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How to beat tax and inflation – in one easy property investment blog post

Property investors have tended to wipe the floor with share investors over the long term for one simple reason: they usually use more leverage. While quoted percentage returns may often be similar over periods of time, when the effect of the borrowing is factored in, the additional gearing on their long term investment returns can make property investors winners.

In the years immediately prior to Paul Keating sweeping his broom through the Australian tax system in the mid-1980s negative gearing had become popular, which fuelled a love of property investment in this country, and a tendency for many to favour that asset class over equities.

Keating changes the rules of the game

Before he became the Labor PM, Hawke’s Treasurer Paul Keating made two key changes in particular. Firstly in 1985 he introduced the Capital Gains Tax which means that today it is far easier to build wealth through buying and holding appreciating assets than it is through attempting to consistently time the market and regularly trading them. This is true in shares and particularly true in property, where transaction costs are high.

Secondly, in 1987 Keating introduced dividend imputation (franking credits on dividends) which removed the iniquitous double taxation on distributions to shareholders upon which tax had already been levied.

A third major change took place in 1993, this time to Australian monetary policy being the Reserve Bank’s introduction of a target range of inflation. Prices growth had been rampant at certain times in previous decades.

The effect of the CPI target has been marked. Today the two preferred ‘core’ inflation readings sit snugly at the bottom end of the targeted range of 2-3% (1.95% if we want to split hairs), and the headline inflation figure is even more benign still at an exceptionally low 1.2%.

High inflation: an illusion of growth?

While property appeared to perform strongly for all owners of real estate through the 1970s and 1980s, there was to some extent an illusion of growth happening. In part, what eventuated was a material devaluation of the associated mortgage debt caused by high inflation. When inflation is prevalent long-term creditors (property investors) tend to win and lenders lose.

But while property prices were nearly always moving higher, the value of many properties did not increase at all – as many of those who proceeded to sell and re-buy property discovered. And while salary levels jumped, the cost of living was often increasing sharply too.

How growth really happens

Growth is usually in some way related to an income stream and re-investment.

If you put cash in a term deposit it can only grow if you re-invest the interest income. The intrinsic value and growth of a share price is driven by the increasing profits of a company, some of which are re-invested and some of which ultimately should be passed on to the shareholders in the form of dividends. Shareholders may also elect to re-invest their dividends via a dividend re-investment plan (DRP).

The real value of a property is only truly driven up by it being improved (sub-divided, rezoned, renovated) or by it being in higher demand, which in part results in higher rents from a landlord’s perspective. With properties, too, we often must re-invest some of the income for repairs and maintenance, lest we be left with some land and a house that has fallen down!

While a property which increases in price in line with inflation retains only the illusion of being a ‘growth asset’, what we really want to seek are assets for which the demand is growing. Just as there are both fabulous companies in which to invest and ventures with diabolical prospects which will inevitably sink into insolvency and fail, property investors need to identify the outstanding prospects.

Properties which will outperform

Yield investors who prioritise cash flows like to get on the front foot and suggest that properties which attain higher spot yields today in the regions will be the ones to capture capital growth in the future. This can sometimes be true.

Sweeping generalisations should be avoided, and what many property investors today don’t yet appreciate is that in times of lower inflation combined with a structural change towards lower interest rates, the rental income on a property can actually represent the bulk of investor returns for sustained periods of time.

But…think back to what we said about how wealth is most easily created in today’s taxation system: through holding outperforming, compounding growth assets in a tax-deferred manner for the long term rather than identifying moderately undervalued assets in order to trade or flip for a shorter term gain.

In property, in spite of what you might have read in various forums over the years, location and growing demand are important. In fact, they are critical. 

Thus what Australian investors should identify are the areas where there will be massive population growth but a limited supply of land available for release over a sustained period of time. This is particularly so if you are in the earlier part of your investing life and are planning upon holding for decades. We make our own judgement call on this, of course, but I know where I’ll be looking.

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About

Pete Wargent is a Chartered Accountant, Chartered Secretary and has a Financial Planning Diploma. He’s achieved financial freedom at the age of 33 - as detailed in his book ‘Get a Financial Grip – A Simple Plan for Financial Freedom’. Pete now manages his investment portfolio, travels and works as a consultant in the finance industry from time to time. Visit his blog


'How to beat tax and inflation – in one easy property investment blog post' have 1 comment

  1. Avatar for Property Update

    November 1, 2012 @ 1:48 am gherlashdawn

    I enjoyed reading this post it helps me actually. thanks for this!

    Reply


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