Australians have long had a love affair with direct residential property and many baby boomers have done reasonably out of it. But federal Treasurer Peter Costello has changed the landscape at a time when property does not look that attractive.
The result may be a seismic shift over time as diversified superannuation growth funds become the investment of choice for those wanting to build wealth.
The cut in the personal tax rates and the increase in the thresholds announced in the budget have reduced the attractiveness of gearing as a wealth-creation strategy. Meanwhile, superannuation has got a new lease of life following the abolition of tax on superannuation benefits withdrawn by those aged 60 and the end of reasonable benefit limits.
To illustrate this new world order, let's in the first instance analyse the impact of tax, investing in the same growth strategy by gearing into a managed fund, on the one hand, or salary sacrificing into a superannuation fund on the other.
Assume that under the gearing strategy, the investor borrows $100,000 at 7.5 per cent a year for 10 years. All distributions are reinvested and the investor funds the after-tax cost of borrowing plus tax on distributions from after-tax income. For example, an investor at the top tax rate, making various assumptions about the taxable distribution, will be paying $6,261 in year one to fund the after-tax interest costs and tax on distributions. Alternatively, if we gross this amount up by the investors' tax rate, the investor could have made a gross contribution to a super fund of $11,702 in year one. If we assume the pre-tax nominal return in both cases is 9 per cent a year, the results of these two strategies for investors in different tax rates over 10 years are shown in the table. The results assume the loan has been repaid and capital gains tax has been paid in the case of the gearing strategy.
Super gives a better result than gearing for investors on the top two marginal tax rates. On the 31.5 per cent rate, gearing produces a better result, however, it is questionable whether the extra return offered by gearing is sufficient to justify the extra risk. If the investor geared into a residential property producing the same return, the conclusion would be essentially the same. However, the assumption that residential property returns are likely to be comparable to a diversified growth fund is at best highly optimistic over the long term.
These changes to super have come at a time when the property market is struggling along the eastern seaboard. This is clear from some recent comments from one of the more realistic and respected commentators on the property market, Neil Jenman.
Jenman uses two primary measures to predict what will happen with residential property. The first is affordability and the second is yield. He says when the percentage of an average family income needed to pay the average mortgage exceeds 30 per cent, then they are in real danger. At the moment, in New South Wales, the affordability percentage is at 37 per cent and nationally it is 33.2 per cent. The point here is that property cannot keep going up when it has already gone way beyond the ability of the average person to pay for it. Jenman says it will have to fall or, at the very least, remain stagnant, leading to the inflation-adjusted price to drop significantly. Then there is yield. Jenman highlights that yields are still low - typically about 3 per cent in Sydney. Take off holding expenses of at least 2 per cent and the yields on many properties are close to zero. Low yields and less potential for capital growth is a pretty ugly combination. You suddenly have a world where a mainstream super growth fund is significantly more attractive and the prospects for real estate are less enticing. That's why wealth accumulators may be more interested in getting their head around super.
For investment markets this may have more voluntary super dollars looking for a home on top of the mandated super that already provides a base level of demand. This liquidity is good news for equity markets as it ensures continued demand for shares in quality companies, helping the market overall. That said, it does not mean markets cannot fall and after such a dream run over the past few years the next phase is likely to be more volatile. The bottom line is super is now very attractive. While quality property in growth locations purchased at a reasonable price will always have a place in client portfolios, it may need to make room for a new neighbour. Expect both wealth accumulators and pre-retirees to take a much closer look at how to optimise super strategies. You might find dinner party conversations move away from property prices to the excitement that is super. Now there's a crazy thought.
