Rent - Don't buy

[Dimebag]

PS

I think this analysis also demonstrates how inequitable the current tax system in NZ is. Property investors can be pocketing millions of dollars in tax-free capital gains, whilst claiming tax losses from operating outgoings.

Yet employees working hard to earn their money through productive activities are taxed extensively.

I'm actually doing my honours dissertation over the summer on whether NZ ought to introduce a revolutionary flat-tax system, as propounded by Hall-Rabushka (see "The Flat Tax" - available from Amazon.com). One of HR's key claims is that current systems of tax are highly inequitable, and that a much fairer and more efficient system can be achieved by casting a much wider and more equitable net at a lower flat rate of tax, rather than the current system which favours particular forms of income over others, and results, in particular, in excessive taxation on employment income.

As the above analysis shows, this reasoning may be particularly strong in NZ.

Cheers,
Dimebag

[Halebop]

It all comes down to assumptions. I'm certainly not a strong property bull but even I'd suggest property has over the last couple of decades done better than 5%. Certainly not 10% but perhaps 7% (In the last 20 years inflation has run at 3.7% per annum). But those headline numbers are irrelevant, as even Property Bulls would agree. Borrow 80% of the purchase price and even 5% capital growth becomes 25% ROE on a cash flow neutral property. But it is here that lies the crux of argument too...

Assuming 5% growth, on average, in order to maintain 25% capital growth, I need to on average maintain 80% leverage too. Fundamentally though, we have seen that rents have not kept pace with capital values, squeezing cash flows and increasing risk to investors blinded by spiralling capital values. When cash flows don't keep pace with capital values, we typically have a bubble situation. Either the cash has to play catch up or capital expectations have to correct downwards.

On top of this, in order to maintain my returns I have to keep borrowing 80%. So cash flow gets progressively worse under current market conditions while my risk for performing exactly the same historical function rises as yields fall. It has the hallmarks of a Pyramid Scheme. The growth orientated property investor must risk ever greater amounts of capital, supporting ever greater amounts of debt, funded by a proportionately shrinking cash pool. I suspect it is largely unrecognised that this is all propped up by the taxation system.

A perennial investment maxim is to never invest on the basis of tax. Governments can be capricious, covetous and sometimes just stupid. If tax is a key pillar holding aloft the mathematics of the transaction then you will one day be disappointed by the outcome. Reduced tax incentives, falling cash yields and 80% leverage make for a somewhat combustible mix.

Lastly, don't ignore productivity growth, demographics and population growth on the property equation. Oxymoronically wage growth and employment demands coupled with New Zealand's low investment in capital equipment will start to pressure productivity growth. The property slowdown in '97 was augered by a steep drop in productivity.

[Mick Jagger]

just being a bit *****now, but also the $40,000 deposit or whatever amount it is can get 8% for no risk at all in the bank so we should net the value of that off the annual end profit as well, right?

[wns]

Thanks for your thoughts Dimebag and Halebop.

I definitely wouldn't be buying property where you are relying on tax breaks and appreciation to get a positive return. For me it has to stack up from the cash flow point of view. At the moment that eliminates most properties. In fact I haven't bought real estate for about two years now which is why I started investing in shares again. Happy to hold real estate though.

Dimebag, when you are negative geared like the example you gave ($400k place renting for $400pw), it starts to severely limit your borrowing capacity. The bank / finance provider will look at your debt servicing ratio, which is a comparison of your interest repayments compared to income you earn / receive. Normally they allow up to about 25-35%, something like that. Normally 75-80% of rent is included on the income side. With negative geared places there's only so many properties you can purchase because each additional negative geared property impacts further on the DSR. Looking at it another way, how many lots of $10-16k can people afford to go backwards by per year?

quote:Originally posted by Mick Jagger

just being a bit *****now, but also the $40,000 deposit or whatever amount it is can get 8% for no risk at all in the bank so we should net the value of that off the annual end profit as well, right?

How can you earn 8% on your money 'in the bank' at the moment? I'm not aware of any banks offering anywhere near 8% - not in Australia anyway. I suspect NZ would be the same. (?)

Owning shares in some of the listed banks would earn you a gross dividend yield of approx 8% but that isn't risk free.

[wns]

quote:Originally posted by Dimebag

PS

I think this analysis also demonstrates how inequitable the current tax system in NZ is. Property investors can be pocketing millions of dollars in tax-free capital gains, whilst claiming tax losses from operating outgoings.

Are capital gains tax free on investment properties in NZ? They aren't here in Australia.

[Halebop]

Within certain reasonable limits all capital gains are tax free in New Zealand. (It may be another matter as to if your New Zealand capital gains are tax free in Australia though?). New Zealand's Capital Gain status is not very transparent and pretty much requires the average investor to lie (or lie by omission) on their tax returns.

Gains are not taxable so long as the investment is not a trading activity. The uncertain area comes into defining "trading activity", which is highly subjective and often rorted. Sometimes Property "Investors" find themselves categorised as traders following Inland Revenue audits. I suspect many Sharetrader members would fall into this category with both their property and share interests.

The issue of capital gains in New Zealand is somewhat a political powder keg. Not many politicians have the testicular fortitude of Australia's Hawke/Keating Labour party of the 1980s. The current tax system encourages property investment at the expense of the tax base, savings, current account and more productive asset classes. Logically, the proceeds of a gain from an asset is little different from the proceeds of working for a living. Why should those with capital not pay tax when those who work pay their share? On the other hand, those with capital encourage employment and prosperity (even property investors employ accountants, builders etc while business owners employ staff, contract outsiders and sometimes earn export dollars too). Those with capital already pay income tax on their cash earnings so I could also see the argument for saying capital gains is double dipping.

Having said that, the tax system encourages a logical person to leverage, reducing taxable income by purchasing a low yielding property with a relatively expensive mortgage. They hope to gain on the transaction by swapping the tax loss cash flow for an untaxable capital gain. Leverage in business can increase returns but also increases risk. Research has shown it more typically reduces returns, retarding innovation by impacting cashflows, mindset and flexibility. I see no argument that this would be any different for a small investor with a couple of units or town houses. So via the tax system we are encouraged to exchange low yeilding, low growth rental incomes for high yielding foreign debt obligations, eshewing more dynamic, diverse and profitable forms of saving in the process.

It would be a brave New Zealand politician who rams home a capital gains tax (they are after all, complex and emotive where the owner occupied home is considered). A smart one might start by looking at removing some of the borrow and hope incentives. While still rortable, I would remove all depreciation allowances and only allow deductions for actual maintenance (not to be confused with "enhancements" either). This would hopefully place a clearer focus on cashflow and enable housing investments to be better compared with businesses and shares rather than tax rates.

I also hope the Reserve Bank of New Zealand stays out of fiddling with bank lending practices. Such moves could well backfire or have strongly negative consequences. I do think they could look at forcing Finance Companies to operate more like banks. There are so many sources of finance these days that restricting the interest rate mechanism to bank lending seems too narrow.

[minimoke]

quote:Originally posted by Halebop

Within certain reasonable limits all capital gains are tax free in New Zealand.

I'm not so sure on this. Capital gains on land sales aren't free of tax if the intent at teh time of purchase is to make a profit on the sale.

I think the political tools are already there to assess CGT but IRD for whatever reason is not enforcing them. I can’t help but feel that if we were to examine most rental property transactions in NZ the primary motivator of the owner at the time of purchase is to resell the land and make a capital gain – they should therefore be taxed on the sale of their property but IRD isn’t following through. IRD continues to be misguided when they hear the “intent” of the purchaser was to create an income stream – the numbers simply don’t stack up in most cases to support this view.

If we have a look at Dimebags model there are a couple of problems with it. Firstly his $6,000 annual costs are way short for the true costs. $10,000 - $15,000 on an annual average would probably be closer to the mark. And the banks won’t lend on a two week vacancy rate – they are looking at a 6 week vacancy. This means you have to have more of your own cash to make the loan repayments stack up – which increase your risk exposure in your personal life.

Actually his model is a prime example of the fallacy that the “intent” is for the income. It would be clear to IRD that it makes no sense to have total costs in excess of $36k to make $20k. Realistically there is no way this property is going to get a return. IRD don’t have the balls to follow through and this means that the property rorter is trading at the expense of the average tax payer who has to pay more in tax to supplement the loss of govt revenue.

Perhaps if Cullen wants to get tough on the property market he should be insisting that all rentals that cannot show a positive cash flow and are indeed unlikely to ever recoup their losses and still create a positive flow should pay their capital gains tax. He should also encourage much lower interest rates so that those who genuinely want to get into rental property business can do so and actually make a profit from their risk taking.

[Mick Jagger]

wns - term deposits in New Zealand for a 1 year term are about 7.5% or a little more ... ok i'm rounding it up a little when i say 8%... but rock solid fixed interest securitys from decent NZ corporates are paying yields of 8% easily... so the point i'm making is the same...

[Halebop]

quote:Originally posted by minimoke

I'm not so sure on this. Capital gains on land sales aren't free of tax if the intent at teh time of purchase is to make a profit on the sale.

That would then be a trading activity. It's easier to spot with land sales because typically there is no income.

[wns]

quote:Originally posted by Mick Jagger

wns - term deposits in New Zealand for a 1 year term are about 7.5% or a little more ... ok i'm rounding it up a little when i say 8%... but rock solid fixed interest securitys from decent NZ corporates are paying yields of 8% easily... so the point i'm making is the same...

Mick – I don’t know a lot about banking, but if the bank can afford to pay you 7.5%, what are they doing with your money to make a profit?

They could be lending out your money at a higher rate (eg. 15% for someone’s credit card or 11% to a developer) and make money on the spread. Or they could go out and borrow money themselves against your deposit and lend out your money and the borrowed money to make an even higher profit. Either way, your money earning 7.5% may not be as safe as you really think. Is your 7.5% a risk free return? No. Is it safer than someone’s 10% deposit on real estate? I don’t know enough to answer that but it would depend on a number of factors such as the purchase price, the rental yield (and therefore direction & size of cash flow), the strength of the buyer’s financial position, their capacity to meet their loan repayments, the term they can hold for and the health of the property market.

Last time I looked, in Australia a bank term deposit earns somewhere in the vicinity of 4.5 - 5.5% so that is why 8% surprised me.