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Bring on the death of negative gearing

Bring on the death of negative gearing

Friday 20 May, 2016
Despite the fact that I work in the industry that gains the most from negative gearing, I’d much rather see it gone.
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At the risk of putting myself in an awkward and potentially career ending position, I want to discuss the realities of negative gearing. Why could this land me in hot water? Well, simply, my day job is running a company that is involved in the selling of property, to both investors and owner-occupiers, as well as the leasing and management of investment property. But I feel that sticking my neck out is worth it. Negative gearing has become a serious talking political point. On the Labor side of the fence, Bill Shorten has put forward a policy that would see negative gearing effectively removed on established properties, but protecting those who already own investment properties and have already taken advantage.

On the other side, The Libs have likened the idea of removing negative gearing to that of an economic apocalypse. The real estate industry is launching a serious campaign to dissuade voters from Labor’s position. In many ways, this is to be expected. After all, the biggest beneficiaries of negative gearing are the real estate agents. Negative gearing has contributed to strong growth in the investment side of real estate purchasing, which has in turn increased demand and has drove the price of housing up. It has allowed many agents to sell property quicker as investors make pragmatic and often quick decisions as opposed to the more emotional owner-occupier mindset.

Put simply, it’s helping agents make more money and making their job easier.

With the above in mind, it might surprise you to hear that I’m actually in favour of negative gearing’s abolition.

Many have waxed lyrical over a number of modelling predictions that would see this policy result in a mass exodus from the property market. Those opposed (and pay very close attention to who they are) have suggested that rents will skyrocket and property prices will drop by up to 20 percent overnight. Make no mistake, the potential for these areas to alter exists; however the doomsday predictions for the property market are nothing but fear mongering from the minority that stand to gain the most from maintaining the status quo.

Let’s start with property prices.

The premise of this argument is that investors will immediately dump their investments and flood the market creating an oversupply, which will manifest in reduction in value. Labor’s policy is grandfathered, meaning that it will not affect existing investors. It’s fair to say, then, that investors will be far less likely to sell their existing assets as they will be forgoing their negative gearing benefit.

This theory also suggests that investors only invest in the property market to enjoy a negative gearing benefit, which is absurd. With the volatility of the share market and incredibly low interest rates, property is still the best investment available to most of us. The removal of negative gearing will not make property investment unviable for investors by any stretch of the imagination, and anyone that tells you that it will is straight out lying.

The other big argument is that the removal of negative gearing will send rents skyrocketing. This argument is inherently flawed as it assumes the following:

That A) rents are artificially being held down by investors trying to maximise their negative gearing benefit (as someone that deals with investors every day, I can tell you that I’ve never met one that offers rent reductions to increase their negative gearing benefit!), or that B) investors will abandon the market, and the move will result in a reduction of supply of investment properties which will in turn increase demand and raise prices (as pointed out earlier, investors with existing negative gearing benefits would be crazy to leave the market after its removal)

The determination of rent, for the most part, boils down to what the market is willing to pay (taking into account basic demand and supply forces). For rents to increase, the supply would need to reduce, which won’t happen (while growth may slow, it won’t reduce for the reasons already outlined). If anything, the policy will result in more owner-occupiers being able to enter the market, which will reduce rental demand – and as basic economics tells you, if demand decreases then so do prices, not the other way around.

The Lib’s argument most likely is based on a move in 1985 by the Hawke/Keating government to alter negative gearing legislation, so that investment losses could only be deducted against investment gains – ie: your investment loss could not be claimed to reduce your regular personal tax.

During the brief period before they surrendered to investor pressure, rental rates in Perth and Sydney increased, which those in favor of negative gearing have repeatedly used as evidence. However, the same effects were not felt in other capital cities and the data shows that vacancy rates were incredibly low at the time prior to this change, meaning there was already large demand in place driving rental prices up.

In short, it didn’t happen.

This brings me to another key part of Labor’s policy: new housing. Whilst their policy calls for the removal of negative gearing benefits for existing housing, they will still be available for new builds. This means that investors looking to gain a negative gearing tax deduction can still purchase new properties for the purpose of investment.

The idea is that this will drive demand in the new housing sector (to address the oft referenced housing shortage) which will also give a much needed boost to the construction industry which is good news for the economy at large. If this works as planned, investors can still enjoy negative gearing benefits but owner-occupiers will have less competition from existing investors – and there is absolutely nothing to suggest that this won’t work exactly as planned.

With the myths dispelled, it’s important to look at some of the risks associated with keeping negative gearing, as those fighting against its removal have been strangely silent on them.

If we cut it down to basics, negative gearing encourages higher risk, and, in my view, unhealthy investment. The principal behind negative gearing is to allow investors to claim their tax loss on an investment against their personal tax. There is solid logic behind this, as it encourages investors, whilst offering them a level of protection to minimise loss. The flipside of this is that it encourages investors to make a loss to enjoy the benefit – and this is exactly what happens.

To maximise your negative gearing benefit, you have to ensure that the expenses related to your property are as high as possible (as I said before, investors aren’t usually in favour of reducing the rent which is the alternative strategy). This leads to two synergistic strategies for investors: interest only loans, and high mortgages.

The higher the mortgage, the greater the loss and the greater the tax benefits. Since the idea is to owe as much as possible on the property, it stands to reason that interest only loans are popular with investors, as they don’t end up in a situation where their mortgage reduces.

That’s right, we are talking about a strategy that encourages higher debt. The idea is that the investor will reap the benefits of capital growth when they sell the property down the track – an idea that has proven to be quite fruitful for investors over the past twenty years as we’ve seen house prices rise significantly.

This is where the risk factor comes into play, and it’s the type of risk that could do far more damage than the damage being alleged by the removal of negative gearing. Housing prices in this country are exorbitantly high; we all know this. So what happens if we experience a market crash? Not a market crash brought on by the removal of negative gearing, but a market crash brought on by any one of a variety of very plausible scenarios that may play out in the coming years.

A crash would result in a lot of investors being stuck with high interest-only mortgages on properties that are now potentially worth less than they paid for them. They might have enjoyed their negative gearing, but they’ll never enjoy the capital gains payoff, making the entire process worthless. Not to mention that their ability to continue to service these mortgages might be diminished if the crash was caused by significant interest rate increases. Negative gearing doesn’t taste so sweet when the bank is repossessing the property.

The bottom line is, negative gearing encourages bad investment. Good investment in property is investment that results in you paying down the debt that you incur to make the investment in the first place. That type of investment provides a valuable, unencumbered asset that will help you gain wealth and assist in retirement; the type of investment that helps build a sustainable economy not strangled by personal debt. Australian households are now holding three times as much debt on average than we did 25 years ago, and you don’t need to be an economist to understand that this is not a good thing when it’s combined with our debt to income ratio being the highest in history – and one of the highest in the world.

The Liberal Government has been very keen to remind us that we need to live within our means. Well, the best way to start doing that is to have them stop encouraging an investment strategy that discourages investors from paying down debt.

They’ve also been keen to scare us into thinking that negative gearing is there for the benefit of average income earners who rely on a salary or wage. According to the ABS, the median annual cash earnings for all earners in Australia (full and part time) is $52,052 per annum – that’s your average income earner; those with a total income of $52,000 a year or less represent 59 percent of all taxpayers. Of those, only four percent use negative gearing. More importantly, 42 percent of the negative gearing benefit (in monetary terms) is enjoyed by people with a wage over over $80,000 – even though they only represent 33 percent of people who utilise negative gearing.

Whichever way you spin the numbers, (and trust me, Scott Morrison has been doing a lot of “spinning,”) it’s clear that negative gearing helps the upper end of town far more than the lower end of town.

It’s a counterintuitive way to invest.

The idea of sound investment (for the average investor at least) is to put your money into something that you can afford, will increase in value over time, has a comfortable level of risk associated with it and will deliver a return. If you want to futureproof the economy, and protect those looking to invest in the market, we are far better off having a policy platform that encourages people to pay down debt, not keep it high in order to reduce tax.

The arguments against its removal are flawed, the economic risks associated with maintaining the current approach are real and the alternative being proposed is pragmatic.

Methinks the Libs and the real estate industry doth protest too much.

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