Be alert to rental property cycle

By ANNE GIBSON

The good times for property are leading many to consider the attraction of buying an apartment, flat, unit or house to rent out.

Auckland chartered accountant Nigel Smith, of taxation specialists NSA, says the numbers have to stack up.

Each person, family trust, company or couple's circumstances are different, but he still has some advice for those considering taking the leap.

"At the moment, it is a good time to be buying rental properties but don't get caught up with the hype. In a few years, when your fixed mortgage comes up for renewal, interest rates could be a lot higher and we could be back to having an excess of rental properties again," Smith warns.

"Right now, the rental property market is actually good," he says.

"We have strong tenant demand - almost euphoric - low inflation but increasing house prices and still generally low interest rates. Thus, while inflation is low, we are still seeing house prices moving quite well. But remember that a few years ago, these factors were all the reverse."



But should people mortgage themselves up to the maximum to buy this rental property?

The arrival of negative-gearing advocate Dolf de Roos has left Smith pondering the aspect of borrowing generally.

"Perhaps starting with negative gearing, what worries me is that too many over-commit themselves. They end up using their spare cash to fund the shortfall in a rental property. If a tenant moves out, are they then in a position to cover the rent until they find a new tenant? What if repairs are needed as well?

"I don't have a problem with people having to commit cash towards a negative gearing proposal. The key is to ensure that they have a steady cashflow and can actually afford to cover both the shortfall and any vacant periods.

"About three years ago, there were a number of empty rental properties and landlords really felt the squeeze as tenants moved to get better properties at cheaper prices.

"Most people don't understand that they have to make a certain level of capital gain just to stand still where they are contributing cash to a rental property, net of their tax refund. It would be good to use that example.

"That example also obviously ignores the impact of depreciation recovered, that is, when you dispose of a property there will be some tax liability because the value attributed to the building will give rise to depreciation recovered in most circumstances.

"While it is possible to write down the building value on sale, this has to be done either in the sale and purchase agreement by stating the value on the building and the land separately, or on some form of external evidence by the vendor, that is, a valuer's report or Government valuation to give the appropriate proportions of the sale price.

"I think that what Dolf de Roos is suggesting is actually very smart. I think there are a lot of New Zealanders that are over spending and if they had a rental property there would be a form of committed saving, that is, they couldn't spend the money that they didn't have.

"New Zealanders as a whole seem to be over-consuming. I see this frequently with clients.

"The two issues that I have with Dolf are that he recommends people gearing up to the maximum extent possible and he doesn't consider the impact of a downturn in both rentals and property markets.

"I have seen people gear themselves up to the maximum extent possible by buying property at any stage in the cycle, then to find property values drop and effectively they exceed their gearing ratio over all their properties. They then potentially face a mortgagee sale.

"The second issue relates to cashflow. People must have an adequate cashflow to cover an increase in interest rates, drop in rentals, repairs or untenanted periods.

"When acquiring a rental property, it is also important to get preferably a valuer to split out the chattels component at a purchase price so as to maximise the depreciation claim.

"The benefit of this is that it effectively maximises your tax deduction without spending any further cash because depreciation is a non-cash deduction, that is, you don't have to actually spend any money each year to obtain it.

"This, therefore, maximises your depreciation claim, your tax refund if the property is negatively geared, and therefore the amount of capital gain the property is required to make each year to stand still.

"In terms of entities to acquire a property, I think it is relatively simple.

"If a property is going to run at a tax loss for a few years, then I am in favour of a loss attributing qualifying company (LAQC).

"The benefit of this is that it is easy to transfer shares between shareholders without causing depreciation recovered or any problems.

"Let's assume that we have two young professionals earning over $38,000 each. They decide to buy a rental property between them and own the shares 50/50. In a couple of years' time, one of them stops work to have their first child.

"At that time the shares can be transferred to the spouse that remains working. All the tax loss from that point on will flow to the spouse holding 100 per cent of the shares. If the property had been owned as a partnership, then the loss would continue to pass out 50/50 to each spouse, even when one of them stops working.

Unless a Matrimonial Property Agreement was entered into - yet another visit to the lawyer - there would be no simple way of transferring the property between the two without legal conveyancing costs or potentially adverse depreciation recovered as a tax consequence.

"When, in the future, the property stops making a loss, the shares can simply be transferred to a family trust and the company can cease to be a loss attributing qualifying company.

Capital gains therefore accrue outside of the individuals' names and the profits can either be used to repay debt or ultimately to pay dividends to the trust.

"Alternatively, a further rental property could be acquired at that time with the company either continuing to a loss attributing qualifying company or again the shares transferred to the trust and the company ceasing to be an LAQC.

"Where a property is going to make a profit from day one, then it is better to put it directly into a family trust. ... "

"It is interesting to note that in the past few years there has been a movement towards people acquiring commercial properties as opposed to residential.

"Clearly, there are a lot less tenancy hassles and there is certainly a better yield. While the capital gains might not be as good, they don't need to be because you are not running at a loss each year. Thus, a commercial property can in fact provide the same overall return with a lot less tenant hassle.

"Finally, I clearly believe you have to be careful at what stage you buy any sort of property in the cycle. Interest rates are increasing at the moment and it is likely for instance that commercial property yields will increase as a result.

"As noted, commercial properties are facing an increase in yield with the increase in interest rates.

"This will drop the value of properties generally but nonetheless property remains a long-term investment.

"As long as people are conservatively geared - and commercial properties obviously do have a lower gearing overall as the banks will generally only lend 70 per cent on that property itself, with the balance having to be acquired over a home - then people should be able to ride this out relatively simply."

NSA