Negative gearing strategies smashed by COVID-19

It is often forgotten that one of the keys to Scott Morrison’s narrow victory at the last election was his fight against the ALP’s proposed crackdown on negative gearing.

Particularly in the key states of Queensland and Western Australia, voters were very keen to hang on to negative gearing – a process by which landlords are able to offset losses on a property against their total income.

The old saying of being careful what you wish for applies to the electoral enthusiasm for negative gearing, with the COVID-19 pandemic having a particularly brutal effect on the widely employed strategy.

As the name suggests, negative gearing means the landlord/investor has negative cash flow – the cost of providing their rental property in interest, rates and other costs is significantly greater than their rental income.

Lower tax bill comes at a cost

The bonus of negative gearing is that this negative number or loss reduces the landlord’s taxable income and thereby reduces their overall tax bill.

While that all seems on the surface to be an exercise in financial foolishness, the really big upside in negative gearing is that the value of the property is rising over time, delivering the landlord a substantial overall profit due to their leverage to this rising price (courtesy of the loan), more concessional tax arrangements on capital gains and the substantial tax reductions enjoyed during the loan period.

Think of it as an exercise in delayed gratification, with the potential for a really big profit down the road and a continuing benefit of lower tax bills – albeit, bought with the cost of a lower amount of cash in the interim.

COVID-19 upends negative gearing strategy

Like so many other aspects of society, COVID-19 has turned this exercise in financial sophistry completely on its head – and not in a good way.

Sure, negative gearing landlords are still getting to pay lower tax bills as the gap between what they pay in interest and what they get in rent widens alarmingly as rental income falls but the financial “fizz” provided by rising property prices has also turned negative – and in this exercise, two negatives most definitely do not produce a positive.

Indeed, the latest figures show that Australian taxpayers were claiming $13 billion a year in negative gearing – a number that looks set to keep growing.

Nowhere is this being played out more than in the big Australian cities of Sydney and Melbourne where vacancy rates on rental properties continue to rise, property valuations are falling and rents are falling fast.

Virus has greatly reduced international student renters

The lack of international students and travellers has reduced demand, particularly in popular inner suburbs, and the six-month moratorium on residential evictions begun in late March has produced rental reductions and deferrals.

Some of those rental deferrals could well turn into effective bad debts if tenants are unable to pay back these rental arrears when the deferrals become due – a situation not unlike the frozen debts being accrued by Australia’s banks.

The big difference is that tenants may simply move out and leave their deferred rents behind – to be perhaps only partly dealt with through retained rental bonds.

Vacancy rates soaring in the big cities

It should be an ideal time for tenants to shop around for somewhere cheaper or better to rent due to growing vacancy rates – another nightmare for negatively geared landlords.

Using Sydney as an example, the Real Estate Institute of NSW (REINSW) Vacancy Rate Survey for June 2020 showed that vacancies in Sydney increased for the fourth consecutive month and now sit at 4.5%, up 0.4% from May and 1.5% since March.

In May, vacancies in the inner ring hit an 18-year high of 5.1% – a result that has been exceeded in June and shows no signs of slowing down yet.

Higher vacancy rates feed directly through into lower rents, with the effect of that greatly magnified for geared investors whose negative cash flow is likely to turn deeply negative.

Property prices are falling – the question is how much

As for the final picture for house prices, that is a moving feast with initial optimism after the first wave of the COVID-19 pandemic being replaced by a much more sombre outlook as Melbourne labours through its stage four lockdown.

The Commonwealth Bank’s range of estimates of home prices falling between 11% and 30% over three years is wide enough to be somewhere in the ball park, which must be a horrifying prospect for highly geared investors that are looking for capital appreciation to make up for the intervening negative yield on their investment.

Lower interest rates can only help a little bit

Of course, interest rates have been falling and that may be helping investors as well, although the lower availability of interest only loans and the prospect of a savage downward property valuation if they look to change lenders might be reducing the amount of refinancing.

Like all investments, the negatively geared property investor needs to have an investment timeline in mind when they begin.

Those who remain employed and can afford to grit their teeth and hang on through this poor market may well come out the other side in one piece – and with that initial timeline perhaps extended by many years.

For those who have had a bad pandemic, the prospect of selling out at a loss to end the pain of rising cash losses might be the only alternative.