Money: Gearing raises risk even with property

Q: I have read some good columns on the risks involved in various geared investments.

However, nowhere yet have I seen a comparison that takes into account that if you borrow to invest in property, the tenant significantly helps pay off your investment. And once the mortgage is cleared, the tenant pays a regular cash amount without hurting your capital investment.

For example: Option one, assuming I have $20,000 now (with no top-ups), let's say I invest with a net return of 6 per cent a year. By my calculations, over 25 years compounding annually I will have $90,987. At a continued net 6 per cent, that will allow me $5549 a year to draw on, without affecting my capital at this point.

Option two is I buy a $200,000 property (two or three bedrooms) in a desirable location with my $20,000 and a loan.

Over the 25 years I manage to maintain it and pay it off without overall contributing any more capital. (Assume tax deductions against salary income in earlier years allows for front-end shortfall etc.)

At year 25 I now will be receiving all the rent, at a modest, say, $10,000 after tax, without affecting my capital.

So my question is: Over the long term, without regular savings over and above paying off my mortgage on my own home and raising a family etc, how can one beat investing in a second property, to provide a better return for that minimal $20,000 investment, in my retirement?


A: Perhaps by making much the same investment, but in a share fund.

Let's start by assuming you've got a fair bit of equity - market value minus mortgage - in your own home.

If not, I wouldn't suggest borrowing a large amount to invest in anything. You'll have too much total debt.

Using your home equity as security, you could borrow $180,000, add your $20,000, and put the $200,000 in a share fund.

If the fund holds New Zealand and/or Australian shares, there's a good chance you'll get as much dividend income as you would rent - especially after you subtract rates, insurance and maintenance.

Dividends do fluctuate. But so do rents. Many landlords have had to lower their rents in recent times. And, when there are no tenants, they get nothing. Also, landlords never know when they'll have to fork out for maintenance. That doesn't happen with shares.

If the fund holds shares in countries beyond Australasia - which I would recommend - the dividends will tend to be lower. At the same time, though, capital gains will tend to be higher.

If your dividend income doesn't cover your mortgage payments, you can sell enough units to make each payment. Your investment should still grow - probably not every year, but over the long haul.

That's one of the beauties of investing in shares or a share fund. You can take a little of your capital gains whenever you need the money. (You may be able to do a similar thing with property, using a flexible mortgage. But it's not as simple.)

Whether you're in a share fund or a rental property, with any luck you'll land up mortgage-free in year 25 with an investment that generates, say, the $10,000 you mentioned.

If history repeats itself, the share fund investment might, in fact, be bigger than the property one.

So why don't more people borrow to invest in a share fund? Perhaps we should ask, why do so many people borrow to invest in rental property?

Probably because they feel safer in bricks and mortar. But, as I've said many times lately, that might be false security.

If you borrow to make any investment, your risk rises. You stand to make more, or lose more.

Any geared investment is not for the faint-hearted.

Q: As much as you are likely to be sick of this debate, I think there are a couple of things that much favour shares over rental properties, given that returns over time are similar:

* With shares you don't have to deal with tenants or rental agents.

* There is no constant investment in time and money for maintenance.

In fact, the biggest effort required with shares is having to take the dividends to the bank, and that occurs only if you don't have them direct credited.


A: You're right on two counts.

First, those are two strong advantages of shares and share funds for many people - although there do seem to be some strange ones out there who like dealing with tenants and fixing houses.

Secondly, yes I am sick of the debate. Because it's Christmas time, let's declare peace between landlords and share investors for a couple of weeks.

After that, though, it's back to the battlefield!

Q: I've just read your latest book, Investing Made Simple - great book by the way!

In one of the chapters you cover gearing to invest in managed funds, such as listed index funds, UK unit trusts and passive NZ-based unit trusts.

I'd be interested in your opinion on the interest deductibility of any money/capital borrowed to invest in either listed or unlisted trusts.

My understanding is that, particularly with the UK-based unit trusts which have little or no dividends, it might be difficult to claim interest costs.


A: It depends. Generally speaking, even if the dividends are small, you can deduct interest you pay. If the dividends are non-existent, you need to look at why they're non-existent.

As I said above, dividends on international share funds tend to be lower than on Australasian funds. Quite often, they are cancelled out by fees. So, in any year, you may not end up with any net income from the fund.

But that doesn't matter, as long as the dividends do exist. And they don't even need to be paid every year.

Staples' Guide to New Zealand Tax Practice gives an example of someone borrowing money to buy shares in a company that pays no dividends in the following five years.

"Even though the company paid no dividends, the interest is deductible provided the company has no restriction in its articles of association preventing the payment of dividends in the future," Staples says.

"Income does not have to be derived in the same income year in which the deduction is claimed, as long as it relates to deriving gross income for any income year."

For further assurance, I sent this Q&A to Inland Revenue to check it out. It said you should make certain your fund doesn't prohibit or restrict the payment of dividends.

How often would there be such restrictions?

KPMG tax partner Craig Elliffe says he doesn't know of any New Zealand or Australian-based share funds that restrict dividend payments.

But some UK unit trusts give investors a choice of income units or accumulation units.

With accumulation units, you don't receive any payments of dividends or capital gains. Instead, that money is rolled up, and the value of your units rises.

Until you get out of an investment in accumulation units, "there is no potential taxable event," says Mr Elliffe. So arguably you would not be able to deduct interest on money borrowed to make such an investment.

Got that? Ready for a complication? There's an argument to be made - and the IRD could well make it - that if you were in an accumulation units investment you should pay tax on any capital gain you make when you get out of the investment.

A counter-argument can be made, too, that you shouldn't pay such a tax. It's one of those iffy areas of the New Zealand tax law that make lawyers and accountants rich, the IRD busy, and the rest of us crazy.

Suffice to say here that if you did end up paying tax on your capital gain, you would be able to deduct any interest you had paid over the years.

A final note: Despite the first paragraph, the above letter wasn't written by my auntie. I swear!

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