This article is a no-frills, cold hard look at the cashflow reality facing heavily leveraged residential property investors who are holding properties that are not new builds. If this is you, the question we’re looking at is whether you need to make some tough decisions to sell and retire debt.
So, this is the deal.
Many residential investors have a portfolio of disallowed residential property, funded by debt that’s now subject to the deductibility of its interest being progressively disallowed.
Since the removal of interest deductibility, we’ve seen interest rates more than double. This means we’re now seeing rates generally being re-fixed at 6.5% or more, if you’re subject to commercial lending criteria.
We also may not have seen the end of interest rate rises as the reserve bank grapples with inflation.
As we enter the 2024 year, 50% of the actual interest incurred by these property owners is non-deductible. In 2025, 75% of the interest won’t be deductible, and in 2026 none will be deductible.
This means that, as they roll off fixed rates, many residential investors are seeing their interest bill double at the same time as they see their tax bill rise to levels never seen before. Essentially, they’re on a ‘taxable income’ that doesn’t exist, and in fact probably represents a cashflow deficit – particularly if the bank also insists on principal repayments.
Bear in mind that many investors will also experience their new tax bills as a double hit. They’ll find themselves liable for the previous year’s terminal tax and – for the first time – also liable for next year’s provisional tax where they’ve crossed the threshold of $5,000 for the first time.
So, these investors are caught in a two-pronged hit. The impact of interest rates doubling and tax increasing due to the deductibility being removed.
This is also happening at a time when lending criteria for property investors has never been tougher. Stress testing of income to qualify for debt is happening at unprecedented levels, meaning that many investors simply wouldn’t qualify again for the debt levels they currently have. Banks are now much more inclined to impose principal repayments on lending, which requires more money that can’t be found from a portfolio that’s trading at a cash deficit after tax.
Now, here’s the thing I hear a lot. “Don’t worry, the National Party have promised to restore interest deductibility, so all will be well”.
For many property investors, this promise has become the perfect excuse not to focus on making the changes necessary to cope with the impacts of the removal of interest deductibility, which is the law in place now. Many have their heads in the sand and have not even projected their cashflows.
The departure of Jacinda Ardern means the election result now looks to be anything but a forgone conclusion. There are coalition possibilities on the left that more or less match those on the right, with the prospect of New Zealand First or the Māori Party potentially holding the balance of power.
It would be a brave man that would predict an election outcome right now.
And, even if National do get elected, it’s likely that actually repealing the interest deductibility law could take a year or two. It’s unlikely to be a high priority, and the effective date for the law change would probably be 1 April of the following year.
So, for any investors facing a cashflow crunch, now is not the time to wait and hope things change. The question is, what do you need to do?
Firstly, don’t assume you can simply increase your rents to cover it. During a recession, and with the cost of living as high as it is, your tenants on fixed incomes are the ones who are hit hardest. They probably can’t afford a rent increase and you simply can’t squeeze blood from a stone.
Step 1 is to project your interest bill out over the next 4–5 years, based on when your existing low fixed rate loans mature.
Step 2 is to then estimate your tax bill based on that same interest no longer giving you a tax deduction beyond the 2025 tax year.
This exercise will reveal whether you have a cashflow deficit from the portfolio. If you do have a deficit, you’ll need to consider how you can fund it.
If you’re reliant on using lines of credit that are associated with the portfolio that’s causing the cashflow deficit, you’re effectively digging a deeper and deeper hole.
You’re also running the gauntlet of whether a lending review could result in those lines of credit being cancelled by the bank if you can no longer meet their qualification criteria.
The best plan is to talk to your broker, who sits between you and the lender. They can help you get to grips with whether you still fit the lending criteria, so you can clearly see your level of financial vulnerability.
This scenario may lead to the conclusion that you need to sell some property to reduce your debt and correct the loss position and the tax position.
The question then becomes, what assets are best to offer up in a market that’s as weak as we’ve seen it in decades?
It’s going to be hard to find a buyer for multi-income properties that don’t meet the new build definition, as there are very few investment buyers about because of the tax settings.
Run down rental properties will often need money spent on them to achieve a sale in a weak market.
This means it’s likely to be a pretty gloomy picture as to what price you can achieve in this situation. Gaining a sale will mean meeting the market, as painful as that might be.
One thing is certain though. Calculating your position and facing it head on (and, in so doing, retaining control of your own destiny), is far better than hitting the financial wall and finding yourself at the mercy of a lender who’s only interested in getting their mortgage repaid.
If you’re in this position, I urge you to do the work now to get clarity on your cashflow projections. Don’t wait and hope for a change of government to return the deductibility and fix the challenges we currently face.