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Abolition of Negative Gearing: Potential Impacts on Commercial Real Estate
If you already have property investments or are considering starting a portfolio, you may be nervous about the prospect of negative gearing being abolished in Australia.
The proposals made by Labor mean the benefits of negative gearing for those who would use it for tax minimisation may be cut drastically. This could force investors to turn to other property investment avenues.
Some lingering questions …
What impact will this have on residential real estate investment and what will be the knock-on effect on commercial real estate? Will the changes to negative gearing spark a downturn across the whole property sector? Will the move make commercial property investment a better option for investors?
This article will explore all of these ideas, but first let’s look at what negative gearing is and how it is commonly used in Australia.
What is negative gearing?
Negative gearing is when the interest on the loan used to buy an investment property is higher than the net rental income, after the expenses of maintaining the property. It means a loss for the investor, but current tax laws allow this loss to be deducted from any other income, such as wages, reducing the taxable income for the year, making the investment more attractive.
The end result of this is that investors are effectively earning less income which means less tax to pay at the end of the financial year. Investors can still make a long-term profit on their investment when the value of the property increases to a point greater than the outlay costs.
Investors and financial advisors are always looking for tax breaks and negative gearing allows them to take advantage of this loss. So, negative gearing has become a popular strategy for Australian investors over the years.
Interestingly, negative gearing isn’t allowed in most other developed real estate markets overseas. Many economists claim that negative gearing inflates house prices making it more difficult for first-time buyers to get on the housing ladder.
What are the proposed negative gearing changes in Australia?
Opposition trade spokesman, Jason Clare, has claimed that if Labor wins the election, they will move to abolish negative gearing by January 1, 2020.
The effect on the commercial real estate industry? Those who would normally use negative gearing for tax minimisation may turn to other property investment avenues such as commercial real estate, should the changes come into force.
Who will be affected by the changes?
The restriction will not apply to investors who buy in brand-new or off-the-plan developments. The reason new build properties are not subjected to the changes is because they are seen as being higher risk. This is particularly true if you are buying into the apartment sector. Buying new build or off-plan real estate is seen as a higher risk because anything can happen between when you sign your contract and go to settle.
Labor’s rule change would also not affect people who are currently negatively gearing investment properties. Investments made before the date the new rules are brought into force will also not be affected by this change. Currently, nearly 1.3 million Australians own an investment property that is negatively geared and their investments will be fully grandfathered.
This will mean that Australian taxpayers will continue to be able to deduct net rental losses against their wage income on existing investments.
How will the negative gearing changes affect commercial real estate?
With investing in residential property less appealing for new investors, commercial property investment could become more attractive. Here’s why …
Commercial real estate investment represents higher returns
In general, commercial property provides a higher ROI (return on investment) than residential real estate.
From suburban warehouses to high-rise office buildings, commercial real estate has been demonstrating growing profitability in recent years. Attractive yields appeal to investors of commercial property as it is not uncommon to see yields of 5.5-6% in Sydney.
The ASX/Russell Investments 2018 Long-term Investing Report found that residential property in Australia averaged 8% in gross returns per year from 2007 to 2017. However, the rental yield for commercial real estate, such as warehouses, averages 8-10%, compared to residential rental returns of 3.6%.
Price stability and growth potential
Commercial real estate pricing has historically demonstrated lower levels of price fluctuation compared to residential properties.
If anything, prices tend to appreciate because valuation for commercial properties is determined by the amount paid, and lease agreements frequently allow for rent increases in accordance with inflation.
You and your tenants could agree on a set rate (e.g. 4% per year) or a rate indexed to the consumer price index (CPI). And, over time, this can add up. If you rent a commercial property for $90,000 per year, in five years the rent will be over $109,000 per year, which is a significant increase.
Ability to diversify
As an asset class, commercial real estate is highly diverse. It includes property assets such as:
Investors frequently build portfolios of commercial real estate assets that benefit from important economic and demographic trends, such as investing in:
- Warehouses to profit from the popularity of online shopping
- Data centres to capitalise on the continuous growth in data usage
- Health care facilities to benefit from the presence of an ageing population
- Office buildings or spaces in areas that are experiencing steady levels of population growth
Investors with a budget below $2 million could look at retail or office strata and smaller freehold buildings, provided they have a large enough deposit. Over time, they could step up into industrial warehouses, larger office spaces, and high street retail opportunities.
Investing in commercial real estate presents several benefits, which include the potential for capital growth, diversification benefits, and reliable inflation-linked income.
A variety of property types to spread risk
Commercial real estate is more diversified than residential properties. Not only are there properties of all sizes, but an investor can choose between different sectors, such as:
- Office: Tenant demand, in Sydney in particular, is expected to remain positive. The vacancy rate also fell to 4.1% in January 2019, which is the lowest level of vacancy in over a decade.
- Industrial: The industrial sector remains strong, with technological advances having positive influences on tenant demand.
- Retail: The Australian retail property sector continues to perform well, despite a difficult retail situation globally. A growing population, strong employment conditions, and sustained household spending are underpinning this trend.
By spreading their investments across a variety of asset classes, investors can not only diversify their portfolio. They can also spread the risk. If one market, such as retail, is being adversely affected by economic conditions, the office or industrial markets may be thriving.
While residential tenants may remain in place for an average of six-to-12 months, the average lease for commercial real estate is between three and ten years. This means that commercial real estate investors have a greater certainty of rental income, which supports easier cash flow planning.
Lower ongoing expenses
Unlike their residential counterparts, commercial tenants generally cover (or pay part of) council, insurance, water, and other outgoing costs, so there are fewer ongoing expenses for commercial property investors to be concerned about.
Tenants may add value
With commercial properties, tenants are more inclined to keep the premises well-maintained. They may even improve the layout and structure at their own expense, such as regular painting and even custom landscaping.
This is because they are carrying on business at the property and have clients or customers that they want to attract and impress. These property improvements can add value and may even justify higher rental amounts if a new commercial tenant moves in.
The potential for Tax-Efficient Ownership
If you are a business owner, you can buy a commercial property through your own Self-Managed Superannuation Fund (SMSF) and rent it back to yourself. Now you have the best of both worlds – a business with a long-term commercial location and a tenant who is firmly committed to paying the rent.
There is no equivalent in the residential property market – you cannot use your SMSF to buy your own home.
Commercial property is a hot commodity right now
Returns from office buildings are steadily climbing as corporate conglomerates rush to occupy state-of-the-art high-rises in downtown Sydney and Melbourne. And Australia is actually the second most popular country in the world for companies seeking to establish an Asia-Pacific headquarters.
It will be interesting to see if and how property investment will shift if Labor gets into power and implements such a monumental taxation change, potentially making commercial property investment more appealing to some investors than residential. If so, it may be yet another reason to invest in Australian commercial real estate.
Discouraged by low rates of return on cash assets and now by the possibility of negative gearing being abolished, investors everywhere are directing their attention to commercial property. With blue-chip corporations willing to spend millions on upscale office spaces in prime locations, commercial real estate is a sector worth considering.
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The Labor Party’s plan to limit negative gearing to new housing does not yet have an initiation date, but Prime Minister Scott Morrison has suggested it won’t be until at least May 2019. It remains to be seen if this widely talked-about event comes to pass.
Nonetheless, whether you are new to property investment or building a portfolio, commercial real estate is an excellent and reliable part of any sound investment strategy. It provides a comparatively high yield and lacks many of the downsides that accompany residential real estate.
You might also find this Checklist Before You Buy Commercial Office Space helpful.