The one thing most investors get wrong

Housing affordability continues to make headlines, with a variety of strategies being canvassed to discourage investment in residential real estate. These include reducing the availability of interest-only loans, and Labor's policy of allowing a tax offset against wages and salary only on brand-new investment properties.

Last week's budget tried to dampen investor enthusiasm still further by preventing tax deductibility for travelling expenses for visiting a property, and eliminating the ability to claim depreciation on assets that were part of the original purchase by the use of a quantity surveyor certificate.

There is anecdotal evidence that these measures are having an effect - which is a sad reflection on the mentality of the average property investor. There is a fundamental investment principle that should be framed and hung in every investor's home:

An investment should be judged on its merits; any tax benefits that may come with it should be regarded as the cream on the cake.

I was reflecting on this with my accountant last week when we were discussing the state of the nation in general and the budget in particular. I said, "If I found a fantastic investment property, in the right location, that ticked all the boxes, and I could get it for a bargain, do you really think I would care what kinds of tax deductions I could get?"

He smiled, and responded, "Sadly Noel, most of my clients don't have that mindset."

Obviously, it's time for a refresher course on investment. The main reason we invest is to buy an asset today in the expectation it will increase in value, enabling us to build wealth for the future. There are a wide range of assets in which one could invest, but most experienced investors prefer property or shares because, if well chosen, they should provide good capital growth over the long haul, and an income along the way.

Borrowing is a great tool for anyone investing in growth assets. It enables you to buy the asset now, instead of saving up for it, and also magnifies your net return.

Suppose a person buys an investment property for $500,000, and by using the equity in their own home as a deposit can borrow the entire purchase price on an interest-only basis. If the net yield from the property is 4 per cent, they should receive $20,000 a year in taxable income, and if they can borrow at 4.5 per cent, their cash outlay for interest is $22,500 a year. Their cash shortfall is just $2500 a year, and if the rents increase by inflation the property should be at least neutrally geared within five years, which means it is now costing nothing to own it.

If the property increases by 4 per cent a year, it should be worth $740,000 in 10 years.The debt would still be $500,000 so they have made a pre-tax profit of $240,000 for a minimal outlay.

But that is the perfect scenario. It assumes that interest rates stay where they are, the property is continually rented, there are no big outlays for renovation or maintenance, and the capital gain is 4 per cent a year. There are many people who are facing capital losses rather than gains, including those who paid more than $800,000 for properties in remote mining towns and are now facing losses of over $400,000 a property - or would be, if they could find a buyer.

Note carefully that these examples ignore any tax benefits that might go with the deal. As I said before, they are the cream on the cake. The message is simple - buy the right property and you should do well, buy a dud and you will take a bath. Remember, borrowing magnifies any investment outcome - positive or negative.

Noel Whittaker is the author of Making Money Made Simple and numerous other books on personal finance. His advice is general in nature and readers should seek their own professional advice before making any financial decisions. Email:noelwhit@gmail.com.

The story The one thing most investors get wrong first appeared on The Sydney Morning Herald.

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