I expect many participants in the property industry will spend the coming months devising ways to navigate the negative gearing and CGT changes, to maintain investor interest.
As a business that is completely independent, with no vested interest in any asset class, including property, I wanted to examine some of these potential strategies.
Remember: property is not the only game in town
I want to be clear about the purpose of this blog. It’s not to invent a new justification for borrowing to invest in residential property.
At ProSolution, we are asset class agnostic. We have no bias toward property, shares, or anything else. The fundamentals and what’s appropriate for the client decide the asset class, not what we know best or where our experience sits – we have equal knowledge and experience across both major asset classes.
Not every business operates this way. Some are property only. With the negative gearing and CGT changes now law, social media and the internet will likely be full of new strategies claiming to get around them. To a man with a hammer, everything looks like a nail.
This blog is our independent analysis of the potential strategies I expect to see promoted over the coming months.
As a recap, in earlier blogs we calculated the after-tax internal rate of return on borrowing to invest in established property. Under the new negative gearing quarantining and CGT rules, that return falls from around 11% to 8.4% per annum.
Lever 1: chase a higher rental yield
When negative gearing is quarantined, there’s no annual tax benefit, so the cost of holding a property is much higher. Say it costs $25,000 a year pre-tax to hold a property. For an investor on the highest marginal tax rate, negative gearing brings that down to about $13,000. Quarantine the deduction and it costs an extra $12,000 a year to hold the same asset, with no extra return to show for it.
One way to offset this cash flow drag is to target a property with a higher rental yield. To match the after-tax internal rate of return available before the changes, I estimate gross rental yield needs to be almost 5.5% of the property’s purchase price.
There are two ways to target a higher yield.
- Location. Higher yielding locations tend to be outlying or regional areas with limited rental supply. The trade-off is these areas typically deliver less capital growth, so what you gain on yield you lose on growth, and the internal rate of return doesn’t improve much. If you find a property yielding 5% gross, you would still circa 6% p.a. in compounding capital growth to get to an 11% p.a. after-tax internal rate of return. That requires the property to deliver above 11% p.a. In total return (income + growth), which is unlikely for a property in an inferior location.
- Size or finish. The other lever is increasing accommodation, through extra bedrooms or a granny flat, or improving the finish.
Investors can often create additional value by purchasing an asset they can improve over time, thereby strengthening both its value and income profile. This is typically a prudent strategy. However, they should never compromise on location, because location remains the most important driver of long-term capital growth.
What could happen over the coming months
In the current market, an investor could purchase an investment-grade two-bedroom apartment or villa unit in Melbourne for approximately $900,000 and rent it for around $750 per week. That equates to a starting gross rental yield of approximately 4.3%.
Melbourne property prices have been falling again this year, while rents are likely to continue rising. If these trends continue, the starting gross rental yields available to new investors could become materially more attractive.
Based on my modelling, a starting gross rental yield of approximately 5.3% to 5.4% may generate enough additional rental income to compensate investors for the inability to claim negative gearing deductions in the year they are incurred and the higher effective rate of capital gains tax.
The emphasis must be on the starting gross rental yield. This is the yield an investor locks in when they purchase the property, and it establishes the foundation for their future cash flow.
By contrast, a property’s theoretical yield can change post-acquisition because either the market value of the property changes or the dollar value of the rent changes. While this is a useful performance metric, any changes in theoretical yield driven by movements in market value are inconsequential to the investor’s cash flow. Only changes in rental income affect the investor’s actual cash flow.
For example, a gross rental yield of approximately 5.3% to 5.4% could be achieved if:
- the property’s value falls from $900,000 to approximately $850,000 and the rent rises from $750 to $850 per week; or
- the property’s value falls to approximately $800,000 and the rent rises to $800 per week.
If investment-grade two-bedroom apartments or villa units become available at these price and rental levels, established property may once again become attractive from an after-tax internal rate of return perspective (relative to what was achievable before the tax change).
Conclusion: gross rental yields on investment-grade property are not yet attractive enough to offset the tax changes. Investors should not compromise on property quality simply to achieve a higher yield. However, if prices fall and rents continue to rise, some investment-grade established property may become attractive again.
Lever 2: gear less and aim for neutral
Without negative gearing, there’s no tax incentive to borrow aggressively to invest in established property. So, some investors might think the solution is to gear lower and aim for neutral gearing, where the property breaks even for tax purposes. Is that a way around the tax changes?
I modelled an $850,000 property funded 100% by debt, with the investor aggressively repaying principal to reach neutral gearing within 10 years. To get there, the investor needs to repay around $43,000 of loan principal each year, reducing the loan balance to around $415,000 by year 10. In year 11, rental income is projected to exceed costs and interest by $1,000, and the investor starts using the carried forward quarantined rental losses.
However, funding both the pre-tax rental losses and the loan repayments over those 10 years requires a lot of extra cash, and the after-tax internal rate of return suffers. I estimate it at 7.3%, well below what’s needed.
This points to something important. Borrowing to invest in established property worked as a strategy for two reasons. First, the only cash contribution required was funding the after-tax holding costs. Second, the tax deduction cut those holding costs substantially. Remove the second reason and the strategy no longer works. Putting more of your own capital in only drags the internal rate of return down further, even if it means utilising the carried forward losses sooner.
Conclusion: reducing gearing, whether at purchase or over time, doesn’t lift the internal rate of return – in fact, it does the reverse.
Lever 3: use a company to preserve negative gearing
Last year I wrote about using a company to invest in property to reduce CGT.
The same structure could, in theory, be used to get around the negative gearing quarantining too.
A company issues you a million shares at $1 each. You borrow the money to buy those shares. The company takes your million dollars and uses it to buy an investment property.
The company then owns the property directly – no loan. It collects the rent and claims the normal property deductions (council rates, property management, and so on) at the company level. Whatever profit is left after those deductions, the company pays out to you as a dividend.
On your side, you are not borrowing to buy a rental property. You are borrowing to buy shares. Therefore, the interest on your loan is a deduction against share investment, not against rental income.
We think this is risky and likely falls foul of the anti-avoidance provisions. Part IVA of the Tax Act applies where a taxpayer enters into an arrangement (scheme) for the dominant purpose of obtaining a tax benefit. To avoid Part IVA, an investor needs a genuine commercial reason for structuring the acquisition this way, other than the tax outcome. We can’t think of one.
There’s also a practical funding problem. The property sits in the company’s name, but the loan needs to sit in the individual’s name, the loan needs a security guarantor. Using the property itself as security would only weaken the Part IVA argument further too.
Conclusion: the tax compliance risk here is too high.
Lever 4: buy a new dwelling to keep negative gearing
Buying a newly constructed property lets investors avoid the negative gearing quarantine after 1 July 2027 and keep the old 50% CGT discount. But as I have written before, new build property tends to be in locations where land supply is abundant, not scarce, which retards future capital growth. Plus, more than 50% of the purchase price tends to be in the improvement, not the land. Therefore, less than half your money is in land, and that land is often in an inferior location. We therefore need to assume a lower capital growth rate over the long run, and the after-tax internal rate of return suffers accordingly.
There’s a second problem. Demand from uneducated investors for new builds will probably rise, but developers will not be able to lift supply fast enough. Therefore, prices are likely to climb in the short term, and there’s a real risk that investors overpay due to FOMO, especially once the tax benefits get capitalised into the price. Since those tax benefits are unique to the purchaser and don’t transfer to the next owner, investors need to be careful they are not prepaying for something that disappears at resale.
An alternative to a house and land package in a new estate is a newly built townhouse in an established suburb, hoping for better capital growth. But these small-scale developments are typically only viable where land is cheap, and land is cheap for a reason: an inferior location, or an inferior position within a good suburb, like a busy main road. And be wary of using the last 5 years’ growth in these properties as a guide to the future. Much of that growth has come from rising construction costs, not the underlying land.
It’s also worth noting the Treasurer hasn’t yet defined what qualifies as a “new residential dwelling.”
Conclusion: investing in newly built property carries higher risk and is unlikely to deliver an adequate long-term internal rate of return.
Lever 5: small-scale property development
Another option is a small-scale property development: buying an old house on a large parcel of land, demolishing it, and building several dwellings, be it apartments or townhouses.
The attraction of investing in established property has historically been the compounding capital growth that occurs over many decades. That is what made the strategy worthwhile. A property growing at 7.2% p.a. doubles in value roughly every decade, meaning after 30 years it is worth 8 times the purchase price. The distribution of that growth matters. In the first decade, an investor receives only 14% of the total return, versus 57% in the final decade.
A small-scale development is a fundamentally different proposition to a long-term passive investment strategy. It is closer to running a business, with business-style risks: cost overruns, an inability to maximise value due to planning restrictions, shifts in markets and interest rates, and whether the completed product sells for what was expected. Therefore, this strategy requires the experience, temperament, time, and asset backing to execute it successfully – just like running a business does.
The other significant risk is buyer’s agents who promote their ability to source a development site. Any feasibility study needs to be completed by a genuinely independent and experienced party, one with no vested interest in whether the purchase proceeds. We have done this at ProSolution and have seen too many buyer’s agents convince investors a development stacks up economically when it clearly does not. This reminds me of a saying: never take advice from someone who does not have to live with the consequences.
Conclusion: we think small-scale property development only suits a very small cohort of investors.
Lever 6: high-yield specialised property
The final category of high-yield opportunity is specialised residential property: NDIS housing, co-living, boarding houses, student accommodation, and short-stay properties.
Many investors are drawn to the gross yield on these properties, but net yield matters more. A property that looks like it produces strong cash flow does not always do so once expenses are accounted for.
The other risk is the extent to which that high yield, tied to the property’s unique use, is already priced into the purchase price. And what certainty is there that the property can continue to be used for that purpose? For instance, many NDIS properties are purpose-built at significant cost, but what happens if government policy changes how these properties are used or funded? Similarly, if tenancy regulations change, co-living and boarding house properties may no longer be usable for that purpose.
Finally, there is the question of what capital growth these assets can deliver over the long run.
Conclusion: specialised residential property carries higher risk and therefore does not suit a lot of investors.
Commercial property
Back in June I wrote about commercial property values and concluded they are significantly elevated relative to long-term historic measures. Using the recent tax changes as the hook, commercial property buyer’s agents will likely promote this asset class heavily in the coming months, which will attract more investors and push prices higher still.
In that blog I examined what could happen to an investor’s return if/when the valuations revert to the mean, and anyone considering commercial property should read it before committing capital.
My view is blunt: commercial property values are too high at present, and the most probable outcome for an investor buying now is a loss, not a gain.
Our verdict
We have thought carefully about whether any structures or strategies exist that help navigate the negative gearing and CGT changes. At this stage, none of the opportunities including those discussed above appear attractive to us.
Therefore, if you come across a person or business promoting an alternative residential property investing strategy, the first thing to check is whether they have a vested interest. The second is to scrutinise the evidence cited, the financial analysis completed, and the assumptions underlying it.
We hope this blog serves as a useful resource in navigating the noise we expect will surround these significant taxation changes. And it is worth remembering that property is not the only game in town.
