Negative gearing: investors wake to potential problems

An ALP plan to cut negative gearing prompts questions as polls predict a tight election.

For investors, Tuesday’s federal budget would normally dominate debate around future financial plans. But the decision by the ALP to make huge changes to negative gearing and the very real possibility emerging in polls that Labor could win the election makes real estate investment outlook a crucial issue.

The debate around negative gearing will easily outstrip items such as super contributions or bracket creep because house ­prices affect everyone. But let’s just look at negative gearing strictly from an investment perspective.

Negative gearing — the ability to claim the amount of costs above income on an investment against tax — works best when those interest rates are high.

In recent years the costs — ironically — have plunged as interest rates have fallen to record low levels.

In other words, negative gearing has not been very effective of late … but the gradual increase in standard variable rates, which have been pushed through by the banks in recent months means that this wealth management tool is getting more attractive.

Yet even with this weakened investment scenario, negative gearing is hugely popular — there is at minimum 1.2 million Australians actively engaged in this investment approach.

What those investors want to know is what will happen if Bill Shorten and the ALP get their way?

To be precise, Labor plans to scrap negative gearing only on existing housing stock — investors would be able to continue to negatively gear new houses.

The first set of numbers — though hardly the last — we have been shown on the move is from the Grattan Institute, which suggests that house prices would only fall by 2 per cent if the changes planned (coupled with a capital gains discount windback) go through.

For property investors, assuming this is a reliable forecast, a string of negative factors that are emerging around real estate ­prices just now would also have to be added:

• Foreign buyers, a key stimulant in local apartment prices, are suddenly facing a credit strike from the major banks — just this week Westpac added its weight to CBA and ANZ in saying it is not lending to foreign investors on local real estate any longer.

• Official rate changes by the RBA are less and less effective in the property market as banks autonomously keep their own rate schedules.

• Oversupply, especially in Melbourne and Brisbane, is becoming a reality.

• Australian investors are increasingly being kept out of the market as the banks seek to satisfy a regulatory requirement that investment books don’t grow faster than 10 per cent a year.

So at the very least the removal of negative gearing will become another factor pushing house prices down.

In parallel with this downward pressure on house prices, the next key factor from an investor perspective is the outlook for rents — or what’s called rental yields, the income a property can produce expressed as a percentage of the value of the property.

Rental yields have been steady for many years — there has been some compression in the inner suburbs where prices have been exceptionally strong but they have remained in a broad band between 3 per cent and 5 per cent gross. After expenses these figures fall to about 2-4 per cent net. In other words, rents as an investment return have been poor and often deteriorating.

Economist David Bassanese of Betashares makes the point that the presence of negative gearing has brought more than a million landlords into the market and in so doing it has created an artificial subsidy to what rents would be if that landlord sector did not exist.

He points out that while prices have moved higher on every measure, rentals have not. Putting these factor together, it is surely safe to assume that rents for existing residential properties will rise if negative gearing is removed.

Though property is always host to a range of local factors there are some universal realities: For example, the majority of new housing stock is at the outer ring of the major cities. Similarly, the vast majority of private investors do not invest in new houses — they invest in existing stock found in the centre and middle-ring suburbs. Where there is new property bought by private investors it tends to be in city centre apartments.

Logically, if you can negatively gear only new properties then that should be the sector that investors move towards. However, tax changes alone are highly unlikely to entice private investors to housing estates at the edge of the city. Rather, a likely outcome is that inner-city vacant blocks will immediately be enhanced in value — new houses built close to the city surrounded by existing stock that can’t be negatively geared will surely become highly attractive.

On the other hand, existing stock — which dominates middle-ring suburbs will become much less attractive for the simple reason the market will revert entirely to homeowners.

Everyone with an agenda can model the points made above to suit their aspirations — real estate advocate the REIQ said yesterday 79 per cent of property investors would “get out of property” if the ALP change became reality.

Away from the politics, and strictly from an investment perspective it would be practical to assume the arrival of the ALP in power would play a key part in making house prices fall and rental yields lift. Negative gearing would move from the mainstream to a niche wealth management activity pursued by a much smaller number of investors than the 1.2 million engaged in it today.