I would like to explore a funding strategy that may help investors prioritise investing in the highest-quality property they can afford while managing the cash flow impact of quarantined negative gearing.
However, before I explain the strategy, I want to make one point very clear: this is not an attempt to justify investing in established residential property. As a firm, we are staunchly asset-class agnostic. We readily acknowledge that, on a like-for-like basis, borrowing to invest in shares is likely to be substantially more effective from a wealth accumulation, tax, and cash flow perspective.
That said, we acknowledge some people have a strong preference for residential property. There may be several reasons for this. They may be uncomfortable with share market volatility, unwilling to borrow as much to invest in shares as they would to invest in property, or they may see property investment as part of a longer-term strategy to help purchase or upgrade their home.
For investors with these preferences, we have considered whether there are alternative funding strategies that could help them manage the impact of the proposed tax changes.
The problem the strategy solves
As you would know by now (I have covered this in past blogs), quarantining negative gearing significantly increases the out-of-pocket cost of investing in established residential property.
Consider a very simple example. A property generates $20,000 of rental income per year after direct expenses, but the interest on the loan is $50,000. That creates a $30,000 annual cash flow shortfall.
Previously, that loss could be offset against other income, such as salary and wages, potentially generating a $12,000 to $14,000 tax benefit (referred to as a negative gearing benefit). This reduced the after-tax holding cost to around $16,000 to $18,000.
However, the loss must now be carried forward and may not be used for another 10 to 20 years, until the property generates taxable income or is sold.
This creates a significant cash flow challenge. For example, an investor may be comfortable allocating up to $18,000 per year towards a property’s holding costs, but not $30,000. In that situation, investing in an established property may not be financially feasible.
A potential financing structure to combat this
One financing structure to make investing in established property more affordable from a cash flow perspective, whilst also improving the after-tax internal rate of return, is to borrow the negative gearing tax benefit you would previously have received.
Using the earlier example, you might contribute $18,000 per year from your own cash flow towards the property’s holding costs, then borrow the remaining $12,000 required to fund the total $30,000 shortfall.
In effect, you are borrowing the tax benefit you no longer receive upfront and repaying that debt when the benefit is eventually realised, either when the property is sold or when the carried-forward losses can be offset against future rental income.
The objective is to align the cash outlay with the timing of the tax deduction, rather than forcing the investor to fund the entire shortfall years before receiving the associated tax benefit.
Another important benefit of this funding structure is that it allows investors to focus on acquiring the highest-quality investment-grade asset their budget permits. Without it, investors may gravitate towards higher-yielding properties to minimise their cash flow contribution. However, this can compromise asset quality because higher-yielding properties are often located in inferior areas with weaker prospects for long-term capital growth. We want investors to focus solely on asset quality when selecting a property and then maximise its rental yield after acquisition, as discussed here.
How to compare the numbers
Before looking at the numbers, it is important to recognise that focusing on the internal rate of return alone can lead to the wrong conclusion.
An internal rate of return measures an investment’s annualised return, considering the amount and timing of your capital contributions and proceeds. It is a useful way to compare different strategies, such as borrowing to invest in property, investing in shares without gearing, or making additional super contributions.
However, dollar-value outcomes matter just as much. Ultimately, the purpose of investing is to accumulate enough wealth to fund a comfortable retirement and achieve your financial and lifestyle goals.
For example, if I could choose only one, I would prefer an investment that delivered an 8% p.a. after-tax internal rate of return and accumulated $3 million of net wealth over one that returned 12% p.a. but accumulated only $1 million.
So, you must consider both (1) internal rate of return and (2) dollar value return.
With that framework in mind, let’s consider how this cash flow strategy affects investment returns.
So, do the numbers stack up?
First, there is no strategy I can identify that will fully replicate the outcomes available before the tax rules changed. These changes clearly reduce the attractiveness of borrowing to invest in established residential property.
Second, on a like-for-like basis, borrowing to invest in established property will be inferior to borrowing to invest in shares, because negative gearing remains available for share investments and the cash flow is stronger because a share portfolio has much lower direct expenses.
However, as I said earlier, some investors can have a strong preference for property.
The cash flow strategy described above (borrowing the negative gearing benefit) produces a higher after-tax internal rate of return (9.0% p.a. versus 8.4% p.a.) because the investor contributes less of their own capital. However, because additional debt is used to fund some of the property’s holding costs, it produces less wealth in dollar terms than paying those costs entirely from the investor’s own cash flow (approximately $210,000 less wealth after tax in today’s dollars after 30 years, or approximately 15%).
Interestingly, the high debt doesn’t materially change the LVR over the projection period – the investment still accumulates reasonable equity.
For these projections, I have assumed the same underlying returns for both property and shares: a 3.0% gross income yield plus 6.5% annual capital growth. I would ordinarily use a lower long-term return assumption for shares to allow for volatility and sequencing risk. However, I have not done so here, as the purpose is to make a like-for-like comparison.
When could you use this strategy?
This strategy may appeal if you prefer property because you are uncomfortable borrowing to invest in shares, or because owning property supports a longer-term goal, such as purchasing or upgrading your home. In that case, you may like to use this financing strategy temporarily, perhaps for only the next few years.
It may be particularly attractive if you believe there is a reasonable prospect that quarantined negative gearing will be unwound and you also find current property prices and rental yields appealing.
If negative gearing is reinstated, you could stop using the holding-cost loan facility and return to funding the property’s shortfall in the usual way.
What you need to make it work
There are 2 important borrowing preconditions for this strategy.
First, you need sufficient equity in existing property and enough borrowing capacity to establish a separate loan facility for holding costs. The larger the facility, the lower your financing risk is. As a general guide, I would consider access to at least $200,000 prudent.
Second, you must have the discipline to use the facility exactly as intended. You should only borrow the amount that broadly replaces the lost negative gearing benefit, or at least substantially less than the property’s total holding costs. If poor cash flow management could lead you to borrow more than planned, this strategy is not appropriate.
You also need to consider your investment temperament. The property may grow more slowly than expected or even decline in value while the loan balance continues to increase, potentially creating a lot of negative equity. If you have purchased a quality property at an attractive price, that situation may only be temporary. However, you must be comfortable holding the investment and riding it out.
Please get personalised professional advice
It is essential to obtain personalised tax and credit advice before implementing the debt and cash flow management strategy outlined in this blog. The loan facilities must also be structured and operated correctly to preserve interest deductibility and minimise the risk of any future challenge by the ATO.
Our general view, based on the tax rulings and case law we have considered, is that the interest should be deductible where the strategy is implemented correctly and the borrowed funds are used solely for income-producing purposes. This includes interest on the loan used to acquire the established residential investment property, as well as interest on a separate facility used to fund its holding costs, provided the property is genuinely available for rent or tenanted.
However, deductibility will ultimately depend on the investor’s individual circumstances, the purpose and use of each borrowing, and whether the loan transactions can be clearly traced. For that reason, personalised tax and lending advice should be obtained from appropriately licensed advisers before proceeding.
Where this leaves you
As I have noted in previous blogs, if property prices fall sufficiently while rents continue to rise, some locations and property types may begin to offer attractive initial rental yields. That could go a long way to compensating investors for the loss of the immediate negative gearing benefit from an internal rate of return perspective.
You may also believe interest rates will be lower in the future than they are today, which will further help investment property cash flow.
If you also expect negative gearing may be reinstated in the coming years, investing before that occurs may be attractive, particularly while prices and rents remain favourable. After all, the price you pay and the rent you receive will largely determine your future holding costs (the only other major variable is interest rates).
If those conditions align, this strategy may provide a practical way to invest in established property now without placing excessive pressure on your cash flow.
Important information: This blog focuses on the capital allocation decisions investors must make when considering an established property, particularly the trade-off between rental yield and asset quality. These decisions can have significant tax and loan structuring consequences. Therefore, before acting on any information in this blog, investors must obtain advice from suitably qualified and appropriately licensed or registered tax and credit advisers who are familiar with these matters.
