Chapter 02 – Residential property

The client’s home as an investment

The family home occupies a special spot in the Australian psyche. At about 70%, our home ownership rates are amongst the highest in the world. Since the Second World War there has been an explosion in home ownership: cheap land, new building materials and methods and government policy combined to see most able to afford at least some sort of a home somewhere. Something their forefathers only dreamt about.

The family home also occupies a special spot in the Australian investment history. It was the highest earning asset class, with an average annual return of about 10.5% compounding in the 20 years to 31 December 2015(source: ASX Russell Annual Investment Report June 2016). That’s the average: in some regions and suburbs, particularly those that wealthier clients usually live in, the average annual return is even higher than this. In July 2014 the Australian Property Monitors Quarterly House Price Report shows the upward trend has continued, particularly in Sydney and Melbourne, with the Sydney median price moving above $800,000 and the Melbourne median price moving above $600,000 for the first time. By June 2015 the median house price in Sydney exceeded $1 million and Melbourne reached $670,000. Like most other people, some clients would not have accumulated any wealth at all if it was not for their regular principal repayments and the steady rise in their home’s value over the years. Most clients can attribute most of their wealth to their family home.

Our advice to clients always says “own as much home as the bank will let you, as soon as you can. And then pay the loan off as fast as you can”. The clients who followed this advice did very well. We doubt that this is going to change much in the next ten years, despite events so far this year. We still think clients should buy as much home as their bank will let them. And then pay the loan off as fast as they can.

There is no real reason for residential property to prices to fall. The economy is strong, there are more jobs, and there is a greater ability to pay than ever before. The population is growing. Certainly the basic psychology of home ownership has not changed: people still want to live in and own nice houses, and they are prepared to pay to do it. It’s a status thing as much as anything else.

We think homes will cost a lot more in 2020, and 2030, than they do in 2015. Clients should be fattening their residential property portfolios even if everyone else is thinning theirs out.

What are the trends?

Despite our overall positivity, it does seem that the rate of home ownership is in fact declining. But it is not declining nearly as fast as the population is increasing. Department of Family and Community research on trends in home ownership indicates that the overall rate of home ownership has declined marginally in recent years. This appears to be due to:

  1. the population aging, and moving into alternative accommodation;
  2. the traditional family unit breaking down and a correlating increase in single parent families and group households, which tend to rent rather than own;
  3. an increase in the average age of first home buyers, due to the higher cost of housing, increased participation in post-secondary education and training, HECS debts and the trend to later child bearing.

The decline is only marginal, just two or three percentage points over more than 20 years. But there does seem to be a permanent change in Australia’s home ownership profile since the early 80’s.

What are the advantages of home ownership?

The most important advantage of home ownership is more of a psychological advantage than a purely financial advantage. It’s the nesting instinct. It explains why young couples spend so much time getting the house ready, turning it into a home, before the first baby arrives. It’s a territorial thing. This is your space and your home is your castle. It provides a sense of permanence and control which is important to overall psychological happiness.

And it avoids the psychological disadvantage, the perceived social stigma, attached to not owning your own home. Do not under rate this one. Perceived social status is a big factor in why people buy in suburbs like Brighton or Double Bay.

Residential properties, and the loans used to buy it, are a great way to save. Many people would not save a cent if it was not for the principal component of their home loan repayments. And later, when the home is paid off, the owners save rent.

The home is usually CGT free. The principal residence is excluded from the capital gains tax net, by dint of social policy and political survival. Improvements to the home are usually CGT free too: it can be that a $100,000 improvement creates $150,000 of value. And that extra $50,000 is tax free.

For older people the home is outside the assets and the income test for the old age pension. And increasingly reverse mortgages are being used to access some of the large amounts of equity in the home during old age without having to sell it. Reverse mortgages turn homes into tax free reservoirs of wealth, a super alternative, to smooth consumption over a person’s expected life span: they build up the reservoir during their working years and run it down in their retirement.

From time to time governments create benefits for homeowners, such as the first home buyers grant and the NSW stage government stamp duty concessions (although one can argue that these inflate home values by greater amounts, thereby making home ownership harder, not easier).

What are the disadvantages of home ownership?

Property values can go down as well as go up. However as mentioned earlier, the long term trend has seen home values rise.. Remember, short term is five years, medium term is five to ten years and long term is ten or more years. Six months is nothing.

Property can also be expensive to buy and hold. Acquisition costs include stamp duty (work on 5% of the cost), bank fees, solicitors’ fees and titles office costs. Holding costs include council and water rates (which do produce some benefits), interest, increasingly, land tax, maintenance and repairs and real estate agents’ fees. These can be significant and are often ignored when people calculate the gains made on their homes.

Critics of home ownership normally list opportunity cost on foregone investments and a lack of diversification and hence a higher risk than otherwise may have been the case. But historically this has not been the case: property is one of the top performing asset class so there is no opportunity cost. And the lack of diversification has been the homeowners’ advantage: who wants to diversify into a lower earning asset class?

One disadvantage the financial planners do not normally list relates to the opportunity cost of other investments that may have been geared. For example, if a client chose to put a deposit on a positively geared commercial property costing, say, $1,000,000 rather than an equal deposit on a new home costing, say, $500,000, then ten years down the track the client would probably have been better off with the commercial property. But it’s not a fait accompli and it does depend on the assumptions you make about the relative price movements in each asset class. One commentator has been saying for years that he thinks clients will be better off renting their home and investing in the share market. One day he will be right. Let’s hope his wife does not leave him first.

Critics argue that residential property is an illiquid asset. It is less of a problem in the last ten years or so as equity access loans, i.e. debt facilities linked to the value of the home, have allowed clients to cash out some of the value of their home, whether for consumption purposes or for other investment or business purposes.

Deductions for the home as a place of business

Some clients run businesses from their own home. The home can be a place of business as well as a primary residence, and the costs connected to the home as a place of business can be deductible for taxation purposes. These costs included a portion of the interest on any loans used to buy the home, usually calculated on a floor space basis, a portion of the running costs such as the rates, electricity and so on. It also included depreciation of any plant and equipment to the extent it was used to produce income.

When considering whether the home is also a place of business the ATO considers whether:

  1. the area was clearly identified as a place of business;
  2. the area was not suited or easily adaptable to private or domestic use;
  3. the area was used predominately for business purposes; and
  4. the area was regularly visited by clients.

Generally speaking we advise clients against claiming occupancy costs connected to the home, such as interest and rates, because of this CGT disincentive. The home is basically broken into two assets for taxation purposes and, only one, i.e. the section not used as a place of business, is exempt from CGT.

Deductions for home offices

Clients can claim deductions for home offices.

To be honest, there is not much in these deductions and it is usually not worth the bother of complying with the ATO’s substantiation rules. There is one exception to this: sometimes the depreciation claim available on plant and equipment can be significant. Desks, tables, book cases, chairs, computers, ‘phones, faxes and similar equipment can easily exceed $20,000 or more. This amount is spread over the useful life of each asset, and this can easily add up to a deduction of say $2,000 a year.

The ATO cannot tell a client how much he or she can spend on a particular item of plant and equipment: so that nineteenth century oak partner’s desk that you have always wanted can be depreciated if it is actually used just for professional purposes. The family home has a special place in the Australian psyche, and deserves a special place in this book. Rightly or wrongly for most people the family home is the most valuable asset and investment they will ever own. It is also the asset, probably the only asset, which produces warm emotion and fond memories, and exerts a significant influence over the family’s day-to-day happiness.

Is it worth owning a home?

This value of a home is measured not only in financial terms, but also in emotional and familial terms. The quality of the family home is an important variable in determining the quality of family life. This is not to underestimate the importance of other factors. Obviously lots of other things are pretty important too. But generally speaking, the better the family home the better the quality of family life. This is particularly so for those who spend the bulk of their time in the family home, such as mothers and young children.

From time to time various heads pop up saying that the Australian obsession with the family home is financially damaging and that most people would be better off owning a parcel of shares or other investments rather than their home. One such head belongs to Phil Ruthven, of IBIS Business Information and a noted commentator on financial matters. Ruthven has said publicly that most people will be up to $300,000 better off by renting a home rather than owning one. His argument is based on the observation that historically the investment performance of homes has lagged behind that of the other major asset classes, most notably Australian shares and international shares.

There is some concern as to whether this is right. It appeared to be right, up to the end of 2000. But since then local and international share markets have been in a spin whereas residential property, at least in Sydney and Melbourne, has boomed.

But who knows how long this will last for. Markets are fickle things and perhaps home prices are about to dive and share prices are about to soar. Perhaps the traditional pre-2000 relativities are about to reassert themselves. Perhaps Australian shares and international shares will be better performers over the next ten years.

This may happen. But if it does we do not think that this changes the basic wisdom in a client owning his or her own home. Buy it and pay it off as soon as possible to minimise the effect of non-deductible debt, and then borrow in a tax-deductible format to acquire other investments. This should also consider the other major asset classes as appropriate and in line with their own risk return profiles and financial profile.

One great advantage of the family home, and the family mortgage, is that it forces clients to save. Debt repayment is a form of saving. Every month at least some principal is paid back to the bank. We prefer to see it paid back as fast as possible, since debt on a family home is not tax deductible and is therefore very expensive. But even a small amount of principal repayment is better than none. Many respected commentators have wondered whether the average person would save anything at all if they did not have a home loan. The answer is that they probably would not.

Another advantage of the family home is that the increase in its value is tax-free. Family homes are not subject to capital gains tax (“CGT”). This means that provided certain conditions are met any profit on the sale of the family home will be outside the capital gains tax rules.

Family homes provide a nest for the family. The psychological value of a home of your own, however humble, is huge. Home ownership is an irresistible force: have a chat with someone over age 25 who does not own their own home and ask them what they want the most. Nine times out of ten it will be their own home. And if they have kids it is ten times out of ten.

When should you sell your home?

There is really no answer to this question. However, as a general observation we believe too many clients are too ready to sell their homes, particularly when considering upgrading to a new home.

More than once we have seen a client quickly put his or her home on the market for sale the day after they sign up for a new home (and, amazingly, they have often taken the advice of the agent who sold them the new home. Strangely, he thinks it is a great time to sell, even though he has just sold to them.) More than once we have seen the client regret that decision within 12 months, as property values continue to return their long term average of more than 10% pa.

Clients are well advised to at least consider never selling their homes, even when buying new ones. Just rent them out through a reputable agent and let time do the rest. Those clients who have done this have almost always benefited significantly after a few years have passed, even though the first few months may be a bit tight.

Investing in residential property

Property is a tangible asset, bricks and mortar, something you can see and touch. It exists. It is there. This is a big reason for its popularity. The residential property market is more stable than the share market. Clients are less likely to panic and rush to sell based on short term considerations.

Clients will have more control over property than shares and they can add value to by renovating or rebuilding. Residential property rents usually increase in line with inflation.

There is steady demand for good rental properties in most areas. If the landlord is prepared to meet the market in terms of rent then he or she will almost always find a tenant, and the Sunday papers horror stories are not that common in the real world: most tenants take reasonable care of the property and some take great care, treating it as if it was their own.

Some banks lend all or even more of the purchase price, which means capital is not a barrier to entry and almost guarantees a steady supply of potential purchasers when you come to sell.

On the down side, residential property is illiquid, which means it cannot be easily and quickly converted to cash. You cannot sell the laundry. A house or unit may be slow to sell in a sluggish market. But normally an owner can borrow against the property and this removes some of the liquidity risk.

In addition to the high entry prices, there are many other costs connected to buying and holding residential property. Stamp duty, solicitors’ costs and bank fees all take their toll: allow 7% of the purchase price. And often the already low rental yields are all but eaten up by costs such as rates and repairs, even before interest is considered. Which highlights that residential property is a capital gains play: people buy residential properties expecting them to go up in value. And the Australian tax system favours capital gains over other forms of income, not taxing unrealised gains and only taxing half of that gain when it is realised (assuming the property is held for more than 12 months).

Evaluating an investment property

It’s not just about location, it’s also about timing.

Consider proximity to facilities such as schools, shops, public transport and work places. These can all be important for potential tenants as well as potential purchasers.

Never forget quality. This is crucial. The nature of the materials and the quality of the workmanship both make a big difference to the finished product, and its re-sale value years down the track.

The building must be appropriate to the market. For example, one bedroom trendy apartments may not work in a new family orientated growth area, and a four bedroom family home may not work that well in the middle of the café scene.

But the basic question is this: can you see the property increasing in value? Remember residential rental yields are very low and the only way you will make a dollar is by the property’s value increasing.

Have a look at, the website of James Property Advocates, for detailed information on what you should look for in a residential property investment.

A word of warning on apartment developments

The last few years have seen a trend to inner-city apartment living. All we can say is that there are apartments and apartments, and great care should be taken if you intend to go down this road. Problems abound. These range from the quality of the workmanship, over-supply issues, body corporate management issues, noise and privacy issues and views being damaged as new projects come on line.

In some cases commissions of more than 10% are being paid to the selling agents, which sadly includes many accounting and financial planning firms.

Officers from the National Australia Bank recently told us that they would not lend more than 70% of their assessment of market value (which is usually less than the amount paid) and certain developments were off the lending list altogether due to serious concerns with the quality of the underlying work.

Think seriously before buying an apartment. It is a lot safer to buy something that comes with its own piece of land.

ATO eyes landlords’ claims

The ATO will closely scrutinise landlords’ claims for rental property deductions during the 2014/15 income tax year.

Pilot studies have discovered serious discrepancies in about 85% of claims. The discrepancies include claiming deductions for:

  1. initial repairs, when they are really capital in nature;
  2. improvements, such as bathroom and kitchen renovations, when they are really capital nature;
  3. interest that is not related to the rental property;
  4. say, 11/12s of the cost of a rental property in a holiday area that is not genuinely available for rent for eleven months of the year;
  5. the full cost of travel to interstate locations and not apportioning some of the costs to private purposes.

Property owners who sell investment properties without declaring a capital gain will be subject to particular scrutiny: it is pretty hard to have not made some profit as a landlord in the last 20 years. Depreciation is also high on the agenda. Residential property owners are well advised to engage a quantity surveyor to prepare the property’s depreciation schedule. It is well worth the cost to make sure the deduction survives an ATO audit.

The ATO expects to raise several billion dollars of extra tax from this project.

Capital gains tax on the family home?

The CGT principle residence exemption has long been a cornerstone of the Australian taxation system. There is no basis in public finance theory for this exemption: a gain on the value of the family home is no more or less an increase in “better offness”, i.e. income, than a gain on a rental property. Why should the owner of the rental property pay more tax than the owner of the principal residence in similar circumstances?

The answer is, of course, connected to politics. And hence the family home is sacrosanct.

Or is it? The NSW State Government’s recent stamp duty changes are in effect a capital gains tax on the family home. And the possibility of a more formal and widespread CGT in the family home was raised at the national summit on housing affordability when. Judy Yates, Associate Professor of Economics at the University of Sydney, said that nearly $21 billion in tax revenue was foregone every year due to the principal residence exemption. It’s hard to see a change under a Liberal government. But would a Labour Government see things differently? Would CGT on luxury homes fit in its agenda?

Of course it is already possible for gains on the sale of a home to face income tax. Consider a person who buys a block of land, builds a home, lives in it briefly for a few months and then sells it at a profit, which is what was always intended. It is quite possible that this gain has to be included in assessable income under current law, as part of the taxpayer’s ordinary income, and without the benefit of the 50% CGT discount factor.

Are you thinking of buying residential property?

Interest rates have dropped, auction clearance rates have increased. The median price of homes in Melbourne has increased in the last quarter and is expected to continue to increase due to Victoria’s growing population.

Nonetheless now is still a good time to buy.

Residential property is one of the top performing asset classes over the last ten, twenty and even thirty years. After businesses, it is the main driver of wealth in Australia.

Residential property is a funny asset class. It does not behave the way other asset classes behave. It’s not driven by economics. It’s driven by emotions: lifestyle aspirations, social consciousness, perceive social standing, success, greed, fear and a myriad of other emotions impact the buy sell decision. An increase in interest rates creates fear and a more than proportionate response, skewing the dynamics towards the buyer.  And there is no objective market price, as there is for say shares. The buy sell negotiations are personal and there is plenty of room for psychology. People will sell good assets for bad reasons over the next few months.

Now could be a good time to buy.

It takes nerves of steel to buy when the market is up. Contrarian investment strategies take guts. But that’s where the money can be made. Residential property is a very long term investment: you should be at least working on a ten year time horizon, if not twenty years. And well located properties in good condition will prove to be very good investments over that time frame. Who cares what happens in the first three months after you buy?

Think of your children: a key recommendation to our clients is to have as many residential property investments as you have children. The idea is that the family is the relevant economic unit and it is hedging itself against runaway prices in the future. There is a body of thought that places this as a much better head start than a private school education. Who knows? But it is food for thought.

Think of your tax bill. The property obviously has to stack up as an investment, with the key criteria being location and condition. But once that is ticked off the heavy tax benefits can make the investment sing. The maths of the matter are that most heavily geared residential properties break even on cash flow once the tax break is factored in. This means only modest increases in prices translate to large percentage returns on investments.

We stress buying residential property is a ten to twenty year proposition. Take your time and evaluate the proposal carefully before you commit. Get expert advice if you think it is needed. There is an abundance of good quality information at your local book store

One tip: always buy residential property in your own name or your spouse’s name and “and or nominee”. This gives you 14 days as of right to insert a nominee, such as the trustee of a family trust, into the contract without setting off double stamp duty. The estate agents are familiar with the process here and will have the extra forms for you to sign as nominee easily at hand.

The Dover Group