The Government has announced big changes for the property market again. The change fueling heated debate is the removal of tax deductibility for investor's mortgage expenses.
Tax bills will be higher under these new laws, which will affect how property investors will leverage their portfolios. Currently, from a tax perspective, the optimal debt level is such that the rental income is equal to costs for the property, maximising the potential write-offs. Without these deductions, landlords will have to revisit the amount of leverage they are comfortable with.
Keep in mind, even without the tax benefits, investors will continue to use debt to purchase properties. The ability to leverage makes property investing quite appealing. You can earn higher returns using borrowed money, but the risk is higher too.
With many considering whether to pay down debt before the tax changes come into effect, we wanted to share some of our ideas. The question is, when should we pay off loans and when we should instead invest elsewhere.
The risks of mortgages
The obvious risk of having a mortgage on an investment is clear. While gains can be magnified, so too can losses. The worst-case scenario is where the property price falls below the mortgage value; selling the house will still leave you with an outstanding loan.
The other clear risk is due to interest rate changes. Rental income may cover costs now, but not if interest rates approach the long-term average, around 7-8%. Getting your mortgage down to a comfortable level may involve estimating the interest costs if rates increased 2-3%.
Other risks include problems with tenancies, unexpected maintenance, natural disasters etc. While these may result in loss of income or decreases in prices for all property owners, a large mortgage can exacerbate the issues. Paying down a mortgage is a sensible approach to reducing these risks.
Returns of shares vs mortgage repayments
We expect the returns from shares to be higher than the interest cost of a mortgage. For those taking a long-term approach, investing extra cash in shares may look more appealing than paying down debt.
Since February 1992, the NZ share market returned roughly 10% p.a. There have been times where floating mortgage rates exceeded 10%, but typically they average around 7%.
However, share returns are very uncertain. The best year since February 1992 delivered a return of nearly 70%. The worst year saw shares dip by a third. There are five-year periods where NZ shares have not delivered a positive return.
On the other hand, repaying a mortgage offers a guaranteed return, as you incur less interest costs moving forward. There is some uncertainty regarding the future movements in rates, but this is small compared to the volatility of shares.
The chart below compares the floating mortgage rate to annual share returns from December 2004 to February 2021.
Floating mortgage rates from www.rbnz.govt.nz. NZ share returns represented by S&P/NZX 50 (gross) index. Past performance does guarantee future returns.
So over the short-term, paying off debt makes more sense to get a certain return. Investors with a longer time horizon may prefer to invest in shares instead of maximising repayments.
Some consideration should also be given to interest rates at the time and the investor's tolerance of financial risk. If your investment portfolio is a diversified mix of shares and bonds, the expected returns may be comparable to mortgage interest rates. In this case, it is usually more sensible to repay the debt.
The case for diversification
One common problem with property investments is the lack of diversification. In order to invest in residential property, you must tie up a significant amount of capital in one property. Even with a diversified portfolio of rentals, each is subject to the same risks (e.g. the new changes in rental laws).
Another reason to invest instead of repaying your mortgages is to diversify your overall position. Assuming the debt is manageable, investing in shares helps spread your risk away from property. If the property market takes a hit, some of your investments will be in a different asset class.
There are a variety of factors to consider when making decisions like these. If the changes in tax laws will put strain on your financial position, it might be time to get rid of debt. Speaking with a financial adviser may help you decide whether it is best pay down debt or invest elsewhere.