Rental Tax Laws - When to Pay Off Debt

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.

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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.

Can Gamestop Be Stopped?

At the start of 2021, shares in Gamestop, a struggling video game retailer, were selling for about US$17. On the 27th of January, the price had reached nearly US$500, climbing more than 1,000% in less than a week. No significant developments within the company or industry had been unveiled, so what caused this meteoric rise?

To explain what happened with Gamestop, we need to discuss shorting. This is when you borrow a stock from another investor, sell it, then buy it back later to return to the lender.

Imagine you borrowed something from your friend, maybe a set of golf clubs. If you expected this thing to become significantly cheaper in the near future, you may be bold enough to sell it. Then you could buy it back later and return it to your friend, making a tidy profit. This is the idea behind shorting stocks.

The high risk is clear. With a typical investment, you purchase something that will make you money through income or capital gains. The worst outcome, if you purchase shares in a single company for example, is the value goes to zero.

With shorting, the returns can be high, but the potential losses are limitless. Imagine you sold the set of golf clubs you borrowed from your friend for $1,000. Maybe you planned to buy a replacement for $750, but the deal fell through. Now they're asking for their clubs back but you can't find replacements. You may have to pay much more to get the clubs back. Even worse, imagine the people who have the clubs you are looking for knew of your predicament, asking for $5,000 or more.

This is one of the problems with Gamestop stock. Currently half of Gamestop stocks are shorted, but in January, more stocks were shorted than actually existed (a symptom of something dodgy going on). If the price went up, the investors shorting the stock would be in some trouble. Even worse, if those holding the stock refused to sell to those shorting, it would become very difficult for them to buy stock to return to their lenders. Even worse again, when each short-seller decides to cut their losses and buy the stock back, this again drives the price upwards.

This all culminates in what is known as a short squeeze, a massive spike in a share's price due to short-sellers trying to get out of their positions.

Enter the WallStreetBets community, a congregation of retail investors on the online forum Reddit. WallStreetBets is a place where investors with a near limitless tolerance of financial risk discuss their investment ideas. A key figure is Keith Gill, who had already invested in Gamestop, believing it to be undervalued.

There are a few reasons Gamestop frequently came up in discussions. First, there was the advocacy of investors like Keith Gill. Also, many of the people on WallStreetBets enjoyed playing video games and saw Gamestop as an important part of their childhoods. Seeing big hedge funds betting the company would fail irked them. When some of these big players publically announced their short positions, such as Citron Research claiming the share price was sure to collapse, many bought the company's shares in defiance.

Someone had noticed the huge amount of shorting going on and they realised the delicate position it put these traders in. Coupled with an almost vigilante attitude, the WallStreetBets community wanted to stick it to the man, forcing hedge funds to take losses by driving the price up. The movement picked up traction and the price began to skyrocket.

The short-squeeze began. Early purchasers reaped huge gains on Gamestop shares, but the community urged each other on, refusing to sell. Melvin Capital, one of the big short-sellers, saw their flagship fund fall by more than 50% in January as a result of the surge of demand for Gamestop shares.

But the story is far from over. Robinhood, a popular trading platform used by retail investors, restricted the buying of Gamestop shares during the frenzy. Investors holding shares could only sell during this time. They faced significant backlash and accusations of protecting hedge funds during the halt. Over the next week, the price fell to below US$60. In mid-feb, it would drop to closer to US$40.

While short-sellers lost huge amounts of money on the way up, the cratering share price hurt many retail investors who bought at the peak. On WallStreetBets, many continue to hold onto their shares, purchased at US$350, with the attitude of martyrdom. For these investors, sticking it to the man is worth it in the end.

The aftermath of this fiasco may lead to a reshaping of the market. A congressional hearing was held on February the 19th regarding the events. Present were Vlad Tenov, CEO of Robinhood, hedge fund billionaire Ken Griffin (majority owner of market-maker Citadel Capital), and Keith Gill, the retail investor who helped kick the whole thing off.

There is a lot to discuss here; was the trading halt on Robinhood implemented to favour hedge funds, or due to capital issues? Is there evidence of illegal trading by hedge funds, leading to more Gamestop shares being shorted than existed? Does the community effort to create a short squeeze fall under market manipulation? How about hedge funds publicly announcing their positions to affect share prices?

With Gamestop shares pushing US$120 as I'm writing this, it seems the story isn't quite over yet. We will have to wait and see.

As a tangent to Gamestop's story, I highly recommend reading through this Q&A thread, where Rick Smith, CEO of Axon Enterprises, discusses how his company found itself targeted by short-sellers. He describes some of the tactics used against the company in order for these large investors to profit off their demise. He goes on to describe some issues in the financial system relating to short-sellers.

Lastly, Dimensional released the short article below regarding how they reacted to the volatility of Gamestop shares. We hope you find it interesting.

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Flexibility in Practice: How We Handled GameStop

GameStop has been front and center in the financial news on account of the stock’s significant price volatility over a few weeks. And that has put it top of mind for many clients, as we’ve been fielding questions on how GameStop’s volatility was handled in our portfolios. This incident serves as an opportunity to highlight how Dimensional’s investment process is built to handle developments within markets, given that many of our portfolios held GameStop in January. GameStop’s rise and fall in price was extreme, to be sure. But our process is built to react systematically to the changes in stock prices that happen every day.

Our goal is to increase expected returns and manage risk in our portfolios so that we can deliver better outcomes for our clients. Therefore, it naturally follows that we should use all the information we have about expected returns, and—given that market prices change every day—we believe a daily process is essential to efficiently using this information.

Size, relative price, and profitability contain information about expected returns. By late January, GameStop had increased in size and relative price rather dramatically. Our investment process is set up to respond to new information about securities and their expected returns on a daily basis.

EXHIBIT 1
Market Prices Can Change Rapidly
Closing price of GameStop (GME) from December 31, 2020-February 10, 2021

At its closing peak on January 27, 2021, GameStop had a market capitalization of $24.2 billion, making it larger than over 200 of the constituents of the S&P 500 Index and as large as Whirlpool and American Airlines combined.

We evaluate stocks daily using many variables to assess long-term and shorter-term expected returns. As the price of GameStop climbed, it quickly moved out of the small cap and value space, becoming a large cap stock. For a dedicated small cap portfolio, we consider that exposure to a large cap stock no longer fits the intended asset class of the portfolio. Importantly, our daily process allows us to consider that in real time as prices change.

In contrast, an index-tracking approach does not have the same flexibility to respond to price changes; by design, an index will wait to respond until its next periodic reconstitution date. Small cap indices holding GameStop quickly saw it become the largest index holding as the stock price increased and generally continued to hold it as the price fell.

After peaking, GameStop’s subsequent fall in price put it in the low profitability growth space of the small cap market, which we exclude across our equity portfolios due to low expected returns. Our daily process allowed us to again respond quickly. By February 3, we had completely sold GameStop from all Dimensional portfolios.

Before the sharp price increase in January, GameStop had been a high revenue earner in our lending program over the previous year due to its high cost to borrow. As we do for all stocks held in our portfolios that lend securities, we work to maximize the revenue received, which we believe benefits the portfolio’s overall return.

The cost to borrow a security also contains information about expected returns. We take that information into account when making trading decisions. In addition, we look to avoid purchasing stocks at loan for high fees, as the expected returns on such stocks are low. Dimensional’s portfolios stopped buying new shares as the information from the high borrowing rate on GameStop indicated a lower expected return.

This example highlights how we implement our daily process each and every day. However, what we did with GameStop is not unique to this situation. We regularly use new information about expected returns in a flexible manner to maintain consistent exposure to higher expected returns. GameStop is a case in point of how quickly prices can change and the importance of a robust implementation process that can be nimble and respond systematically.

Insider Trading And The Cost Of Borrowing Shares

At the start of this year, while COVID-19 was beginning to reshape the world, a number of US senators became embroiled in scandal.

During the 2020 Congressional insider trading scandal, several US senators sold large quantities of shares prior to the market crash, allegedly using knowledge given to them at a closed senate meeting. The investigation is ongoing.

These allegations are particularly heinous, as the trading came at time when the US government was largely downplaying the seriousness of the pandemic. The trading activity seemed to go against the message being sent to the American people.

Prior to the 2012 STOCK Act, which prohibited using non-public information for private profit, insider trading was not uncommon for high-ranking members of the US government. A 2019 study showed politicians outperforming the market by 20% from 2004 to 2010, with high ranking Republicans outperforming by 35%. Following the introduction of the STOCK Act, the investment performance of politicians started to look similar to that of retail investors.

In developed share markets, the regulator keeps an eye out for unusual transactions. In NZ, a few cases pop up, such as one last year. The infrequency of such cases shows the FMA is doing a good job ensuring the public has trust in our stock markets.

Analysing the data implies some degree of insider trading in global markets, if you know what to look for. The cost of borrowing shares is one indicator.

Borrowing shares is an important part of short-selling, a method by which you can bet against a stock. In essence, short-selling involves selling a share today and buying it at a later date. This requires borrowing the shares from another investor, selling them at today's price, then paying the original owner at the market price in the future.

The borrowing cost incurred is a fee paid to the owner of the shares. These fees are determined largely by demand, or how many investors want to borrow that particular stock, how many shares they want to borrow and how quickly they want to borrow them.

If you had information not yet known to the public which, when released, would cause a company's share price to drop, short-selling would be the perfect way to take advantage of this. You could sell some borrowed shares before the announcement, while paying the lower price back to the share lender after the fact.

An increase in short-selling leads to an increase in borrowing costs for the company's shares. Not only has this been observed in global share markets, Dimensional research shows shares with high borrowing costs tend to underperform their peers over the short-term. It seems some investors are benefitting from information before it is made public and included into the share price.

Dimensional incorporates this research into their portfolio strategies by screening borrowing costs of shares. They avoid the purchase of shares with high borrowing costs in the short-term in order to provide higher expected returns to clients.

I have included below a short piece by Dimensional, including a link to the research regarding this topic.

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Securities Lending Fees as a Short-Term Driver of Stock Returns

Securities lending involves the owner of a security (the lender) temporarily transferring ownership of the security to an investor (the borrower) in return for compensation. Traditionally, the value added from securities lending comes from the revenue generated from the fees lenders receive from borrowers. Dimensional has engaged in securities lending for many years in its efforts to enhance returns for fund shareholders. Research by Dimensional shows that market participants may be able to further enhance their investment outcomes by using information from prices in securities lending markets to identify short-term differences in expected returns across stocks.

We examine the informational content embedded in securities lending markets by testing the relation between the price to borrow stocks, or borrowing fees, and subsequent stock performance. Using data from 14 global securities lending markets1 for 2011-2018, we find that stocks with high borrowing fees tend to reliably underperform stocks not on loan over the next several days, and that this relation is more pronounced within small cap stocks.

High fee stocks that remain high fee one year later tend to drive this underperformance. Our research shows, however, that the persistence of high fees is not systematically predictable. While the relative magnitude of borrowing fees and borrowing utilization contains some information about the likelihood of high fees to persist, their predictive power is not sufficient to reliably identify which high fee stocks will remain in that group over time.

To incorporate these research insights into a robust investment process, we need to carefully balance the tradeoffs between expected return, revenue from lending activities, diversification, turnover, and trading costs. Our findings suggest that turnover and costs can be potentially high if buy and sell decisions are triggered by stocks crossing frequently the high fee threshold. Instead, we believe that an efficient approach to incorporate the information in borrowing fees into a real-world investment process is to consistently exclude from additional purchase small cap stocks with high borrowing fees.

View the research on SSRN

1 The following countries are included in the analysis: Australia, Canada, China, France, Germany, Hong Kong, Japan, Korea, Malaysia, Singapore, Sweden, Thailand, Turkey, and United States.