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Returning expat and looking to invest? Your property market primer

August 12, 2014

Here's a summary of the Australian property market for those who might have been away for a few years or are recently settled, are thinking of investing, and need to get up to speed.

In the first instance, know that you will be following a well-worn path. Residential property investment is very popular in Australia. Around 30 per cent of Australians rent and 80 per cent of the rental stock is supplied by, according to the tax office here, an army of nearly 2 million private – mums and dads – investors.  Australia’s population is growing fast – around 2 per cent a year – driven by strong net immigration. Many of these new arrivals opt to rent.

Although Australia is a huge land mass, 65 per cent of the population live in one of the eight state or territory capital cities. Land values are therefore high and, in conjunction with restrictive planning rules, supply is perpetually struggling to keep track with demand, despite significant building activity.

These fundamentals are by-and-large the friend of a prospective investor; but they also present dangers as well.  There is a bewildering array of investment opportunities available to the prospective landlord, ranging from the traditional older-style houses in the established suburbs of our capital cities, through to new developments – typically high rise apartments in and around the city centres or housing developments on the fringe of the cities. The investor’s choice of asset type will heavily influence whether they make a success out of investing.

Tax is a critical variable for individual investors and in the way it influences – or distorts, depending on your point of view – the market as a whole.  But the interplay of difference taxes can make it difficult for the inexperienced investor to judge how to respond. For instance, buy an established or second-hand property and you’re subject to a stamp duty of between 3 and 5 per cent.  New or yet-to-be-built (locally known as off-the-plan) property is often entitled to major discounts on the base rate.  This alone steers many people towards new property (usually a fatal mistake, in our view).

Negative gearing

But, there are also tax implications around holding a property and exiting the property.  Annual net earnings from property investment are added to an individual’s overall earning and taxed at their marginal tax.  If you make a loss on a rental property i.e. the gross rental income is lower than holding costs such as the interest on the loan, management and maintenance fees, then this loss is tax-deductible.  Curious as it may seem from overseas, well over a million Australian investors made a loss on their investment in 2011/12, and claimed $8bn in rental losses.  This is an intended strategy – known as negative gearing – rather than a nation inept at being landlords.

The reason this occurs relates, in part, to the final piece of the tax jigsaw – the treatment of capital gains.  In Australia, capital gains for investment properties are taxable, but only when the property is sold. Further, these capital gains are taxed at a far more favourable rate – i.e. lower – than income. Consequently, investors are incentivised to minimise rental income and seek capital growth.

Note that the tax situation accentuates what rational, well-informed investors would do anyway – invest in property that has a propensity to reap capital gains.  With the help of leverage, it is capital growth that delivers the wealth investors want.

As such, we steer our clients towards assets where the fundamentals are stacked in the property’s favour; where demand is strong and supply is constrained. We tend to buy two-bedroom older-style houses and one- and two-bedroom apartments in small older-style apartment blocks on leafy residential streets within two-to-12 kilometres of the Melbourne CBD (The city could also be Sydney or Brisbane).  Because these properties are close to employment opportunities and in areas replete with amenity-generating infrastructure, there are always more people who want these properties – both to buy and rent – then there are properties available.

We avoid new properties – be it in the city centres or on the fringe 50 kilometres from the CBD.  Invariably, buyers pay a premium over fair value for a new property. The property can lose 10-20 per cent of its value in the resale market. Moreover, there is no scarcity value in these properties. In many locations, there is a glut.  This has negative implications for finding tenants, the level of rent and, in the longer term, capital growth.

Investors have to be very disciplined to follow this advice to stick with older properties, as developers employ large marketing budgets and tricks to lure the unwary.  Financial advisors often receive large commissions to encourage their clients to buy new properties and developers will guarantee the level of rent for a period of time.

Investors are also enticed to buy into more exotic investments – such as housing for defence staff, short-stay apartments and accommodation for miners in remote locations. All may seem attractive on the surface but they rarely have the qualities to make good long-term investments.

Note that there are restrictions on people from overseas investing in Australian property.  Put simply, non-permanent residents aren’t allowed to buy established property.

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