Negative Gearing – The Long Con: How to Purchase Profitably
Hello dearest readers and casual observers (not that you’re not dear to me too!)
So here it is, the long promised and well overdue article on negative gearing and the dos and don'ts of purchasing a property.
Firstly, I think it is important to set the scene, to get into the mind of the excited purchaser. It is a wonderful and exciting time purchase a property. Whether it is your first or your fifth time, there is nothing like scanning realestate.com to see what properties are doing in your target suburbs, sipping on a latte with all the other tyre kickers at local auctions and leafing through binders of off-the-plan properties with a broker.
It is an exciting time, especially your first time. This is the biggest investment decision of your life. Your first home you live in just does not have the same flavour as buying a house for profit. You are about to become a landlord. Power is your new sword. A lord of the estate, as it were.
But how do you do it? How do you take the real first step? All of the googling and crashing auctions with your significant other are fun pastimes, but when it comes to taking the actual jump you start to freeze up like a first-time skydiver at the door of the plane. Like that skydiver, you rely on someone to push you out the door. Enter, the property broker.
Now, I do not want you to imagine the sly and sinister character, Hedley Lamarr, from Blazing Saddles; however, that is the first image that springs to my mind. Also, if you have never watched Blazing Saddles, then stop reading this now as you do not deserve to know any more. Mel Brooks is a cinematic genius who deserves at least 93 minutes of your time. Look, I know I am being a little unfair to property brokers. In their defence, 90% of them have no idea what negative gearing is and why it is the worst possible long-term investment strategy that can be applied to purchasing a property. They are just repeating what they have been told and so they believe what they are telling you.
It is important to understand the difference between an off-the-plan property broker and a real estate agent. An agent is regulated, has a licence and is applying the trade of being a licensed and currently-registered agent (the currently-registered part is important later on. This will be on the test so write it down). You are not going to hear that agent talk to you about negative gearing, he is going to send you off to your finance broker and accountant. A property broker, on the other hand, does not need a licence to sell you an off-the-plan property. This is a grey, no man’s land of regulation and like the wild west, a space where the Hedley Lamarrs of the world can prosper. So, if you have a property broker in your house telling you all of the benefits of a long-term negative gearing investment strategy it might be time to check all the silverware …
Okay, Shaun Fox (you say), you have a flippant and upbeat manner about you and are clearly witty, charming and dashingly handsome (I may have taken some artistic licence on your part here 😉), but why is it such a bad idea? My broker told me this is how the rich people do it. It’s how they manipulate their taxes to get rich!
I hear this all the time and my first thought is that I want to sell that person a seaside resort timeshare package in Antarctica, because if you are going to throw money away you may as well give it to me. Let me ask all of you one question: if you buy any investment where the return on investment is less than whatever that investment makes you each month (so you are effectively losing money every month), is that a good investment? And is your solution is to offset the losses you made on your investment against your tax? Let’s call this a stupid tax. Like in the game of monopoly, where you think you are going to make it to the GO square, but you land two spaces short and have to pay what I call stupid tax. A space that is incidentally right between the two actual rich people on the board.
How many rich people proudly announce how much money they lose on their investments...? SO, this part of the lesson is on you. Don't be an idiot.
Let me tell you a little bit about negative gearing. Negative gearing was not created as a tool to purchase investment properties, it was introduced in 1922 to assist businesses that might make losses in their first few years of operations. It was not until decades later that some proactive accountants rolled it out as a marketing strategy for property purchasing. Please do not get me wrong, negative gearing is not evil. It is a mechanism that, if deployed correctly, can be a very effective tool in the fight against poverty; however, the other side of that coin is that it is a double-edged sword that, if used incorrectly, can wound you deeply.
At this point you are probably more confused than when we started, so let me give you examples of good use of negative gearing and stupid use of negative gearing.
You purchase a property with a rental return of $2,000 per month and the mortgage repayments are $3,000 per month, so you are losing $12,000 per year. You can now offset a portion of this against your tax (only a portion – you are always still going to be out of pocket). This is an older established property (e.g. commercial or large residential block), which is the perfect site for a development. You take two years to secure council plans to renovate or develop the block to create additional properties or enhanced income. At the end of the development works, your property returns $5,000 per month and the mortgage repayments are still $3,000 per month (you probably borrowed some money for the works). You are now making $24,000 a year in passive income.
In this instance taking a short-term loss is acceptable and the negative gearing helped offset that short-term loss (remember short-term loss, it will also be on the test).
You purchase an off-the-plan property on a 30-year loan term where the rental return is less than the mortgage repayments. I am not even going to bother with numbers here because stupidity transcends math. The issue with this strategy is that there is no strategy – you are locked in for the long haul. There is no uplift from a future development, you just bought the currently council-approved building on the property and you have 10 years of depreciation. When a property broker takes into account the deprecation to help offset your property purchase... I am not telling you to punch him in the face as I am a peaceful person by nature, but feel free to give him a glass of fridge water (as a side note, to all of those people who keep water in a jug in the fridge, this is never a good idea and guests actually do not like it, they are just too polite to say so). It will take you roughly seven years to get to a zero point before you are actually starting to make any progress.
Let me give you a little insight into the off-the-plan property market and you might see what has my garter all twisted up. The biggest problem with the off-the-plan negative gearing strategy is that it is a long con to hide over-inflated property prices. Generally, an off-the-plan investment property is in a new area on the fringes of existing suburbs, still waiting for main infrastructure and facilities like schools or rail or whatever. This is one of the big upsells from a property broker: buy now and the value will increase after these things are built. This is true; however, buying in areas like this means you should be able to purchase at a discount not a premium. In fact, the first guy who bought this contract got that discount (and here is a secret, it wasn’t you).
Here is an example of the process. The first guy in the deal makes the most amount of money and that is the developer. He buys some farmland, develops it into 200 property lots and sells these directly to the open market for say $200,000 each. He directs you to use an allocated builder who charges you $250,000 so all up you can have your new investment property for $450,000.
Here is the light on the transaction. The developer is making a profit on the block of land around $80,000 plus he is getting a kickback from the builder of $30,000, making a total profit of $120,000. Good for him, everyone needs to make a living.
Here is where the issues come in. The developer uses property brokers to sell their stock. The developer pays a $30,000 commission to the broker, so he increases the block price to $215,000 to offset at least half of the commissions. The property broker, wanting to make more on the transactions, adds an extra $20,000 to $30,000 on the price so he can make a profit of $50,000 to $60,000. Have you ever bought an investment property and there was a shortfall in valuation of mysteriously this exact amount of money? I bet there are more than a few people steaming right now.
Sure, people need to make a living, but we are not talking about other people, are we? We are talking about you and your future, so f*** all those guys and look after number one… because that is what they are doing.
So, go directly to the developer and ask him what sort of a deal he can do you. All developers have a marketing budget to pay these brokers and there is nothing stopping you from getting those discounts yourself. Get out there and do a little horse trading. If you are going to do something, do it right and if you are going to make a financial decision that will affect the next 10 to 30 years of your life, then do not be lazy about it (also on the test).
There are plenty of amazing properties out there that are positively geared – the attractive cousin of negative gearing, and like the name suggests, it makes you money. I will tell you a little secret, I will pay more tax every year if I can because it means I made more money, which sure beats losing money. This is where the rent is higher than the mortgage repayments. Also, do not get tricked into paying off more money up front to purchase the property in order to lower the mortgage repayments. While doing this is a great idea, just make sure you are not being tricked into helping hide the overpricing of the property.
Queensland is a great place to find really affordable properties with great rental returns. There is currently a huge amount of infrastructure being built there, which will increase property prices. You can start out by taking a look at someone like Queensland Property Group. Another amazing way to increase your rental returns is to get creative. Remember, you are purchasing a property to make a profit. Have a look at what Ian Ugarte from Small is the New Big does: Ian takes existing houses and retrofits them to be self-contained mini units. The rental return for the property is spectacular.
So, what was on the test, guys?
Negative gearing is good on a short term two to three-year strategy that has a big upside.
Off-the-plan property sales do not require a registered agent to sell (ask them what their last job was).
Don’t be lazy and don’t become too excited and buy the first thing the first guy tries to sell you.
I know this has been rant-y, my friends. I am more than a little passionate about this particular topic. All I ask is that if you disagree with what I have written here, then let me sell you that timeshare in Antarctica I spoke about earlier – it is a great deal and the way global warming is going let us call that a medium to long-term investment strategy 😉
Live long and be prosperous