbered portfolio,” he says. “Better than super.”
It’s quite a turnaround, and it puts him in a position to give some salient advice. “Get rid of your ego. Greed and ego made me go down the path I did in the first place and lose it all. Use common sense, a calculator and your brain.”
BOX: A planner says…
We asked financial Planner Paul Moran for his thoughts on investment property strategies. One thing he stresses is that tax liability is incurred based on the contract of sale date, not the settlement date, and capital gains are the profit made between the taxable cost price and the taxable sale price after allowing for investment expenses. Provided assets are held for at least one year, only half of the gain is assessed.
This is a key point. “Whatever strategy is applied, actually settling on the sale far enough before the end of the financial year allows you the greatest opportunity to manage the gain to your advantage,” he says.
Strategies might include:
- Selling in a lower tax environment, such as the first full financial year post-retirement;
- Making personal tax deductible superannuation contributions where possible in the same year that you sell (talk to a tax advisor first);
- Selling half the property to a partner, if you own it as an individual. “This produces only half the capital gain in a single financial year, and may have the effect of allowing you to divide the gain in to more than one financial year.”
- “On the other hand, buying with a partner allows you to divide the capital gain in half and can reduce tax by keeping the gain in lower tax brackets.”
- Studying depreciation. “Many people don’t understand that depreciating assets increases the capital gain over the longer term by effectively reducing the cost paid for the investment.”
- Owning property (and shares, for that matter) in a low tax environment such as superannuation. Capital gains on assets held for a year in a super fund are set at a flat 10%. “Deferring the sale until you are retired and have converted your super into a pension can mean no capital gains tax at all.”
