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With interest rates at record lows, how affordable is it to run an investment property?

Why invest in property in today’s market?

As we begin to see the slow return of certain freedoms and a willingness of our governments to get the economy up and running, many sidelined investors are beginning to wonder if now is the best time to access the property market? With the share market volatility predicted in the short term and banks paying a return of less than 1%, investing into property could provide an attractive alternative for potential investors.

In past economic declines, the Australian property market has held up well. Following the last recession that Australia faced in 1990, house prices declined by only 4 per cent showing that in an uncertain and volatile market, people tend to feel secure investing in property.

What is positive and negative gearing?

Positive Gearing

Positive gearing is simply when the rental income is greater than the total expenses. In this case the positive income would typically be added to the investor’s taxable income.

Negative gearing

When the total expenses for running an investment property are greater than the income received, we refer to this difference as negative gearing. Expenses an investor incurs on top of their mortgage payments include property management fees, body corporate fees or building insurance, maintenance, rates, etc. The out of pocket expenses, are typically referred t0o as negative gearing and is tax deductible from the investor’s taxable income – see example below.

Example of typical client scenario/assumptions:

Client Income $120,000
Tax Rate 39.5%
Purchase Price $550,000
Interest Rate 5%
Rent $500 per week

 

Expenses Income
Interest only loan (90% loan @ 5%) $24,750 Rent @ $500 pw $26,000
Rates, management fees, etc $7,000 Less Expenses    $31,750
Total Expenses: $31,750 Net Income/Loss: -$5,750

The negative cash flow of $5,750 is what is commonly referred to as negative gearing. The amount can be deducted from the investors taxable income.

Scenario 1: Negative gearing without depreciation
Pre tax cash flow Post tax cash flow
Net income $0 Tax refund $2,271
Out of pocket expenses $5,750 Net cash outlay $3,479
Per week -$110 Per week -$67

Based on the above client scenario, this investor would receive $2271 back in their tax return reducing the overall cost of the property to $3479 per annum or $67 per week.

 What is depreciation and how does it work?

Depreciation refers to the prescribed loss in value of an asset over time. Most people understand the common analogy – “a car depreciates as soon as you drive out of the dealer showroom”, but what does this really mean?

Well when it comes to cars (except some rare collector models), this analogy refers to the loss in value a car will experience as it goes from brand new to used, experiences wear and tear, and then newer, more updated models are introduced. If the car was used for business purposes, then the ATO have set methodologies an owner (or company) can apply to receive a tax deduction due to the falling value of the asset, without having to wait to sell the car and claim the loss in one go. This regular tax deduction spreads the deductions more evenly over the life of the vehicle and assists with the affordability of the asset. This type of tax deduction is referred to as depreciation.

Whilst most would agree property is an asset that increases in value over time, there is an ATO approved method that allows investors to claim a tax deduction (depreciation) on the assumed loss in value of the physical elements of the building and its contents. Depreciation for property is separated into two components – 1. Capital Works, which relates to costs associated with the construction of the building and fixed elements such as driveways and 2. Plant & Equipment, which relates to items such as blinds/curtains, hot water systems, air conditioning units, etc.

The depreciation for Capital Works is a flat line (i.e. same amount each year) that will typically last for 40 years from when the property was built, although this does not apply to properties built before July 1985. The depreciation for Plant and Equipment reduces over time with most deductions being accessible in the first 10 years of the life of the items.  Recent changes to depreciation rules in May 2017, mean only the original owner of the property can claim the Plant and Equipment depreciation element, unless they have renovated the property and incurred the expenses themselves.

Scenario 2: Negative gearing with depreciation added
Pre tax cash flow Post tax cash flow
Tax depreciation $10,000 Tax refund $6,221
Out of pocket expenses $5,750 Net cash outlay $471
Total deduction $15,750 Per week +$9

The example above is based off the earlier scenarios but includes $10,000 of depreciation. This figure could vary up or down depending on the age of the property and if it was purchased new or second hand.

As a result of depreciation, this property would now have a positive cash flow of $9.

What impact does record low interest rates have on owning an investment property?

The scenarios above were based on an interest rate of 5%. However with the recent reductions in interest rates, many investors are able to achieve an interest rate of between 2.5% and 3% when purchasing an investment property.

The below table shows the impact of changing the interest rate from 5% to 3% based on the same assumed client scenario:

Expenses Income
Interest (90% loan @ 3%) $14,850 Rent @ $500 pw $26,000
Rates, management fees, etc $7,000 Less Expenses (-$21,850)
Total Expenses: $21,850 Net Income/Loss: +$4,150
Scenario 1: Negative gearing without depreciation
Pre tax cash flow Post tax cash flow
Out of pocket expenses $0 Tax refund -$1,639
Net income $4,150 Net cash outlay $2,511
Per week +$80 Per week +$48
Scenario 2: Positive gearing with depreciation added
Pre tax cash flow Post tax cash flow
Tax depreciation $10,000 Tax refund $2,311
Out of pocket expenses +$4,150 Net cash outlay $6,461
Total deduction +$5,850 Per week +$124

How do you purchase an investment property if you haven’t saved for the deposit?

As homeowners focus on repaying their mortgage, one of the often-overlooked strategies is the ability for them to release equity from their home to fund an investment property deposit. As outlined in the table below, in the current low interest rate environment this can be executed without necessarily putting any additional stress on the homeowners personal cash flow – despite them borrowing 100% of the new property plus purchase costs. Typically purchase costs include items such as stamp duty and legal fees.

The below table  is based on the same assumptions as above, however assumes the potential investor borrows 100% of the property, plus purchase costs. In the table below, purchase costs are assumed at $25,000 meaning the investor would be borrowing $575,000 ($550,000 value of the property and $25,000 in purchase costs).

Expenses Income
Interest (100% loan @ 3%) $17,250 Rent @ $500 pw $26,000
Rates, management fees, etc $7,000 Less Expenses (-$24,250)
Total Expenses: $24,250 Net Income/Loss: +$1,750
Scenario 1: Negative gearing without depreciation
Pre tax cash flow Post tax cash flow
Out of pocket expenses $0 Tax refund  -$691
Net income $1,750 Net cash outlay +$1,059
Per week $34 Per week +$20
Scenario 2: Positive gearing with depreciation added
Pre tax cash flow Post tax cash flow
Tax depreciation $10,000 Tax refund $3,259
Out of pocket expenses +$1,750 Net cash outlay $5,009
Total deduction $8,250 Per week +$96

The above table shows that despite borrowing 100% of the property plus purchase costs, with an interest rate of 3% per annum, the property is cash flow positive by $96 per week after tax.

Disclaimer – get your ducks in a row first!

The information in this article is general in nature and does not constitute personal advice. We recommend you speak to the Orium Finance team to understand your borrowing capacity before purchasing an investment property.

Each property will have a different set of characteristics, in which the income and expenses could differ from the above assumed scenario. We’d  recommend you speak to your financial advisor to understand how purchasing an investment property could impact your individual financial strategy, as well as your accountant to discuss the correct structure to purchase an investment property and the potential tax implications that apply to your individual situation.

The team at Orium Finance have years of experience in assisting clients purchase investment properties. Should you require a referral to a financial planner, accountant, or property expert – we can also assist you with this. Click here to get in touch with the team.

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