Wealth creation without breaking the Bank

gearing wealth creation message on image of key-ring with house and keys attached asking if ready for the risksGearing wealth creation has long been a popular investment strategy: the level of gearing employed significantly impacts the performance of the investment portfolio.

Since the 2013 Federal election in Australia, when Negative Gearing was demonised as a cause for high housing cost and low affordability, there has been ‘chatter’ about the benefits accruing to those who utilise this wealth creation strategy; and the distortions that it puts on specific markets. Each election cycle brings the discussion loudly to the fore. Whilst the proponents of legislative action to modify both of these elements is awaited, the community looks to the Reserve Bank (the RBA) for monetary deterrents to the emerging housing price bubble, of particular concern in Sydney and Melbourne.

The RBA is constrained in how it can control the flow of capital into the effected markets without having an impact on all other markets. Its limited pathway is to encourage other Regulators to address the concern – and since the latter part of 2016, there has been a push to change the lending criteria to specific sectors and specific market categories. These challenges have been taken up by APRA, supported by ASIC. The call by the RBA has again been highlighted in the Minutes from their April Meeting (at which the interest rates were again held steady at the historically low rate of 1.5%).

Legislative change to the rules surrounding the practice of negative gearing would, if introduced, impact all geographical property markets – but would only impact property acquired for investment purposes. Proponents of legislative change targeting house price affordability, also want to see amendments to the Capital Gains Tax laws relating to (residential?) property. The unintended consequence would most likely, also be to impact the residential property market for non-investors – but whilst such a move would apply generally, its immediate impact would be on the markets that are creating the greatest capital gains (‘running hot’, or approaching ‘bubble’ territory).

Gearing wealth creation strategy – using property:

Negative Gearing and Capital Gains (Tax) work together to benefit the investor: they enhance the return from investing into this asset class by mitigating the costs of investing.

Negative Gearing

If money (capital) is borrowed by an Australian resident taxpayer to purchase an income-producing asset, the interest paid on the loan will generally be able to be offset against all income derived, not only from the asset acquired, but also from other income.

Capital gains

Investors are aware however, that the actual cost of the loan is the combination of the capital borrowed, and the net cost of interest after allowing for that tax deduction. For the investment to be viable, it needs to generate capital gains to recoup the net interest cost – and hence the importance of the CGT discount.

Consider the following example:

Scenario assumptions –

Asset purchase price (including all associated costs of acquisition, borrowing etc), is: $500,000

Assume the funds are contributed for this acquisition, as follows:

  • Accumulated capital: $100,000
  • Borrowed capital: $400,000

Interest rate for the loan is: 5% p.a. (fixed)

Loan period: 120 months (10 years)

For simplicity and understanding, the loan is repayable in equal instalments off the capital amount, plus interest for the year – and as unrealistic as it is, these instalments and interest are paid annually. We also assume in this case, that the marginal rate of tax for the investor, is 42%.

Using the above assumptions, the following Table shows the cost of this investment over the course of the loan:

  Year           Capital borrowed   Interest for the year   Repayment  Balance of loan  Tax saving on interest  Net added cost
  1   400,000  20,000  40,000  360,000  8,400  11,600
 2    360,000   18,000   40,000   320,000   7,560   10,440
 3     320,000  16,000   40,000   280,000  6,720   9,280
 4     280,000  14,000   40,000   240,000  5,880   8,120
 5     240,000  12,000   40,000  200,000   5,040   6,960
 6    200,000  10,000   40,000   160,000   4,200   5,800
 7      160,000  8,000   40,000  120,000  3,360   4,640
 8       120,000  6,000   40,000  80,000  2,520  3,840
 9     80,000  4,000   40,000  40,000   1,680   2,320
  10     40,000  2,000  40,000    0  840   1,160
 Total               63,800

 

On this basis, the Capital Gain required on this $500,000 property will need to be $63,800, plus the opportunity cost of having the capital invested in a risk-free asset – generating an assumed 3% p.a. (without going to great detail here, take it that by our calculation, the amount required will be a further $122,500, rounded). This makes for a total capital gain requirement of approximately $186,000, just to break-even on the investment, not allowing for the CGT payable. If we add the CGT liability in, there could be need for a further $80,000 in capital gain – a total of $266,000.

The asset will need to sell for $766,000 for the investor to break even on the commitment.

These numbers may work well in some capital cities, or in some suburbs of capital cities, but are quite likely to be a challenge in other suburbs/ urban areas.

Gearing wealth creation outcome – from property investment:

If the above asset sells for $766,000 at the end of the 10-year period, the investor will have outlaid the following amounts:

  • Initial capital: $100,000
  • Loan repayments: $400,000
  • Interest costs: $110,000 (less tax rebates of $46,200)
  • Capital Gains Tax: $  80,000
  • Total outlay: $643,800

The assumption is that all other income and costs of the property have netted the investor no material gain after allowing for tax on earnings; holding costs (in the case of property: rates, property taxes, utilities; and insurance); property and associated equipment, maintenance costs; and property management costs, where an agent is engaged to secure tenants, collect rent, ensure property condition is maintained – and accounting for the financial transactions involved. (If net income is brought to account, then the tax deductibility allowed for in respect of the interest cost in this scenario will be reduced accordingly.)

What becomes obvious in this scenario, is that market timing – both at the time of purchase; and at the time of sale – could be quite critical to the outcome (but that is a topic for another time).

Questioning gearing wealth creation?

Is a return of 3% per annum adequate reward for having the responsibility for an asset of this value?
Are there elements to this scenario that could be arbitraged to deliver a better return from the same investment?
Are there options to utilising available capital and to generate a more reliable, less financially stressful return?

Wealth creation strategy options:

There is a range of options available to investors by which to enhance their financial wealth over time. The key elements to implementation of a wealth creation strategy are available surplus financial resources, availability of suitable investment assets; and time.

The Continuum Financial Planners’ advice team utilises a proven investment approach when engaging with clients1: that investment approach has been well documented and starts with gaining an understanding of the investor’s financial position, their asset preferences, their financial risk aversion – and their financial goals and objectives, expressed with established time horizons. It culminates with the implementation of a documented investment strategy that is thereafter reviewed at agreed times; and updated when circumstances warrant change.

One of the articles to be found in our website Library, deals with the regular investment of a specified amount of money over a protracted period of time: “Wealth accumulation incrementally” deals with the strategy referred to as ‘dollar cost averaging’ – and whilst the scenario assumptions used in that article differ from those used above, the fact that the investment can be undertaken:

  • with no borrowing,
  • using affordable surplus cashflow, and
  • invested into liquid assets,

…can be extrapolated in a financial model to show sound reward for the investment risk undertaken.

The options for wealth creation based on investment assets, all involve elements of financial/ investment risk: readers looking to understand the relative risks involved in the various investment asset classes are invited to read our article, “Investment Portfolio Diversification”.

Another factor that can enhance the investment outcomes is gearing – but conservatively done, rather than resulting in ‘negative’ cashflow outcomes: there is plenty of evidence that modestly geared portfolios (property, shares, managed funds and other variants of the basic asset classes) can improve the financial outcome from investing. (Share portfolios with 30% gearing entering the 2008 GFC would never have received a margin call for instance.)

Having said that, it is important to note that gearing at any level heightens the risk associated with the investment: it can magnify both the yield delivered – and the loss incurred! The investor’s financial risk aversion profile needs to be clearly taken to account when using borrowed funds to invest. Our website article, “Gearing investments to accumulate wealth” discusses the process of investment gearing with further warning as to ‘over’-gearing.

Wealth creation strategy advice:

The experienced financial advisers at ContinuumFP are available to meet with you, explore your wealth creation aspirations with you; and to engage with you in designing, implementing and regularly reviewing the wealth management strategy that will be personalised to your circumstances (which may incorporate gearing wealth creation strategies). To arrange a meeting with one of our team, phone our office (on 07-34213456), or complete the Contact Us form on our website: either way, you will receive prompt and courteous attention.

1 The article “ContinuumFP Wealth Creation process” outlines our process and guides you to related articles for even more detail.