Blog: The Landlord says...

There is a view that property investing is easy and making money is a given. Well a story today shows how it can all go terribly wrong.

Last year we profiled in the NZ Property Investor Magazine a young man who was doing some amazing things. The guy, Laurence Pope (22), basically bought a street load of houses in the Waikato town of Paeroa as an investment.

He became pretty popular with the locals as he transformed what was referred to by some as a “ghetto” into a much smarter street.

Meanwhile other property investors where pretty impressed with his deeds.

However, things have gone wrong. His parents who acted as guarantors are reportedly in some difficulty and the bank probably hasn’t done too well either.

Bayleys have sold eight of the properties in mortgagee sales to other investors across the region.

The homes sold under the hammer for between $64,000 and $90,000, yet Pope had paid around $120,000 for each of the properties and improved many of them.

It’s sad to see someone who made a difference in a town like this fail, but it also shows some of the risks involved in residential property investing.

On the upside the sale also demonstrates what we talk about in the May issue of NZ Property Investor magazine – that is the return to positive cash flow investing.

The article has a comprehensive table showing readers areas throughout the country where you can find cash flow positive properties. Not surprisingly many of them are in the provincial regions.

According to Bayleys Pope’s Paeroa properties sold on rental yields of seven to 10%. These are well above comparable investments in the likes of Auckland, Wellington or Christchurch, and show that by looking outside the square, there are plenty of excellent investment opportunities available in the residential sector.

I wasn’t expecting an Auckland University think tank on retirement income was the sort of crowd who would drop a bombshell on the Tax Working Group, but that’s exactly what they did yesterday.

The Retirement Policy and Research Centre, headed by well-known superannuation commentator Michael Littlewood released a paper which questioned the accuracy of one of the TWG’s numbers on the property market. By questioning the group’s predictions on the size of the residential investment market it also casts significant doubt over the assumptions made about how much revenue the government can raise by putting new taxes on property investors.

To his credit Finance Minister Bill English was quick to comment on the research and even acknowledged it may mean changes to their thinking.

He says Treasury analysis was showing that changes to property tax would make a smaller contribution to government tax revenue than what was estimated by the TWG.

Pity his side kick Peter Dunne on the revenue side hasn’t listened. He made a speech today with the same old line that changes to the tax treatment of property were likely, to make the rules fairer and more equitable for all taxpayers.

Some of the questions one has to ask is what other fundamental errors did the TWG make? Also one wonders whether they were in fact just a ginger group set up to stir up a debate and prepare Kiwis for radical – and unpopular changes – as opposed to an objective working group.

I know last week’s Blog, where we talked about some numbers produced by the NZ Property Investors Federation. It calculated that if the government goes ahead with changes to depreciation rules for residential property investment then rents are likely to rise. Landlords, it estimates, would lose on average $1750 a year if they lost the tax deduction and this amounted to $34 a week, which would be passed on to tenants.

These calculations provoked a response that that this numbers from the federation where use political statements lacking analysis.

Judging by what we have seen from the Retirement Policy and Research Centre there are questions that need to be asked about the TWG and its plans.

The good news out of this is that maybe there is hope that the government will not be as harsh on the residential property sector as first indicated. We will know on May 20 – Budget Day.

It was pleasing to see the NZ Property Investors Federation come out and put the issue of rent rises on the agenda this week.

For those who missed it NZPIF vice president Andrew King calculates that if the government goes ahead with changes to depreciation rules for residential property investment then rents are likely to rise.

He says landlords would lose on average $1750 a year if they lost the tax deduction and this amounted to $34 a week, which would be passed on to tenants.

There is no doubt that any changes to investment rules will impact on the economics of property investment.

After all it is an economic equation which needs to balance up. There is little point in making an investment if the returns are not there. You need to remember that most investors are after cash flow and income; they are not speculators chasing quick capital gains.

Rents are one of the key inputs into this equation and another, from a cash flow perspective, are depreciation claims.

It seems absolutely logical that if you change the rules around depreciation it will have an impact on rents.

So Prime Minister John Key sounds like he has had some dud advice when he told TVNZ that the advice he has received is that proposed changes will have little impact on rents. (We’re looking to find this piece of advice at the moment).

Likewise arguments that tenants set rent is only part of the picture.

What hasn’t been touched on is that if other changes are made to penalise Kiwis who choose to prepare for their retirement by investing in property then there is absolutely no doubt rents will rise.

Property investors have been inundated with reactionary views on what the government plans to do to them through the tax system.

Now a bit of time has passed since Prime Minister John Key outlined the government’s plans to Parliament it’s worth reflecting on what might happen.

The first point is don’t be lulled into a false sense of security. Key dismissed some of the most distasteful ideas such as “comprehensive” capital gains tax, a land tax and a risk free rate of return method of taxing property.

You could almost hear the sighs of relief from investors.

What hasn’t been said though is what the government will do.

It’s pretty clear residential property investment has been singled out as the great evil which needs to be dealt to.

Apparently we all rort the system, pay no tax and are generally bludgers. What bunkum.

My views on this have been spelt out many times – the underlying premise being investors are business owners providing a service. They should be treated just the same as any other business owner and be subject to the same tax rules.

What’s on the cards?

Changes to depreciation for one. Property investors can live with that. After all it’s really just a timing issue and brings forward some revenue for the Crown.

What I wonder is this: Why the government should make a whole set of new tax rules?

It seems to me that Inland Revenue has had quite some success with its so-called Property Compliance Programme. Under the PCP it has been chasing investors who clearly have been buying properties and flicking them on for a profit.

So far they the programme has raised more than $214 million.

This is just the low-hanging fruit. Surely one option is to clarify the rules here and continue to enforce them.

Clarifying and enforcing these rules is something investors could live with too.

If the speculators’ activities could be curbed that would undoubtedly take some of the pressure off house prices. Particularly for those in lower price brackets.

Residential property investors have been a political target for some time now and today’s report from the Tax Working Group (TWG) made it clear they, unfairly, remain in the sights.

The TWG has put the acid on the government throughout the report and raised ideas which will be clearly more than the government can stomach.

The question that I struggle with is how far would a National-led government be prepared to go and clobber the property investment sector?

There is little doubt in my mind that the vast majority of property investors would vote National or some other party on the right of the political spectrum. To penalise several hundred thousand of its core supporters is the equivalent of political suicide.

National has plenty of political capital to burn, but moves such as the TWG have proposed are like lighting a bonfire.

I suspect there is some “low-hanging” fruit the government can pick. For instance the land tax idea is something that wouldn’t be too hard to do, and could raise a reasonable sum of money.

I am told there used to be a land tax (apparently it was a pink form filled out each year which had to be filed by the end of May).

Likewise changes to depreciation are possible. There is an argument which suggests depreciation isn’t really justified when the asset is generally appreciating. There maybe some instances, such as leaky buildings, where there is a genuine reason for depreciation, and the rules could be made to accommodate this.

Also an increase in GST would mean that property investors paid more tax.

One thing which was good to see is that the TWG didn’t get stuck into the argument about loss attributing qualifying companies. Many commentators have described this as a rort that property investors shamelessly exploit.

I have always had trouble with these arguments. The view being that property investors are in business providing a service (accommodation) to customers. They should be allowed to operate under the same rules as any other business. LAQC’s are legitimate structures for them to use.

This was summed up by the Institute of Chartered Accountants tax director, Craig Macalister, at www.netprophet.co.nz when he queried whether the current “emotion” around property investment was getting out of hand.

“We need to be careful not to fall into the trap of selected taxes for different assets or investments for all the reasons why these were a failure in the past,” he said.

The latest round of house price data clearly shows the market has a strong heart.

Overall prices are up, proving, as I long expected, that the bearish pundits were wrong. They said house prices would fall 30%. While I’m happy to see house prices and activity pick up again there are still plenty of obstacles facing the market.

The obvious one is tax changes – but I promised myself we would not talk tax this week – far too dirty. Instead, the biggest obstacle facing the market may be interest rates.

As our table shows, home loan rates have been rising strongly. Up until recently most of the changes were at the long end of the yield curve, now they are creeping right down to six-month fixed rates.

The only area immune from increase, it seems, are the floating rates. These and many revolving credit rates have been falling to quite low levels. It is clearly the part of the market with strong competition.

The range is from BNZ’s 5.59% for its Total Money product, through to ANZ’s 6.45%.

With revolving credit rates the range is from Westpac’s 5.69% to 6.85% at HSBC.

Adding to the complexity of this market there are a number of lenders with more than one offering. In the past month ANZ has introduced what it calls its “Simple Variable” floating rate which has a few conditions attached, but is competitively priced at 5.69%.

The concern for the property market and house prices is that expectations are building that the Reserve Bank will increase its official cash rate sooner than it has forecast.

There are also growing signs that when the increases come, they will be stronger and higher than many expect.

If this happens it will be like pouring cold water onto a property market that is starting to warm up. We will watch next week’s official cash rate announcement carefully.

Next week we have more of the latest house price data coming out. These numbers are always eagerly awaited, but arguably more so this month.

Everyone wants to know whether the market has bottomed and is going to resume its upward trek or crash again.

As readers will know I have argued in favour of the market at least bottoming or maybe embarking on a slow upward recovery.

Not for one minute do I think we are heading back to the boom times again. Indeed as the lead story in the NZ Property Investor Magazine out next week warns, we are unlikely to see another boom period like the previous one.

The story suggests a back-to-the-future approach maybe the best strategy for investors.

My view continues to be that there are a bunch of factors, such as low interest rates, positive migration etc, which will put a foundation under house prices for now.

However I questioned my view when I looked at this chart prepared by ANZ and presented to the NZ Property Investors Federation conference.

The chart shows that if you believe in cycles and history then there is likely to be a further fall in house prices.

On the upside there are five periods where house prices rose, with the latest from 2002 to 2007 being the longest and strongest.

When house prices fell the downward periods lasted from 10 to 24 quarters and the falls ranged from 5% to 40%.

When you look at the strength of the last boom, prices rose 88% over 24 quarters, but have only fallen 16% over eight quarters then you could quite reasonably be expecting to see a further decline.

My guess though is that in this next round of house data releases we will see further gains. After all that is what the Barfoot and Thompson numbers showed earlier this week.

Optimism is returning to the residential housing market, which has some positive flow on effects to the economy as a whole.

This positive feeling is best shown in recent house sales reports which tend to indicate that we are past the low point of the cycle. From now on it will be a steady upward climb, although not steep.

It was useful to attend last week’s NZ Property Investors Federation Conference in Auckland to gauge the market.

You’d expect a group like this to be positive about things, and that did come through in talking to investors.

However, I couldn’t help feeling that the overall theme from speakers was to be cautious out there. The old cliché being we are not out of the woods yet. Indeed a very good presentation from the ANZ Bank left the clear message that some people may be getting ahead of the market.

Clearly the issues for investors are changing at the moment too. Earlier this year I wrote about finance being the biggest issue for investors. This is less of a problem now, and the biggest one is tenants and how to manage them.

The worst thing that can happen for a landlord is to have an empty property with no rent coming in each week.

I suspect with unemployment rising that this issue will continue to hang over the market for some time.

The message for landlords is that they have to really look after their tenants and keep a close eye on their bank account to make sure rent is being paid.

Too often I hear stories about investors not reacting soon enough when things go wrong. The rules are quite clear around what you can and can’t do, and there is plenty of information from organisations like the Department of Building and Housing and others to help investors. One of these is a series of seminars run by DBH to help landlords get it right.

One of the great things about watching interest rates is the poker game that goes on between the central bank and markets from time to time.

Yesterday’s official cash rate announcement was one of those games.

Everyone agrees we are somewhere near the bottom of this part of the economic cycle, therefore the new question becomes when are things going to turn and when will rates start to rise again?

Following the previous OCR announcement we have seen tentative signs of a very modest recovery; this positive news sent all the economists rushing off to make new predictions about rate rises.

We have seen this through our Experts’ Views on www.mortgagerates.co.nz section where all sorts of scenarios are developed and argued. Few, in fact only one, argued for further cuts.

It seems to be the role of the wholesale financial markets to anticipate Reserve Bank governor Alan Bollard’s next move.

Most had decided he was done cutting the OCR, so their next question was when is he going to start hiking?

Yesterday’s statement illustrates how they have a built-in tendency to get ahead of themselves.

Bollard made it very clear yesterday that he views the signs of recovery as patchy at best and any recovery was weak.

He then went onto say that there may be scope for further easing – so perhaps we are not quite at the end of this part of the cycle yet.

What does this mean for borrowers? Well, the basic message is that continuing to use a short-term fixed rate strategy will still work.

This paragraph in the statement is arguably the most crucial for borrowers:

“We consider it appropriate to continue to provide substantial monetary policy stimulus to the economy. The OCR could still move modestly lower over the coming quarters. We continue to expect to keep the OCR at or below the current level through until the latter part of 2010.”

There is always the caveat things may change, but at the moment the risk to the short-term fixing strategy is low.

Attention will now turn to the wholesale markets. We have seen swap rates creep up slightly as the market got ahead of itself in anticipating rate rises. However, they have come back five to10 basis points after the announcement.

I would expect these rates to ease back some more and it is conceivable home loan rates could fall marginally on yesterday’s news…

If they don’t fall, one thing is for sure; the Reserve Bank has put a cap on any immediate home loan rate increases.

One of the more fascinating stories for property investors this week has been changes at formerly high-profile “education company” Richmastery.

This story reports on a restructuring where the business is transferred from one company to another and the former company is put into liquidation.

Richmastery is one of those organisations which attracts a fair bit of criticism; Often it is labelled as promoters of “get-rich-quick” schemes and even the word “spruiker” has been attached to it.

No doubt some of the criticism is well-founded. Other bits are tall poppy syndrome, or just competitors taking a free-hit.

One does have to acknowledge though, that over the years Richmastery has helped many people get into property investment and succeed.

What is interesting to observe is that the company is not as prominent as it was during the boom years. Its advertising is rarely seen these days. The millions of email I used to get in my inbox have stopped coming.

Many companies have a life cycle and one wonders whether these “property education” companies only last for one property cycle? I don’t know the answer.

It seems there are a number of contenders starting to emerge who are eyeing up the space once dominated by Richmastery.

Of course the other reason Richmastery may have gone through this corporate restructure and left behind a shell company with no assets and $76,000 in debts could be something to do with one of the last comments in the liquidator’s report.

It says Richmastery and Gilligan Rowe are in a legal battle. None of the details are revealed, but no doubt a scrap between the two principals would be one riveting legal battle.