In October 2018, Sarah and George took the plunge. After talking to friends, going to seminars, and finding an adviser they could relate to (a mortgage broker), they became property investors.
They went in with their eyes open, aware that building depreciation was no longer a deductible expense. But even without that, the numbers they were confident about stacked up, maybe not in the first year or two, but they looked good after that. Yes, they would need to 'support' the investment in the very early years with some family income, but the prospect of large capital gains untaxed were attractive.
In addition to KiwiSaver, this was their retirement plan.
They purchased a $670,000 two bedroom house in Avondale, Auckland. It was rented at $500 per week. Rents were projected to rise.
They took $134,000 from their prior savings as their 'investment' to make the deposit, and that meant they got the best interest rate on the home loan of 4.98% (average of the five main banks at that time for a 1 year fixed-rate mortgage), competitive in October 2018.
And today in 2021 they are sitting satisfied, pleased they took the plunge. That house is now valued at $935,000. They rolled over the mortgage each year at a declining fixed rate, which was re-fixed in October 2021 at just 2.91%. Interest rates have gone down, rents have gone up, and they are sitting on a $265,000 capital gain even as their mortgage has been paid down slightly.
Their cash flows have eased significantly. In that first year they were -$13,200 in the hole on the investment, but the tax loss which could be offset against their joint incomes from regular work, reduced the overall cash impact to -$9,350. Now three years in, with the rent increases, the after tax cash drain is now less than -$400 per year, and hardly noticeable.
What's not to like?
Actually, they should be concerned. Now might be a good time to quit, cash up while they are ahead. But with the Bright Line Test rules in place, they hesitate. After all, the capital gains have been excellent, and after all those operating negatives, they are still more than +$265,000 ahead, a handsome return on their original $134,000 investment. What else can do that in just three years?
But they are facing some fundamental market challenges.
First, house building is ramping up quickly, and now many analysts say it will rise much further and there will not be the supply shortage the market has got used to. Capital gains from that are unlikely to keep happening.
Second, since October 2021, interest rates on their mortgage have risen almost +200 basis points. While this won't affect them until October 2022, the bite then will almost certainly be larger. Worse, it seems likely that by October 2024 these rates could be +200 bps higher again. That means they face a 5.5% mortgage rate then and the repayments that go with it.
Thirdly, by October 2024, mortgage interest will not be a deductible expense. It is being phased out, so the hurt from that new policy will grow.
| Oct 2018 | Oct 2021 | Oct 2024 | |
| actual | actual | guess | |
| $ | $ | $ | |
| House price | 670,000 | 935,000 | 935,000 |
| Mortgage | 536,000 | 525,280 | 509,522 |
| interest rate, 1yr | 4.98% | 2.91% | 5.55% |
| Rent per week | 500 | 595 | 625 |
| - occupancy % | 95% | 95% | 95% |
| Annual rent income | 24,700 | 29,393 | 30,875 |
| - gross ROI | 18.4% | 21.9% | 23.0% |
| Mortgage payment | 34,788 | 26,489 | 35,252 |
| Rates (estm) | 2,026 | 2,363 | 2,582 |
| Insurance (estm) | 450 | 492 | 538 |
| Maintenance (estm) | 618 | 735 | 772 |
| Cash result | -13,182 | -685 | -8,269 |
| Depreciation, bldg | 0 | 0 | 0 |
| Depreciation, chattels | 500 | 400 | 300 |
| Income tax @28% | -3,831 | -304 | 10,003 |
| Net cash flow | -9,351 | -381 | -18,271 |
| - net ROI | -7.0% | -0.3% | -13.6% |
By 2024, the market dynamics could well have changed. The property cycle is likely to have turned. Even if prices don't reduce, the net cash impact on Sarah and George's household budget will have turned sharply negative.
Reality sets in when that cash outflow of about -$1500 per month is a painful crimp on their lifestyle. Time to exit, even pay the Bright Line Test costs, even if that eats into their large capital gain. At least they will be ahead overall.
But will they?
George and Sarah are part of hundreds of thousands of landlords. One third of all dwellings (1,973,000) are owned by investors (632,000). Even if 10%, even 5% of them think like Sarah & George, that will be a massive wave of selling pressure.
And that could be selling pressure like New Zealand has never seen before. Remember, total normal sales transactions in a year are about 90,000. These sellers will be motivated - facing an $18,000 per year cash outflow from their investment. They will take a lower price (to lock in prior capital gains) just to avoid the tough cash flow reality.
And if such a selling wave starts, they will be doubly motivated to get a deal done before prices for their property fall even further.
When will the pressure stop? In theory, to where a rational 'new investor' sees a net positive return on investment. Even then those investors may be few for a while. It won't really move the market until the lure of large capital gains. Besides, investors are likely to be more attracted to the new-build market where you can deduct interest. Demand for new houses will rise, adding to supply. So that really leaves investors out of the existing home market, dependent on owner occupiers and first home buyers.
In this example, it is a sobering calculation to find a positive ROI in the future we face. And it could be a long way down.
By the above calculations, prices will need to fall to the point where the mortgage payment is only $25,000 per year at a 5.5% mortgage interest rate. That means a loan of 80% of a house price that is as low as $450,000 or less. At $450,000, the net cash flow is effectively zero. It is hard to see how another investor in a declining market would actually pay $450,000, but down at that level is when things might turn.
But that might be the time for first home buyers. Personally I doubt prices will fall that far, but it will depend on the enthusiasm of first home buyers to enter a falling market. Many who have done so in the past were motivated by the prospect of capital gain, so a mind-set change will be required to enter a falling market. Only when enough do so will prices stabilise - and their choices will be extensive when the growing wave of new properties swells.
Gulp.
----
Potential salvation could come from some shifts in public policy. The borders could open and a rush of foreign investors might return. But that will probably require a change of government; not impossible. A change of government could reduce the Bright Line Test 10 year rule, or it could reinstate interest deductibility, even building depreciation. You never know what a political party might promise.
Or secondly, interest rates could go back down again. There could be various triggers for that, including a recession.
However, for these conditions to change, investors are betting on political change to save them. Jerking political change usually isn't a good basis for sound investment decisions, and new investors may well be wary about jumping in again.
*This article was first published in our email for paying subscribers. See here for more details and how to subscribe.
96 Comments
Good article. The cashflow situation has definitely shifted.
The next potential domino will be the continued supply from high levels of construction, and restrictions to migration growth.
If trends continue on their current trajectory it feels certain there will be a correction - and once it starts, it can be a feedback loop (just as rising prices create its own feedback loop).
But as the article points out current settings could be changed at any time - and both Labour, National and the RBNZ seem hell bent on keeping the ponzi going.
I disagree that house prices declining from increased supply equates to some sort of bubble burst or that "animal spirits" cause bubble bursts. That's credit driven IMO (I do believe we're in a bubble)
I will say, even the slightest hint of stabilising or falling prices will send the reserve bank into hyperdrive trying to get them increasing again. Yet they seem perfectly fine with prices rising 30% in a year.
I think it depends on the excess people select, as you can shave a lot off the price by increasing the excess. I am pricing insurance companies, and AMI looks ok, except their contents pricing seems higher than others. But $500 per year I am guessing is not for a detached house for that sort of value, certainly not in the Wellington region. Closer to 2-2.5k
they are still more than +$265,000 ahead, a handsome return on their original $134,000 investment. What else can do that in just three years?
Bitcoin easily. They could have taken their $134K and dollar cost averaged monthly until now. It would now be worth $875,743 before tax. If they were clever enough to look for advice, they could even have set themselves up not to be paying tax.
The irony in all this is that if the central banks and commercial banks weren't intent on destroying the currency through their property and asset bubbles, then it is unlikely the Bitcoin opportunity would have existed.
Re 1, personally, the idea of gearing 'risk / reward' through is the fundamental problem as David has highlighted. I've just illustrated it further.
Re 2, no I'm not. But Lord Key minimises his tax. And he's a lord that the sheeple kneel down to. I don't see any moral issues with minimising tax. It should not be something that only the ruling elite benefits from.
A good article outlining the hardest decision any investor, in anything, has to make :
"When is the right time to get out?"
I can tell you; to the day, when that's going to be - but only afterwards!
(NB: At the risk of repetition - No one wants to 'get out' just to see prices continuing upwards, and Human Nature ensures the belief that "There's always one last up leg, then I'll get out", and if that doesn't happen, losses are run way longer than they should be. Who wants to be the bunny that gets out on the way down "In case that's The Bottom and if I just wait...". If they don't get out, sure as eggs is eggs - that won't be The Bottom)
"Selling half" always sounds good! "If the price keeps going up, be happy, you're still in the game" and "If the price falls, be happy, you took some profit and didn't lose it all".
But in reality it boils down to one thing - leverage - call it by its actual name - Debt.
That's the problem with Property Investment; it is often highly geared (the case study above, includes that), and it won't take much of a fall to wipe out any notional gain. And that will happen way faster than the ability to decide what to do. Before many know it, it will be too late. Then, Hope, takes over from financial sense.
bw: "When is the right time to get out?"
I think I can answer that, over the 25 years I've been a property investor, there is not a single property, residential or commercial that is not worth more today (many significantly more) than when I sold it, no matter how well I thought I did at the time. So my answer to your question is "NEVER"
Ok fair enough, it just seemed way too low. I started looking in late 2018 and you were lucky to find a 2 bedroom flat for that price on the Auckland isthmus let alone a 120 sq m (that's huge for 2 bedrooms) standalone house on 440 square meters. Someone got a very good deal.
Houses have been a good inflation hedge under the MMT financial system, HOWEVER when houses become unaffordable for the marginal buyer..
..houses become an expense/drag [insurance, rates, mortgage, repairs, even body-corp-fees] then people look to take their paper gains.. but who wants to BUY at house when it's going down in value and the debt burden is going up?
Lots of people are mortgage free or have minimal mortgages I suppose. Under MMT newly created money is used to purchase most real estate so the average NZ house could reach 1.5 million by late next year.
It's a macabre, slow-motion train-wreck.
One thing that is overlooked is that these 'boomers' treat their one rental as a hobby ... it gives Mr Boomer a purpose in life after he's quit his increasingly irrelevant and lowly paid lifetime job. We've all known renters who have to deal with this guy and his dodgy weekend plumbing attempts or the gaudy colour scheme due to paint retrieved from the inorganic collection.
Looks like a DGM ground hog day here.
If you were to buy in at the peak of the mother of all global real estate crash in Oct'07 and hold a property till now, you'll be up 158% on capital gains alone.
If you were to buy at 18 year peak mortgage (variable) interest rate at 10.644% and held your property till now, you'll be up 171% on capital gains alone.
If we were to apply the above worse case prediction of cash flow of -$18.271K p.a. to the above scenarios, the buyer who bought in at peak sub-prime in 2007 is still up about 137% and the buyer who bought in at peak interest is still up about 94%.
I guess the story should be the best time to buy is when everyone is scared stiff and uncertainties are rampant.
Time in the market beats timing the market.
All very sensible - in contemporary New Zealand market terms.
But what if we 'do a Japan' next? What if after 35 years, it still doesn't see those number hit a positive return? I know, it's always Japan, Japan, Japan, right!
But no one in Tokyo in 1987 thought they would be the next New Zealand of 1890 either (when the Gold Rush ended). How long did that little correction take to re-correct? 70 years. (or was that Australia? No matter. One of them!) It did, sure, and as long as those of 1890 lived long enough, they were fine.
I'm not sure many Baby Boomers have the luxury of an extended timeframe to wait it out.
But what if we 'do a Japan' next? What if after 35 years, it still doesn't see those number hit a positive return? I know, it's always Japan, Japan, Japan, right!
During the Japan bubble, the sheeple in the West were in awe after hearing about $10 cups of coffee in Tokyo.
Now, they're all experts in why property prices in their suburb could never go the way of those in Japan.
(Reminds of the joke: Patient to Doctor: Are you going to prescribe some medicine for my condition? Doctor to Patient: No. You need specialist attention. I'm sending you to the comments section).
Tokyo or auckland, the same property strategy applies. Which is pay off the mortgage and live rent and mortgage free in retirement. Do you know the nz super is not enough for a person who is renting to live comfortably. In japan it is worse still, they do not even provide universal social security
There was no real property crash in NZ to speak of in 07, and interest rates has lots of room to come down to support prices and the economy, So not a comparable time to this advanced stage of the cycle.
Interesting to pull up some charts of countries that had a crash in 07, like Ireland which had a similar market to NZ and the people had a similar sentiment about property ownership and belief that that it is ok for an economy to be almost totally reliant on property to function.
Granted if your not over leveraged and have good cash flow from a recession proof business to support your property investments in bad times, you will always win long term with property, but too many investors don't have any money.
Great article DC and well done for putting some $ numbers on your chart.
Reading the headline I wholeheartedly agree cashflow is looking negative for the investor in the future, so a bad investment.
Then I look at your chart and quite simply, the cashflow loss is more than overcome by the capital gain, even assuming no more gains till 2024, so a good investment.
Then you forecast house prices, interest rates etc in 2024 which show a bad investment but really who knows where house prices and interest rates will be in 2024?
Excellent article .
One issue I have with the underlying calculation is the assumption of +400 basis points rise in the interest rates - they certainly should rise this much and this fast , but I do not believe they will.
The calculation is applicable to investors that are pretty highly leveraged ( if one is not there is less increase in interest payments and less damage from the new tax deducibility rules ) so not sure how large a percentage of investors will feel compelled to sell , thereby bringing the market down.
Another thing to consider is where one would put the capital released if one did sell . I hear shouts of "BTC" but most people will not touch it with a bargepole . Adds to the incentive to seat tight.
In David's universe central banks wake up to their inflation fighting duty , never mind the torpedoes and things return to "normal".
An alternative universe is one where they keep talking big hawkish game , even increase the rates a bit - but not nearly enough to stop inflation and the real game is financial repression. In that universe Sarah and George suffer a few years of moderately negative cashflow - but the satisfaction of watching inflation melt their mortgage away more than compensates.
The reality will likely be something in between ; my hunch is it will be closer to that alternative universe though ..
This article seems like really bad advice. So they may have to feed a bit of money in for a few years. They started the project with that in mind so no biggie. They got a bit of a windfall so that's great.
If they both have jobs and a mortgage free home they might as well stay on course.
It's probably one of the worst tactics ever in RE to sell because you think the market is going to tank.
I agree cash flow is key. If I was them I would go interest only and then they will have a fraction of the cash flow headache. I realy do think the RBNZ should get rid of interest only loans for investors. Then you realy would see an exodus of investors and a property market that my kids could aspire to
As a boomer with a rental, I/we fit into the story line above quite nicely. The numbers are not dissimilar, nor are the timings. I suppose we are archetypal mum & dad investors. And yes, we've reached an interesting juncture in the road. There are many possibilities from here. It's exciting. If things turn south then I'll be pleased for our children's generation. My advice to them would be to fill their boots on property - become the landed gentry. If things level off, no skin either way really. If things boom on, then we were/are lucky enough to be on the bus & our children & their children will be the direct beneficiaries. My old mate Richard once told me many years ago - buy land old son, they're not making any more of it.
A very good concrete scenario. However, I think for full replacement insurance (and you will need the more expensive 'rental property insurance') you could just about double the premium. Also better to slightly over-insure than under-insure. I know, I've had a house fire.
Then there is the probable need to re-paint the interior between tenancies. New landlords tend to under-estimate maintenance costs. Major expenses could include the following:
New basic hot water cylinder installed .........$1500 to $2000
New watermain ............................................$ 2000
Electrician for bits and pieces, light-fittings, switches, plugs,etc,etc, not much change out of $500 per visit.
Plumber for tap problems, wastes, etc, etc ....not much change out of $1000 per visit.
Gutter cleaning and repair/replacement.........anything from $300 to $2000
Roof leaks
Heat Pump provision and maintenance.
Grounds upkeep.....lawns, hedges, trees and garden,etc
Actually, they'll probably only be able to afford a home unit at today's prices and then you have all sorts of hassles with neighbours over commom area maintenance, parking issues, new roof for carports maybe (share of $20,000)
Fencing upkeep or renewal and maybe painting.
Tenants complaints about neighbours animals (dogs) or cats, or noisy neighbours parties, unsavouy visitors to neighbouring properties and intimidation of the tenants by these people.
Kids wrecking the home because the parents can't control them.
Pets wrecking the place, whether pets permitted or not.
That's about half the possible problems and expenses.
I know all this from experience.
Nice Article. Good to see a good practical example of the realities that some investors face. If the cashflows of such an example are combined with unemployment or any other of life's curveballs then things can turn quickly.
The realities I have about selling rentals is where to you put the money. Most Asset classes are over inflated and due for correction. Term deposits have negative real interest rates, even before tax. If I had a Crypto Wallet I would either loose it or be hacked.
Sold all my Land and property sitting on cash may buy another smaller cheaper house or rent. A $1 Million home that price corrected say only 10% $100,000 equates to rent at $700 a week for 2.75 years + as no rates or insurance or repairs -whats the chance of property declining 10% or more over 3 years, I don't know but risk says unlikely to go up once DTI/Higher interest/rates/Insurance making ownership costlier and perhaps a recession once Covid lock down ends and the real cost in unemployment insolvencies and Bankruptcies mount so downside risk is greater, Ill take that gamble and be happy to miss the last property price increase if there is one, Politicians and Central Bankers may care to consider relocation to Pitcairn, not ideal but safeish from angry voters.
The most unrealistic thing with the projected cashflow table is that it shows rents going from 595 to 625 between October 2021 and October 2024.
I find it hard to believe that there will only be a 5% increased in rent over the next three years. Inflation will force wages upwards and rents will rise with wages.
We had rental units we were pleased to offload 3 years ago. The new owner however spent 10 to 15 k per unit for a refit and increased the rent around 100 pw/ approx 40 percent increase. The units were very ok previously but a bit ordinary when we owned them but this meant the tenants got affordable rent. It just goes to show tenants will pay more and demand will push up the price if they want more of the feel goods. Affordable is a mantra but people still have wants they will pay for as opposed to needs and paying the minimum
I'm just renting now, we went for the cheapest out of 3 houses, like where we are now, but I will change if rents went up and I find a better house. My circumstances are also completely changing my business is working and growing, so will look at buying a decent house in 2 years. People leave and look if circumstances change, they certainly don't stay stagnant and help landlords pay of their debt if inflation increases, especially if there is a competitive market. We will see. Happy to wait for a few years and let the assets within my business grow.
One thing to consider is the value of a mortgage on a rental property. If you let it go by selling up you may have difficulty getting another one should you change your mind and seek to purchase another property. This happened to me to some extent and I realised that a measure of someone's worth could be the amount they can borrow. I thought I could easily borrow again but I had a rude awakening. I felt like I was being made to beg for a new mortgage even though my figures all added up.
That rental property with a mortgage can be a treasure worth holding onto.
I got a lesser amount approved eventually but it wasn't quite enough for what I wanted to do and let it lapse. It was under a million. My point was that you may have a mortgage that was easier to get than it would be currently. The house, too, can sometimes be hard to find, so you may not want to just bail out at the first sniff of trouble.
Sorry to hear that. I found that relatives who think they know a lot about property are not good advisors, "sell everything" was their advice when we had marriage trouble 10 years ago. I think the banks have been told by rbnz to go hard on multiple property owning full time investors too. In the end we went to a second tier lender for a more recent premium purchase, they charge a lot more though, what the heck it's only for a couple years. Also use a mortgage broker to do the leg work, they can work wonders
How old is this couple named Sarah and George? That factor determines their outlook. I am guessing early 30s with kids. In which case they are going to want to pass an inheritance to their kids either when the inevitable death occurs or more likely when their children are young adults. If Sarah and George sell up now they will just be left with their one family home and it is obviously not enough to provide for their children's futures.
This is with a investor from 2018 what happens if someone invested 2021 that property cost them 935,000 had 190,000 deposit 745,000 mortgage at 5.5% that investor is going to lose big time then house prices go down let’s say 15% not looking good for them as would have to sell at a loss or sit in negative equity paying out for years this is what is going to happen people might be ok if purchased a few years ago but you would be quite insane to do it now. Look like you have a small window of time to sell if this is you.
Property is still the way to go, look at the NZX 50 over the last 12 months. The index was 12,600 in Nov 2020 and today in Nov 2021 is still 12,600. This despite a 'booming' economy!
Although I must say the NZ sharemarket did fantastic in 2017 to 2019 when property was tanking in Auckland
We're not living in a normal demand situation. Wait for full border reopening and equilibration, remember that even though no one could travel we kept issuing visas and residence permits as well as blocking returning residents/citizens from...returning.
We have two years of population growth to catch up on.
It makes absolutely no sense for a couple like this to bank a capital gain now rather than wait two years and avoid 90k in taxes. The market is not going to crash 10% in the next two years.
This article talks about motivated sellers but ignores the impact on rents. Creating massive cashflow shortfalls like this will create landlords who are highly motivated to start charging market rents - TradeMe data already shows rents up 10% in the past 12 months, the highest increase on record.
For this couple that may not be much of an impact given their ring fenced rental losses from previous years they will likely be able to offset against taxes until they sell, but for smarter investors who bought cashflow positive properties at good yields it will lead to increases across the board.
I'm just trying to puzzle out the math behind the Income tax @28% coming to ~$10k in 2024. I understand the reduction in interest deductibility will be underway by then - but am unsure of what factors actually go into the calculation. Have spent a half hour digging around the IRD site, but am still unenlightened. It looks to have a fair weighting towards the rental income, but must include other factors. Has anyone found an explanation elsewhere that would be worth a read? Or if it's simple enough - can explain it here?
Thanks!
Greg
Hi Greg,
The interest rate tax deductibility is being fazed out by 2024. From David's table in 2024 the loan is about $510'000 and the interest rate is 5.55%. Now you can't calculate $510k x 5.55% because it's a P & I loan, meaning at the beginning of the 25? year loan term more money goes to interest and less to repayment, so the interest part in 2024 is about $35'700. Multiply this by 28% loss of interest deductibility and you get about $10'000
Hi Greg
My calculations shows there is an error in the calculation of tax payable. The correct calculation should be $7,471 not $10,003
Income = Rent $30,785
Expenses = Rates $2,582 + Insurance $538 + Maintenance $772 + Depreciation $300
Tax Payble = 0.28 x $26,683 = $7,471
cash result = - $8,269 - $7,471 = - $15,740 not - $18,271
This article highlights one of NZ's problems; this blinkered fascination with property.
They have a paper gain-no more- which they can only ever access by selling it. They are at risk from rising mortgage rates and have all the costs associated with rental properties-insurance, rates and ongoing maintenance, as well as possible periods between tenants with no income.
Had they gone into the stockmarket with a broadly spread portfolio they would still today have a healthy gain, be without the risks associated with gearing or the ongoing costs listed above.
I have both a rental property(no mortgage) and stockmarket portfolio, both of which have done well, but I have absolutely no doubt which is the better investment overall.
I've seen and been involved in many many cycles. Along the way I've admired the wisdom and apparent wealth of its most visible and vocal advocates.
Can someone please explain to me why these household names seem to so often end up in financial trouble? Even the big listed players like Bluechip; (can't lose with houses right!) fail also. Could some one please help me understand...
We welcome your comments below. If you are not already registered, please register to comment.
Remember we welcome robust, respectful and insightful debate. We don't welcome abusive or defamatory comments and will de-register those repeatedly making such comments. Our current comment policy is here.