Three months ago everyone was talking about negative gearing and why it needs to go.
Fear drove across all current and future property investors. Optimism filled the air for the young and those that wanted to invest that prices could fall. I penned an article analysing why the government loves high property prices and basically stated why I believed negative gearing was going nowhere.
Since then, I have had many discussions about whether we should keep negative gearing or not – my view has not changed. No one can afford to let it go – the government, the banks and all Australians.
As a Gen Y who wants to buy a home in the near future for my family – my personal interests are aligned with lower property prices for homes in Sydney or Melbourne. It's important however to remember that my personal interests or yours however have nothing to do with that of Australia and it’s in Australia's best interest to keep negative gearing. Sadly, it really is our only option.
To put it simply, negative gearing makes investment in property profitable – without it, it does not stack up.
In February, I role-played out a full analysis of investing in property for 20 years comparing to paying off your home loan. This is usually the choice most people are making and 20 years is a long time. It's more favourable the longer you invest as well.
Now because negative gearing exists you need around a 5% annual capital growth for it to work out worthwhile – if you get a better return than 5% you are winning and obviously the higher the better.
Over the past 20 years, “some" investors have been rewarded because the growth in property prices have exceeded this and in some cases people have got this return many times over. This is an interesting way of looking at things because you are looking at the opportunity cost of not investing and secondly, the risk involved. Please be clear this has not been the case for all investors, many have lost money and do not like to and do not talk about. Many have underperformed 5% considerably and are still holding on for growth to come along.
But what if you get under 4% capital growth, you would have most likely been better off to save the money against your mortgage as the benefit is not that worth the risk involved. So in truth, be very careful that your property goes up every year by at least 4% capital growth.
But if negative gearing goes, your risk goes up considerably.
You will now need around 5% annual capital growth to break even and you will not make significant returns until you get around 6% capital growth. This does not sound like a lot but it’s a big difference.
So fundamentally, you would need to get an even better return than currently for it to be worthwhile. But what has happened to the market?
Now it is much more unaffordable to invest in property because you cannot claim your loss on the property each year.
The demand for investing in to property would be shot twice. One it's not as enticing and secondly it's much harder to afford. Investing in property will not make sense because the risk and return would not be worth it on the new backdrop of no negative gearing and predicted much lower growth.
If it does not make sense, investors will not invest. If investors do not invest, you lose around 30-50% of the current buyers out there overall. Some properties currently sell around 60-90% of all property to investors - such as new apartments.
If investors left, it will send a tsunami across our property prices, especially in the unit and apartment space. It will then spread in to townhouses and potentially after in to houses.
I look at this as a bit of a doomsday scenario where construction and banking sectors will be severely tested with significant losses – two of our most profitable, largest and currently strongest sectors in our market.
There have been reports that removing negative gearing would lead to a 2% drop in prices but that is nothing but nonsense. If you could lose anywhere from 30-80% of your buyers because they do not see value in investing, there will undoubtably be much bigger falls than 2%. We have huge recent price rises of at least 60-80% in Melbourne and Sydney based on investors pushing prices up.
One of the biggest reasons, why it cannot leave is the impact on our residential construction industry. It is built on the back of cashed up developers turning land in to apartments. Usually, the developer owns (or buys) the land then after a tender of a number of construction companies it engages one to build the development for fixed price. They then go out to property investors and try to sell the mainly apartments to investors who speculate on them with the view of making money.
If they sell them all, they make a tidy profit along the way and add 100, 200 or 1,000 new apartments add to our property supply. This is good for everyone as it means that there are more places to live and less pressure on the existing home supply.
In a country that has a growing population, we need developers to make this happen unless we want to be paying ridiculous rents forever in the future.
But if the investors are no longer buying, the developer will no longer be able to sell and if they cannot sell, they will not build.
This is a double blow - it does not increase our housing supply and it takes the majority of the current work from our construction industry.
The other reason is the banking sector that makes money mostly through lending money. Each year mortgage owners are paying down their debt and therefore the bank is making less money from their existing customers each year.
To make more money they are forced to lend more money. The biggest sector they lend to residential property investors and home owners. Banks need Australians to want to borrow to make more money to satisfy their shareholders. If Australians are no longer wanting to buy, they are no longer borrowing. This will put a huge holt to the future profitability of our banks and baring in mind we have some of the most profitable banks in the world, this will not do well for our economy.
Secondly, depending on how the situation plays out any fall in property prices affects two people – the investor first, then the bank. The investor is the one to lose firstly as you would expect as the bank never wants to lose. A 20% fall in prices, would make their $500,000 apartment be worth $400,000. Most likely the debt on that property could be $400,000. A 20% fall and the investor loses all their money and maybe more.
If there is a bigger fall however i.e. A 30-40% fall it gets very messy. Please bare in mind that we are talking from todays prices which have risen this amount in just the left few years. This type of fall and the banks will start losing serious money. That $500,000 place is now worth $300,000 and the borrower owes $400,000. You can see why this is not good for anyone and would be catastrophic to Australians far and wide.
As expected in election year, both parties are coming up with wonderful ideas to win votes. The Liberals have come out since to state that negative gearing is staying. If Labor win, apparently they will make it only available to new property – a disastrous idea if I may say so now.
At first glance it may sound great to be pushing new construction but it makes investing in new property extremely risky for investors. It will firstly inflate prices (so the developer makes more money) on already highly inflated prices - some people call those bubbles. Secondly, existing stock would become cheaper and make people question if they should buy new or old regardless of negative gearing.
Once they buy new however, you will have no market to sell to because once the new property is lived in it is now existing stock and no longer has the buyers you had when it was new – so you pay over the odds to buy it and when you try to sell it no one wants it. That’s what you call a catastrophic loss - the initial goal to increase construction is now the biggest risk in town.
So in summary, while I do not agree with how the world is today for young Australians (and older ones who are renting but want to buy) who are trying their best to get a happy roof over their head of their family, it sadly is the case that the government has no choice but to keep it as it is.
It would be ripping the carpet out on property values and our economy
They may decide in time to limit the benefits of negative gearing to an amount per year – maybe a $20,000 loss per year but doing this retrospectively and even going forward will be a huge challenge.
We do need to take action to help young Australians get a family home. It really is very tough and for most it has become unaffordable in our capital cities. What we do however needs to be thought through and while negative gearing sounds like it would work - if it is taken away the fall out would be scary for all.