Mary Holm 's Opinion

Mary Holm is a personal finance columnist for the NZ Herald.

Mary Holm: Borrowing can be good - or horrid

10 comments
Heavily geared property investments can return more than shares, but they can also go badly wrong

A highly geared investment can be likened to Longfellow's little girl with the curl on her forehead. When gearing is good it is very good indeed, but when it is bad it is horrid.
Photo / Getty Images
A highly geared investment can be likened to Longfellow's little girl with the curl on her forehead. When gearing is good it is very good indeed, but when it is bad it is horrid. Photo / Getty Images

Q: You were wrong in a recent column. Property is the most favoured investment in New Zealand, but not because of tax but because of the availability of finance.

Property investors can finance up to 90 per cent of the asset cost. Whether that is prudent or not is a separate issue. Shares - and not all of them - can be margin traded, but not usually more than 40 per cent and only on the market leaders.

The other critical difference is that dividend imputation credits create tax losses, but are not refundable in cash.

Assume a property investment of $200,000 with $10,000 rental income net of costs but before financing, and a share with the same dynamics, with dividend income of $10,000. The property will only require a $20,000 investment, the share $120,000.

Assume the capital gain is inflation only - say 2 per cent a year, which grows the $200,000 by $4000. Also assume top marginal rates of tax, and interest at 6 per cent a year.

If we work through the example, the return on the $20,000 put into property is 17.32 per cent, while the return on the $120,000 put into shares is 6.24 per cent.

If interest rates increased to, say, 8 per cent, the return on the rental drops to 5.26 per cent, due to the excessive gearing. On the share portfolio, assuming the imputation credits can be refunded, the return is 2.01 per cent.

At, say, 12 per cent interest rates, the property investor loses $3772, or put another way has to get a 4 per cent capital gain to break even. The share investor makes 0.22 per cent.

A: I wasn't wrong, just addressing a different question. I said shares and property are taxed in much the same way, and they are. You're looking at how much an investor can usually borrow to make an investment.

As an aside, many share investors can borrow up to 100 per cent to buy shares if they have a revolving credit mortgage - or an obliging friend or relative. But you're right that if they are using the shares themselves as security, they can usually borrow only about 40 or 50 per cent. And I'm told the vast majority of share investors don't borrow at all to make their purchases.

This is probably a good thing. If we look at shares and property, without any borrowing for either, property is usually a somewhat lower risk and lower return investment.

When we add borrowing - often called gearing - that raises both expected return and risk. And the bigger the percentage you borrow, the higher the risk and return. So a heavily geared property investment, as in your example, will have higher expected return and risk than the more lightly geared shares.

And that's exactly what you found. In good times, with fairly low interest rates, the property did better. But raise the interest rate to 12 per cent and the shares fare better - even though 0.22 per cent is pathetic. If we included an ungeared investment, it would of course do best of all when interest rates rise a lot, as it would be unaffected.

The story is similar if other things go badly. Let's say instead of gaining, the value of our investments in property or shares fell.

That may not matter much if the investors can keep paying the interest and other expenses and hold on until prices rise.

But what if our highly geared property investor loses his job - or his tenants do damage, or the property is leaky or has to be decontaminated after use as a P lab, or something else goes wrong - and he has to sell in a hurry for a low price? His sale proceeds may be less than the mortgage. He not only loses his entire investment, but he's left with a debt to the bank.

A somewhat similar thing can happen to a geared share investor. If the value of the shares falls much, the sharebroker makes a margin call, which means the investor must deposit more money or sell some shares. But the ability to sell part of a share investment, and to do it quickly, makes a big difference. A broker tells me that geared share investors almost never lose their investments and still owe money.

In any case, as we've said, investors in shares rarely use gearing, whereas investors in rental property rarely don't. And with an ungeared investment, the worst that can happen is the asset becomes worthless. You don't also have a debt.

A highly geared investment is like the little girl who had a little curl right in the middle of her forehead. When gearing is good it is very good indeed, but when it is bad it is horrid, (with apologies to Henry Wadsworth Longfellow).

What you're saying, then, is that it's easier to borrow to invest in property than shares, and that boosts property returns. Yes, but it also increases the chances of a really bad outcome - as we've seen in recent years.

On your other point, it's true that imputation credits are not refundable in cash. The shareholder can use them only as a credit against other taxable income. But surely most share investors also receive a salary, income from self-employment, interest income or rent. If their only source of income is shares, they are probably too undiversified anyway, and should move some of their money into other types of assets.

Taxation advice

Q: Mary's advice on taxation of rental property versus taxation on shares is not strictly correct. Ownership of international shares listed outside the NZX and ASX are taxed quite differently from New Zealand property/rental assets. In effect there is an implicit capital gains tax being applied to shares owned in international companies.

You're right, in many situations. But I'm writing a column for people to enjoy over their Saturday morning coffee, not a textbook!

So far, readers commenting on that Q&A have pulled me up for not going into:

• Details on tax on capital gains on New Zealand property or shares.

• How easy it is to borrow to invest in property and shares.

• Tax on international shares.

I was aware of all those issues as I wrote. But none of them affects the main point, that New Zealand property and shares are basically taxed the same. If I'd detoured into the other stuff, I may well have filled the entire column, and lost a huge number of readers en route.

Now that we're in a separate Q&A, here's a quick summary of tax on shares that aren't either based in New Zealand or based in Australia and traded on the Aussie stock exchange:

• People who directly hold $50,000 or less of such shares normally just pay New Zealand tax on dividends received - unless their gains are taxable, as explained last week.

• New Zealand-based funds (including KiwiSaver funds) and people with larger holdings are subject to the fair dividend rate, or FDR.

If the value of their foreign shares, including dividends, falls over a year, they pay no tax. If the shares - plus dividends - grow less than 5 per cent, they pay tax on the actual growth. If the shares and dividends grow more, they pay tax on 5 per cent.

It can get pretty complicated when someone trades foreign shares during the year. No wonder most people get their accountants to work out this tax.

Luckily, most New Zealanders with offshore share investments do it via a managed fund, so the fund manager handles the tax for them.

Which leads to my main point: While New Zealand property and shares are taxed similarly, and international shares are taxed quite differently, many New Zealanders still invest in international shares. That suggests they don't think those shares are a bad deal when compared with local rental property or shares.

Personally, most of my long-term savings are in international shares for two reasons.

Over long periods they tend to bring in high returns, and they offer great diversification.

Even if they were taxed more heavily than other options - which is the case in some market conditions and not in others - I reckon these other advantages more than make up for that. If you don't agree, you can always stick with New Zealand investments.

Tax should never be the driving force behind investment choices. For one thing, tax laws change. But in any case, what matters is not tax but risk and return, after tax and expenses. Overall, I think international shares do well.

On KiwiSaver

Q:Mary, will you ever desist from your KiwiSaver ramblings? Are you going to tell your readers that the Government has stopped contributions until 2020/2021 and that their contributions are just being funnelled into a great big hole?

What also happens when fees and a few more crises reduce their $20 a week to a payout of $10 in 20 years' time?

The fact of the matter is for the majority of the muppets who are investing in this scam they will be lucky to end up receiving $1.05 to their dollar after 20 years of investing.

It is a good form of compulsory saving, but that's all it is. Don't hold it out to be anything more. The returns will be abysmal. I stand to be corrected but I guarantee in 20 years I'll be right not you.

A: In answer to your questions at the start: No. No. And - assuming your third sentence refers to the KiwiSaver tax credit - that has already dropped to $10 a week.

At the risk of making you even crosser, it's letters like yours that convince me I need to write more about KiwiSaver because of widespread misunderstandings.

For a start, in your second sentence you are muddling KiwiSaver and the NZ Superannuation Fund, or Cullen Fund - which is set up to help the Government fund retirees' NZ Super in future. It's a totally different concept. And, by the way, that great big hole contains more than $22 billion of assets.

The halving of the maximum tax credit certainly does make KiwiSaver somewhat less attractive. But only somewhat. If the tax credit dropped further, or disappeared, the deal wouldn't be as good, and some people might take contributions holidays.

But they could still watch their savings grow, glad that they took part in KiwiSaver in its heyday.

As for your 20-year forecast, I'd be happy to take you on, but 2027 is a long way off. So I've made a note to get back to you on KiwiSaver's 10th anniversary, in July 2017.

Meanwhile, my own KiwiSaver account balance is almost double what I've put in - despite being invested fully in shares through the global financial crisis. And I'm self-employed so I don't get employee contributions. Many have done better still.

But hey, don't change your mind. It's great that we taxpayers don't have to pay for Government contributions to your KiwiSaver account.

Mary Holm is a freelance journalist, part-time university lecturer, member of the Financial Markets Authority board, director of the Banking Ombudsman Scheme, seminar presenter and bestselling author on personal finance. Her website is www.maryholm.com. Her opinions are personal, and do not reflect the position of any organisation in which she holds office. Mary's advice is of a general nature, and she is not responsible for any loss that any reader may suffer from following it.

Send questions to mary@maryholm.com or Money Column, Business Herald, PO Box 32, Auckland. Letters should not exceed 200 words. We won't publish your name. Please provide a (preferably daytime) phone number. Sorry, but Mary cannot answer all questions, correspond directly with readers, or give financial advice.

- NZ Herald

Mary Holm

Mary Holm is a personal finance columnist for the NZ Herald.

Mary Holm is a columnist, best-selling author and seminar presenter on personal finance. She is also a director of the Financial Markets Authority and the Banking Ombudsman Scheme, and holds an MBA in finance. Previously she was business editor of the Auckland Sun and Auckland Star, and has worked for the NZ Listener, Australian Financial Review and Chicago Tribune. She has been called “The nation’s favourite investment agony aunt.”

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