We
have a national obsession with property investment in Australia. A key reason
is because of the tax benefits of negative gearing. The idea of paying less tax
is simply too appealing to most people (who can afford it).
Negative
gearing only makes sense if the capital gains on the asset is more than the
interest cost. Otherwise paying less tax is really because you are making less
money, and losing wealth along the way.
Most
people only think of investment property when they think about negative
gearing. But there are actually other asset classes where negative gearing can
be effective. The stock market is one of those.
With
this concept in mind, I tested a $500K investment in the SPDR ASX 200 ETF (STW)
using a negative gearing strategy. A $500K negatively geared investment
property in Sydney was the comparison case. I selected the SPDR ETF because it
is the oldest index ETF listed on the ASX, providing the most data points.
Over
an investment time-frame from 1 Jan 2005 to 31 Dec 2014, the investment property
offered better outcomes through negative gearing:
- Return on Equity on the property was 206%
compared 104% from the ETF
- Total tax offset for the property was $214K
compared to $116K from the ETF
Despite
this, the analysis shows that negatively gearing the Aussie stock market is a
viable option. In fact, ETF offered a few benefits compared to property
investment:
- Lower entry cost - A deposit for an investment
property is likely to cost more than $100K, whilst you can start an ETF
portfolio with a few $1,000s
- ETFs are much more liquid than property
- there is a lot less hassle compared to property
investment. ie. no need to manage tenants / real estate agents
- lower transaction costs - buying an ETF is as
cheap and simple as buying a stock with your online broker. Buying an
investment property is difficult and expensive. You need to consider legal
fees, stamp duty, and other costs
Funding
To
fund the two investments, I assumed a loan at 65% LVR or $325K. This leaves a
$175K equity / cash investment at the start. The mortgage's variable rate is
based on the RBA’s published rate across the 10 year period. The Margin Loan
for the ETF is assumed to be 2.85% p.a. more expensive than the mortgage. This
difference is the spread between a CommSec Margin Loan and a CBA mortgage as at
May 2015.
Both
loans are repaid on a monthly basis, to the same dollar value. At the end of
the 10 years, principal outstanding is $256K (79% of the initial loan amount).
Running costs & other tax offsets
The
cost of the ETF is completely absorbed within the unit price so there are no
other fees to pay - ever. For the investment property, there are a few costs:
- Real estate agent management fee of 6% of rental
income;
- Depreciation on the property - I assumed 40% of
initial investment is depreciated (some consultants suggest you can
depreciate up to 60%!).
Income
The
ETF pays a semi-annual dividend. Over the 10 years, it provided an average
annual yield of 4.7%. I did not factor in franking credits.
The
property starts off at 3.5% gross rental yield. Rent rise every year in
December, at the rate of Sydney rental growth (ABS data). Over the period,
average annual yield is 3.8%.
Asset Value
Property
value in Sydney achieved big growth in the past decade, gaining 58%. The $500K
property in Jan 2004 was worth $792K in Dec 2014. The Aussie stock market
didn’t do as well over this period. The ETF share price increased from $40.79
to $50.25, a rise of 23%.
The
higher asset value growth of property also translates to much higher equity
value growth. Equity in the property grew from $175K to $536K, an impressive
206%. The ETF equity value grew from $175K to $357K, a 104% increase.
Tax offset vs cash flow
Obviously
this whole strategy is about tax offsets - both investments achieved this. The
property had tax offsets of $213K over the 10 years, whilst the ETF offered
$117K of tax offsets.
Interestingly,
the property offsets were achieved with lower impact on cash flow. Negative
cash flow for the property investment was only $82K over the 10 years. The ETF
had $117K of negative cash flow. This is mainly because property is able to
claim non-cash tax deduction in the form of depreciation.
What does it all mean?
This
is another example how why Aussies love investment property and negative
gearing. You can achieve strong net wealth growth and tax offsets - a double
whammy. This also shows that a negative gearing strategy can be applied to
other asset classes.
Investing
in ETFs is a way of achieving negatively geared investment in the share market.
A core benefit of ETFs over individual stocks in this content is
diversification - reducing risks. The risk of investing in a Sydney property
and the SPDR ETF was similar in the 10 years. Sydney property prices had a
standard deviation of $83K, whilst the SPDR ETF measured in at $84K.
On
the face of it, investment property seems to be a more compelling investment
class. They offer higher returns, more tax offsets and lower negative cash
flow. However, I didn't account for a few things that are negative for property
investments:
- stamp duty and other taxes;
- vacancy risk - if you can't rent out your
property you get no income;
- significantly higher legal fees;
- higher transaction costs when you sell the asset,
real estate fees of at least 1%.
The
high cost of entry is also a critical issue for investment property. Currently, 1-in-3
Sydney suburbs have median home price of more than $1M. The initial cash
deposit required is well north of $100K. For younger investors, this is a tough
ask – an idea of reaching that deposit sooner is HERE.
Younger investors can explore the
benefits of negative gearing through other asset classes. The asset must be
able to achieve higher capital growth than the interest cost. One obvious
option is the stock market, which usually delivers higher long term returns
than all other asset classes. If negatively gearing the stock market is an
interesting strategy, an investment in index based ETFs are a good option to
start.
Do you negatively gear the stock market? Share your thoughts in the comments below!
Jeremy Kwong-Law (@jeremykwonglaw) is Cofounder of www.BetterWealth.com.au. He is a former investment banker turned technology entrepreneur, a muru-D alumni (Telstra startup accelerator). Passionated about leveraging technology to provide better financial products & services to consumers. Coffee snob, business book reader, and fitness fan.
