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BUDGET 2018

In the 2017-18 Federal Budget the Government announced a number of significant changes that potentially impact on property investors and owners. Some of the key changes likely to have the widest impact are discussed below.

Travel deductions

Treasury Laws Amendment (Housing Tax Integrity) Bill 2017 contains amendments aimed at preventing rental property owners from claiming a deduction for travel expenses.  These changes are now law and apply to travel expenses incurred from 1 July 2017.

The rules prevent a deduction from being claimed for a loss or outgoing if it relates to travel and the expense is incurred in gaining or producing assessable income from the use of residential premises as residential accommodation.  The term "residential premises" takes its meaning from the GST system.

The purpose of the travel is not really relevant under these rules.  They simply prevent a deduction from being claimed if the travel is undertaken in connection with a residential rental property, which could include travel to inspect the property, undertake repairs, collect rent or meet with real estate agents.

The restriction would apply to transport costs (regardless of the mode of transport used), meals and accommodation expenses incurred in relation to a residential rental property.  

There are some exceptions to these changes.

Firstly, the rules will not prevent a deduction from being claimed if the expense is necessarily incurred in carrying on a business.  This means that if a client carries on a business of renting properties they can still claim a deduction for travel expenses that relate to their rental activities.  Also, the rules do not apply to certain entities including:

·         Companies

·         Superannuation funds, except SMSFs

·         Managed investment trusts

·         Public unit trusts

·         Unit trusts or partnerships, but only if all unit holders or partners fall within one of the categories above.

In addition to the rules that will prevent a deduction from being claimed, the changes will also ensure that these travel expenses cannot be included in the cost base or reduced cost base of a property.

Depreciation deductions

The changes apply to depreciation deductions that would otherwise arise in the 2018 income year onwards.  However, the new rule should only apply if:

·         The asset was acquired at or after 7.30pm on 9 May 2017; or

·         The asset was acquired before this time, the asset was first used or installed ready for use in the 2017 income year or an earlier year and the asset was not used at all for a taxable purpose in the 2017 income year.

In broad terms the rules prevent depreciation deductions from being claimed in relation to these assets if any of the following apply:

·         The asset has been used by another taxpayer (other than as trading stock) before the taxpayer started the hold the asset;

·         The asset was used in the current year or a prior year in residential premises that were a residence of the taxpayer at that time (doesn't need to have been their main residence); or

·         The asset was used for a non-taxable purpose in the current year or a prior year, unless that use was occasional.

Presumably in response to concerns raised by stakeholders as part of the consultation process around these new rules the Government has introduced an exception which is intended to apply to off the plan purchases.  That is, someone who acquires a newly developed property may still be able to claim depreciation deductions for the assets that were sold to them with the property if certain conditions can be met.

 

Main residence exemption

 

In the 2017-18 Federal Budget the Government announced that the main residence would no longer be available to foreign residents or temporary residents.  While exposure draft legislation and explanatory materials were released in July 2017, we have not yet seen any legislation entered into Parliament in relation to this proposed change.

 

The way the rules are set out in the exposure draft legislation is that a taxpayer will not generally be able to claim any exemption under the main residence rules if they are a non-resident at the time of the CGT event, even if they were a resident for some (or even most) of the ownership period.  On the other hand, if the taxpayer is a resident of Australia at the time of the CGT event then the normal main residence exemption rules apply, even if they have been a non-resident for some or most of the ownership period.

 

Interestingly, while the original Budget announcement indicated that the exemption would no longer be available to temporary residents, there was no mention of temporary residents in the exposure draft legislation. It is not clear whether this means that the Government has changed its approach or whether this was merely an oversight.

 

Special amendments are also being introduced to deal with deceased estate scenarios and special disability trusts.

 

As announced in the Budget, it is expected that someone holding property at 9 May 2017 can apply the current rules if the CGT event occurs on or before 30 June 2019.  This gives non-residents some time to sell their main residence (or former main residence) and obtain some tax relief under the main residence rules.

 

Further details will be released in relation to these changes. 

 

From 1 July 2018, the Australian Government will introduce the option of contributing the proceeds of downsizing your home into superannuation.

If you are considering the sale of your dwelling which is or has been your primary residence, the new measure will apply where the exchange of contracts for the sale occurs on or after 1 July 2018. 

But before you decide to make a downsizer superannuation contribution you should check your eligibility for making the contribution . There are a number of considerations to weigh up and the devil is in the detail.  The member must be over 65 years of age.  The property itself had to be the member's residence at some time prior to disposal of the home and it must have been owned for at least 10 years.  Capital gains tax may apply if the property was rented at any time during the ownership.  For more details about the new measure see the ATO's website

The second thing to check is your Self Managed Superannuation Fund Deed and the Deed's Provisions. The Deed will need to have express working that allows its members to make these contributions. Age of the member and employment status may preclude the contribution, depending on your individual Deed.  It is important that you seek advice if you are uncertain about the wording of your Deed's provisions, or if you wish to update your current deed to take advantage of the new SMSF downsizer measure.

In addition, the Deed must provide for appropriate reporting to the Australian Taxation Office as the SMSF will need to receive advice from the SMSF and report those contributions to the ATO by submitting a downsizing contribution form.  The ATO will be running verification checks on eligibility and on the amounts contributed.  Those amounts could potentially be re-allocated as a non-concessional contributions, or may cause a member to exceed their contribution cap. The Downsizer contribution cap is the lesser of $300,000 per person or the sum of the capital proceeds. Any debt outstanding on a mortgage over the relevant property is not considered for the purpose of determining the capital proceeds.  The Downsizer contributions will not be tax deductible.

The third concern is the Age Pension.  Members who may be receiving benefits should note that any contributions and disposal of their primary residence may have an impact on their existing or future Centrelink entitlements.  You may in fact be boosting your super but reducing your benefits.  Again, we urge any super members contemplating this downsizer contribution to first see a planner or contact Centrelink for advice about their specific circumstances.    

 

 

 

 

Shares Versus Property

What is the best investment? Property and shares are the 2 most common ways of building wealth in Australia outside of superannuation.

The topic of whether to invest in property, shares (or both) often leads to heated debate. The 67% of Australians who own the house they live in are usually passionate about they believe is their best investment decision.

Shares and real estate have both generated reliable income and capital returns for Australians over the long-term.

 Source: Corelogic, Housing Market and Economic Update March 2016 

Property and shares are rarely out of the news, with weekly predictions about Australian property bubbles and busts fuelling speculation and creating confusion for the majority of investors. Against this tide of information overload, it is important to remember there are advantages and risks associated with both property and share ownership.

Property ownership

Historically there has been a belief in Australian culture that home ownership leads to an improvement in living standards, representing a symbol of success and security. Therefore people think it is the best investment for the long-term.

Since 1961, home ownership has been relatively stable at around 70%, with a decline in recent years to 67% due to stretched affordability. Home ownership tends to increase with age, alongside general increases in wealth.

However, recent analysis shows a rise in the proportion of renters, as buying a home become less affordable due to rapidly increasing prices.

Both Sydney and Melbourne property prices have enjoyed strong price growth between 2012 and 2016, however despite recent price rises, there are significant risks associated with taking on a large mortgage including interest rate risk and lack of diversification.. 

 

Sources: CoreLogic RPData; RBA

Share ownership

Australia has one of the world's highest share ownership rates, with around 36% of adults owning shares outside of their superannuation.

Owning shares doesn't typically have the same level of personal attachment when compared to property, as the part-ownership of a business is less tangible than a physical house. Notwithstanding, shares have generated reliable income and returns for Australians over the long-run.

Over the 30 years to 2015, Australian shares have generated an average return of 10.8% per year including dividends.

 

 Sources: ASX

 Factors to consider

There are many factors to consider before deciding what is the best investment for you.

  • Your budget for living and investing has limits. Look at what you can afford and test different interest rate scenarios before making a major investment decision.
  • Compare whether you would be better to buy or rent.
  • What is your attitude to share market movements? Would you have the discipline to stay invested even during periods of market volatility?
  • How stable is your income? Would you be able to continue paying a mortgage if something changed to you or your partner's work situation?
  • How much of your decision is impacted by tax? Tax law changes regarding property (negative gearing) and shares (franking credits and capital gains tax) could occur at any point in time.
  • Consider your lifestyle, whether or not you have dependents and the kind of area that would be best to live in. Buying a property in an area with access to desired facilities such as public transport and schools may not always be immediately affordable.
  • Can you commit the required time to maintain a property?
  • Personal values and situations affect your decisions about opportunity costs and risk appetite for investing decisions. Social pressure can push individuals into making choices that are not best suited for them, even though these choices may have worked out well for others.
  • Rather than buying property to live-in, some people buy property as an investment to rent out. This brings another whole other set of potential advantages and disadvantages. Two of the most common are negative gearing and landlord costs.

Property vs shares

Investing in property or shares both have advantages and disadvantages. Below are some factors to consider before making a decision to invest in either.

Consider

Property

Shares

General

Pros:
– Peace of mind and stable place of residence.
– Flexibility to renovate.

Cons:
– Lack of liquidity and unable to quickly change mind after the initial commitment.

Pros:
– Easily bought and sold.
– Regular income from dividends.

Cons:
– Not a physical asset.
– Generally more volatile in the short-term.

Diversification

Pros:
– Lack of correlation with other asset classes and good protection against inflation.

Cons:
– Poor diversification and highly concentrated in a single asset.

Pros:
– Easy to gain exposure to the entire index of thousands of companies to reduce risk.

Cons:
– The entire market can also have periods of weak performance.

Leverage risk

Pros:
– Able to borrow more and leverage returns which can be great during times of low interest rates.

Cons:
– Higher repayments if interest rates rise.
– Leverage magnifies losses so you can lose more than you invested.

Pros:
– No leverage means you can't lose more than you invested.
– Interest rates typically have less impact on share prices.

Cons:
– No benefits of higher leverage during periods of high growth.

Taxes and transaction costs

Pros:
– Potential for negative gearing benefits.

Cons:
– Relatively high transaction costs associated with buying, selling and property maintenance.

Pros:
– Potential for franked dividend benefits.
– Transaction costs and fees can be low.
– Involves very little ongoing effort after an initial investment.

Cons:
– Capital gains tax when shares are sold.

 

 

Inheritance Centrelink and Wills

 

By the pure nature of it, receiving an inheritance tends to come at a time when we are grieving, and at this distressing time, we need to understand whether the inheritance itself impacts a Centrelink aged pension benefit.

 

The key to this is the size of the inheritance, and is dependent on one's existing wealth and how this wealth is structured.

 

The Age Pension payment will stay the same if you are under the assets test and receive a small inheritance.

 

It could reduce the Age Pension, or in the worst case, cancel the Age Pension if you are over these limits.

 

The pension will be cancelled if total assets exceed the upper threshold limit of  $556,500 for a single homeowner or $837,000 for a couple homeowner.

 

There are a number of strategies that can be applied in planning for a Centrelink entitlement  reduction  as a result of an inheritance receipt, the main two most people have used in the past are:

1.       Gifting or transferring their entitlement to another person

2.       Retaining money in the deceased estate for a prolonged period.

 

The above strategies generally have limited impact and have limited  benefit as Centrelink  has  rules  on  the  amount you can gift.  Amounts gifted  above  $10,000 per   financial year  and $30,000 over  5 financial  years  are  considered as an  asset and deemed to earn income for the next 5 years. Transferring your entitlement  to another person is also considered a gift in the eyes of Centrelink.

 

Once the estate proceeds are able to be paid, Centrelink will look to assess your entitlement as an asset. Most people are not aware Centrelink can assess funds held in an estate and as such keeping funds in the estate for a prolonged  period may not be a viable option.

 

One  strategy that  is effective is to spend on the  things  a lack of capital  has  previously  made difficult. We often  see  clients complete renovations on their house, take their dream holiday or invest in assets that are either exempt or have limited Centrelink penalty.

 

The advice of a financial planner can help minimise the chances of Centrelink issuing the dreaded request for repayment of overpaid entitlements.  Contact us for an appointment if you have concerns.

Why you shouldn't feel bad about renting

The property market is rarely out of the news in Australia, with regular predictions of house prices collapsing being followed by weekends of record auctions and prices.

Property has certainly had a good run.  Over the past 10 years property prices in some of Australian major cities have skyrocketed and as property has become less affordable, more people are looking at a popular alternative which is to rent and invest their savings in a portfolio of shares instead.

Despite similar long-term returns, property and shares are always at different points in their own market cycles. When looking to invest for the next 5 years, it's worth thinking about where each is positioned in their own cycle and what that could mean about the future. Since the financial crisis in 2008-2009, property has been in the recovery and then boom stages, helped by low interest rates and supply shortages.

 

But which is better today, shares or property?

History has shown that investments are often most popular near the top of their cycle. This is when the market is hot and there is high confidence that prices will keep on rising. Silly stuff happens at the top of the cycle like was seen in the US property market in 2006-2008.

Today property investing is 3 times as popular as buying Australian shares. This shows how confident people are about real estate investment right now. High confidence around an investment often comes before periods of flat or falling prices as reality catches up to everyone's excitement. For example, US shares were at their most popular ever in 1999 – just before the infamous tech crash.

That said, confidence levels can remain elevated for a long time and it's always hard to pick the peak. Stock analysts were calling the top of the US tech boom years before it actually ended, just as many commentators have been predicting Australian house prices to fall for a decade now.

In any boom you can be sure that many people will try to pick the top but few will succeed with their timing without the benefit of hindsight!

Then there are shares, which have become less popular in recent years with only 7.8% of people surveyed thinking shares are the best place to invest, which is half the long term average.

 

Based on excitement levels, those who are renting and investing in shares currently have the upper hand since they're likely to be investing at a better point in the cycle. Australian shares are still below the levels they reached 10 years ago in 2007 so they are still in the recovery stage.

People who are renting and investing their extra savings in shares are able to quietly squirrel away savings and pay low rents while everyone else is jumping over each other to buy a house. But patience is a virtue for those renting since the strongest temptation to get involved in an investment usually comes around the top when everyone else is most excited. That's when FOMO (fear of missing out) is at its hardest to resist.

All markets move in cycles. It's tempting to get involved when confidence and excitement are high, but doing what's less popular can be the safer and smarter bet in anticipation of when returns inevitably go back to normal.

For more points to ponder on renting vs. buying... visit the article Shares Vs Property further down this page where we discuss the returns of shares vs. property. 

What Makes a Good Investment Strategy?

If you have a self-managed super fund (SMSF), then you should be aware one of the obligations that is placed on you as a trustee is that you must have an investment strategy for the fund that is reviewed regularly. But what makes a good investment strategy? How long does it need to be? How detailed?  

These are all great questions, but unfortunately there is no single right answer. However, here are 5 considerations that can help you along the way.  

1. Diversification  Super law does require that when formulating an investment strategy, trustees must have regard to diversification. Diversification relates to a consideration about the spread of different investments you might have – or thinking about ensuring you don't end up with all your eggs in one basket. However, there isn't a requirement that an SMSF's investments must be diversified, and there are some SMSFs that have large investments in a single asset (or asset class). Most commonly this occurs where the SMSF has a direct property investment, with a comparatively smaller investment in cash in order to make any relevant payments as necessary.    The big risk being so concentrated with your investments into one asset or one segment of the market is what if something went wrong? What if a property bubble bursts?  

2. Risk and return The risk involved with, and the likely return from, the investments are also important considerations, and really ties back into the issue of diversification of investment.  What can sound like an exciting possible return on any particular investment, should always be balanced against a consideration of any risks involved with that investment. The difficulty is that both risk and return are assessments of what may happen in the future. It's important to remember that any historical performance data availability is purely that – it's history! It can provide some guidance as to how well a portfolio manager has looked after the monies under their control, thereby providing some insight into their level of governance, but you should always be cautious when it comes to relying on performance history.  You shouldn't look at any investment in isolation, and always compare their performance against peers and over multiple periods of time. For example, whilst a share fund that provided an 8% return in the last 12 months might sound relatively good, it's not if all other comparable share funds were returning in excess of 10%. In addition to pure investment risk, you need to consider how much risk the members of the SMSF are willing to take on. The answer may be different for each member of the fund, so you also need to think about whether each member has their own investment portfolio in the fund, or whether everything is pooled together.  

3. Liquidity    As a trustee, you need to ensure that your SMSF is able to pay its liabilities as and when they fall due. Doing this for the ongoing running costs of your fund, sounds relatively easy. But you can't forget about the additional liquidity required as members of the fund approach retirement and start to draw on a pension from the fund.   

4. Insurance  Trustees are also required to consider the insurance needs of members. This doesn't mean that the fund has to hold insurance for the members, but this is actually an important consideration. Given that the trustees of an SMSF are also the members, this is about considering whether you have enough insurance of your own, and if not, should you acquire more coverage through your super.  But don't constrain yourself to personal insurance considerations, even though that's all that's technically required.  Depending on the type of investments in your SMSF, you should also consider if you need the fund to take out other types of insurance. This could be a vitally important consideration if you hold property.  

5. Documenting it all    Ensure you document your plans. The actual investment strategy document can be long or short, but you need to show you have considered the above elements.     Most good investment strategies will have two key positions them.       The first is an overall goal that the investments of the fund are trying to deliver.  For example, the fund could be targeting an overall return 2% above the Consumer Price Index on 5 year rolling basis.      The second, it sets out acceptable investment parameters. For example, it may say the fund is happy to hold between 30% and 60% of its investments in Australian shares, but is targeting a holding of 45%. These elements taken together give the trustees something to measure performance against. If the SMSF isn't meeting these objectives, or its investments fall outside of the expressed permitted range, then the trustees  need to be doing something to bring it back in line.   The good news is that as a trustee of a SMSF, you don't have to do it all yourself.  Professional support can help you understand how your fund has performed in the past and is currently performing, and also help you to identify the requirements of members and select investment to give them a chance of future success.                        

Paying for your children's education

Education costs can account for a huge slice of the family budget. The costs of school fees, uniforms, books, excursions and extra-curricular activities can really add up.    

Education costs are usually a long-term goal that can take more than 5 years to achieve, so it's never too early to start planning.

 

HOW MUCH WILL THEY NEED?

How much money they will need will depend on whether you want your children to attend public or private schools, and whether they plan to take up a post-secondary education after that?

For example, if you send two children to a private high school which costs an average of $20,000 a year for each child, by the time they both graduate you will have spent $240,000 on school fees. And that's not counting extras such as school uniforms, trips and sporting clinics.

Public schools are much cheaper but there are still extra tuition fees, textbooks, uniforms and school camps to pay for so a bit of planning and an early savings plan reaps benefits for them later.  The earlier you start saving for your children's education, the better.   Education costs are usually a long-term goal that can take more than 5 years to achieve.

SAVINGS OPTIONS   SHARES?   TERM  DEPOSITS?   EDUCATION FUNDS?

Once you have clarified the financial goal you are working toward, you should consider your other financial obligations. For instance, you might be better paying off your mortgage where you have access to a redraw facility or paying off some other short-term debts first before you start saving. After all, there is no point in leaving yourself short every week and dipping back into those savings.

To help you reach your goal, you could put your savings into a number of different savings structures like: shares, managed funds, term deposits, savings accounts, investment bonds, or education funds.  We advise parents to use help their savings grow by using a structure that pays compounding interest. 

Education Funds are special funds to help save for children's education. If you are considering an Education Fund you should check the following to make sure these funds fit your long term financial plan. Here are some questions to ask before you invest in an education fund. 

·         Fees - What fees will you be charged?

·         Contributions - How much do you need to invest and how often do you need to contribute? Can other people, such as grandparents, also contribute?

·         Investment options - What investment options are available, and do the suggested timeframes for these options meet the timing of your children's education needs?

·         Fund purchases - What can you use the savings for, for example can you use them for primary, high school or tertiary studies? Do they cover expenses such as clothing, laptops and excursions?

·         Access to funds - What criteria need to be met before you can access your funds? What happens if your circumstances change, or if you can no longer contribute to the fund? Do you lose all that you have invested? How difficult will it be to withdraw your money if your children's priorities change? For example, what happens if your children decide they don't want to do tertiary studies?

You should compare the features of an education fund with other investments such as term deposits and managed funds. In particular, you need to consider the Product fees, features and benefits and how the fund is taxed compared to how other investments are taxed.  A tax agent can assist in unrevealing the complexities of these types of investments. If ever in doubt, contact us for an appraisal of the Fund.

AND, WHEN OUTSIDE ASSISTANCE IS NEEDED

Financial Advisors If you need help with a financial plan to save for your children's education, or if you need more information about education funds, consider getting financial advice from a qualified financial adviser.

There are quite a few assistance programs to help parents cope with the extra costs of school. 

Saver plus matched savings Saver Plus is a program to help families on low incomes develop savings habits, and could help save up for larger school costs like fees and excursions. It helps you reach a saving goal and then matches it dollar for dollar, up to $500. Find out more about Saver Plus

Government assistance some financial assistance is available to families on a low income. Some are means tested or require parents to hold a concession card.   In Queensland you may check out:  Textbook and resource allowance 

Has the Government made a start on housing pressures? 

In late November, the Government had a win as the Senate passed two measures to improve housing affordability .

The changes will provide a small incentive for some older Australians to downsize, and assist first home buyers to save a deposit faster and help to overcome one of the barriers for getting into the housing market.

1. Downsizing

Persons aged 65 or over who downsize by selling the family home will be able to make a non-concessional contribution to super of up to $300,000 from the proceeds. These contributions won't be subject to meeting any work test, will be in addition to the current non-concessional cap and won't be subject to the $1.6m balance test for making non-concessional contributions. If a couple, then potentially $600,000 could be contributed to super.

2. First Home Super Saver Scheme

At the other end of the housing market, first home buyers will be able to make voluntary salary sacrifice contributions into super, and withdraw these together with associated earnings for a deposit for their first home.

For more information read the complete article at   http://www.switzer.com.au/the-experts/paul-rickard/paul-rickard---thursday-draft20171214/

 

Can you trust your Deed?

I have lost count of the number of clients who think their self-managed super fund (SMSF) trust deed is like those blue-chip shares they bought two decades ago – you can put it at the bottom of the drawer and forget about it.

Nothing could be further from the truth.

The fact is, your trust, the document that oversees the operation of your fund, is a living, breathing document that you need to keep revisiting to ensure it remains up to date and that it gives the trustee the authority to carry out his/her duties within the framework of the superannuation legislation.

It's worth remembering that the rules governing SMSFs are onerous, and that the regulators expect people who decide to manage their own superannuation to play by the rules of the game. It might be "your money", but it's "their rules".

So how do you know whether your deed needs updating? To begin with, practically every deed drawn up before 2008 needs to be amended to take account of the changes implemented under the Simpler Super reforms. If your adviser hasn't told you about these changes then they have been remiss, and it certainly should be top of mind when you see them next.

Post 2008, and you are still not out of the woods. Over the past seven years there has been any number of changes, whether it be regulatory, legal, taxation or legislative, that could require you to update your trust deed. Again, you need to ask your adviser.

There is no shortage of examples of where legislative change could put the actions of a trustee under a cloud. They can relate to: someone remaining a fund member past 65 years of age where the deed requires their benefits to be paid out; substantial changes in the areas of temporary disability benefits and in-house asset tests; and the payment of reversionary pensions.

This list is far from exhaustive. And, let me assure you, the changes will keep coming, so remain vigilant.

On the flipside, failure to update your trust deed can limit your actions as a trustee in many ways. Let me give you some examples. The fund continues to operate even though the deed quite clearly states it should be wound up because of a certain event has occurred, such as the death of a fund member.

Other examples include: accepting payments from fund members outside the parameters stipulated by the deed; entering into a limited recourse borrowing arrangement when the deed does not provide for this; allowing a fund member to enter into a transition to retirement arrangement when the deed specifically forbids this; and stopping a pension where internal roll-back is not allowed.

As I said at the beginning, there can be dire consequences for acting outside the parameters of your trust deed. You could attract the (unwanted) attention of the Australian Tax Office and that could lead to financial sanctions. They could even decide to wind up your SMSF.

There is the possibility of losing tax benefits as well.

The trust deed is the engine room of your SMSF. It sets the framework for its smooth operation. Like every engine it needs a regular fine-tuning by an SMSF specialist to ensure it's in smooth running order. So the question to ask is: when is my trust deed's next check-up due?

If you think your Deed may need a review, contact us

Australian banks still worthy of a place in most portfolios… despite what some commentators say 

 

Barring disasters, the banks should produce returns of the order of 10% per annum over the next decade. With a yield of 8% including franking credits, we need just 2% per annum growth to get us to a 10% per annum total return. Even if we get no growth in earnings, an 8% per annum return means that banks will be worth a place in most portfolios - barring disasters.

Disasters? What could possibly go wrong?

Anyone who follows the mainstream investment media will have no problem making some suggestions here. Ever increasing capital requirements, curbs on lending growth, new taxes, fines, Royal Commissions and other government interventions have been widely discussed. In addition, some outright disasters have been suggested, with a collapse in the residential property market the most common. And, of course, there is the possibility of an old fashioned, severe recession which inevitably would bring more pain for the banks.

Some of these scenarios are likely and should be factored into any forecast. Others may be unlikely but still are risks that we need to consider. Here, we want to put those risks in perspective particularly those that have been widely covered in the mainstream investment media and where we believe the impacts have been vastly overstated.

Increased regulatory and capital requirements

These are real and are happening right now and, accordingly, are in our base forecast. Most banks have around 10% of capital for each dollar of risk weighted assets – that should head towards 11% over time. This makes the banks safer but slightly less profitable. In addition, we have the bank levy which should slice around 2.5% off bank profits. Furthermore, we have threats of Royal Commissions, fines for bad behaviour, and so on. Collectively, we think these will reduce Earnings Per Share by about 10% over time. This slices just 1% per annum off returns over the next ten years. We include this impact in our forecast.

A slowdown in the growth of residential lending

We think this is highly likely and it is why we forecast future earnings growth at around 2% per annum. This is much lower than historical earnings growth and, in fact, this forecast is much lower than most other analysts' forecasts. And still it gets us to a 10% per annum return.

A recession is likely in the next decade and will hurt the banks

Our forecasts assume that Australia will experience a recession in the next decade. We also predict that, when the recession comes, the market will know about it before we do – and so the chances of getting out early will be small. Hence, the key question is how bad a recession might be, both in terms of depth and also in terms of how well prepared the banks are for that recession.

The depth of a recession is often depends upon the health of the banks to that recession. The more extended the banks, the more they cut lending, the more they harass existing borrowers, and the more they drive the economy into the ground. When banks enter a recession in better shape, the recession is generally milder. We saw that during the GFC where the Australian downturn was much milder than in other parts of the world because, at least in part, the Australian banks entered the recession in reasonable shape.

A 2015 RBA study found that the key drivers of bank lending losses during recessions were: rapid credit growth; high levels of building construction activity; falling bank lending standards; and, rising interest rates.

Today, we have modest levels of lending growth, normal levels of commercial building construction, tightening lending standards and no sign of a central bank with any interest in raising interest rates. Of those four loss drivers, the only one flashing a warning light right now is the high level of residential construction activity. Even there, the banks are scaling back their involvement and watching their risks very closely. In short, the banks are in good shape generally and in much better shape than prior to the GFC. This suggests that any recession in the next decade should be relatively mild so long as these indicators remain strong. If they turn south, caution will be required.

Our forecast assumes that a mild recession will occur and will result in a one-off reduction in profits of around a third and take around 0.5% per annum off 10-year returns.

Even mild recessions will cause short-term volatility

But before we get too comfortable, we should not forget that during a recession, bank share prices will probably fall by 50% or more. But the fall is unlikely to be permanent.

While this may seem dramatic, we would say the same thing about every other sector of the share market. All equities are volatile. All can fall dramatically during recessions. The banks are no different. As long-term investors, we should worry predominantly about a permanent loss of capital.

And that is a possibility if the recession is severe. Accordingly, no matter how attractive the prospects of Australian banks, all the normal rules of diversification still apply.

Impact of a collapse in the housing market

Now, this is where things hot up. The market is divided on this issue. There are those who consider that a collapse in housing prices and as a result, the banks, is almost certain; there are those who  aren't sure; and, there are those who are extremely sceptical that we will see a housing induced collapse in the banks at all.

Farrelly's considers a collapse in housing prices as possible but unlikely:

  • We still seem to have a shortage of housing that not even the residential building boom is meeting;
  • Bank lending practices are being tightened but not sufficiently to cause an out-and-out collapse.

 

Nonetheless, it would be foolish to say that a collapse in housing prices couldn't happen. Accordingly, we consider the impact of an extreme example - a 35% fall in the prices of houses nationwide and an accompanying recession that sees soaring unemployment and a 10% default rate amongst mortgagees.

Helpfully, the major banks produce detailed reports showing the Loan to Valuation Ratios (LVRs) of their mortgage lending books. This is all we need to do our own stress test.  Consider two loans, one has a LVR of 50% (in other words, $50 worth of loan for every $100 worth of house), while the other has an LVR of 90% ($90 worth of loan for every $100 worth of house.) Now assume that property prices fell by 35%.

Post the fall, the first loan now has $50 worth of loan for $65 worth of house, while the second has $90 of loan for every $65 worth of house. If the first borrower loses their job and can't repay the loan, the bank has the option of putting the property on the market, recouping their $50 loan and sending whatever is left back to the unfortunate borrower.

The second borrower would be a problem for the bank. Here, a default potentially costs the bank a loss of $25 for every $90 of loan.

Now let's assume that 10% of all mortgages default. The results for the major banks are shown in Figure 1 on the following page.

Figure 1: Bank stress test (35% downturn in property prices & 10% default rate)

 

ANZ

CBA

NAB

WBC

Size of loan book ($ bill)

274

436

285

414

Loss as a % of loan book if 10% default

-0.5%

-0.6%

-0.6%

-0.4%

Loss In $mill

-1,479

-2,660

-1,807

-1,482

Loss as a % of 2017 pre-tax profits

-15%

-19%

-19%

-13%

Pre-tax profits 2017 ($mill)

9,704

14,114

9,306

11,050

Source: Bank reports, farrelly's analysis

 

That's right. A perfect storm of a 35% fall in residential property prices and a 10% default rate would result in the banks' profits falling by about 17% on average. While this is clearly not a great result, it falls a long way short of a disaster.

In a year or two, profits would rebound and normal business would resume. Farrelly's calculations suggest that the whole episode would reduce 10-year average returns by around just 0.5% per annum.

Now, a much more likely scenario is that if residential property prices do fall that it will be more like a fall of around 20% (rather than 35%). This causes a one-off reduction in profits of closer to 4%. It's a blip.

Residential property lending makes the banks safer, not riskier

The bottom line is this: residential property lending is actually an extremely profitable and safe activity for the banks. The fact that the Australian banks' lending books are highly concentrated in home loan lending should be a source of comfort rather than concern. It's the equivalent of having 70% of a portfolio invested in government bonds – the concentration, in this instance, makes the portfolio safer, not riskier.

Disclaimer: This article is not legal advice and should not be relied on as such. Any advice in this document is general advice only and does not take into account the objectives, financial situation or needs of any particular person. You should obtain financial advice relevant to your circumstances before making investment decisions. Where a particular financial product is mentioned you should consider the Product Disclosure Statement before making any decisions in relation to the product. Whilst every care has been taken in the preparation of this information, Australian Unity Personal Financial Services Ltd does not guarantee the accuracy or completeness of the information. Australian Unity Personal Financial Services Ltd does not guarantee any particular outcome or future performance. Australian Unity Personal Financial Services Ltd is a registered tax (financial) adviser. Any views expressed are those of the author and do not represent the views of Australian Unity Personal Financial Services Ltd. If you intend to rely on any tax advice in this document you should seek advice from a tax professional. Australian Unity Personal Financial Services Ltd ABN 26 098 725 145, AFSL & Australian Credit Licence No. 234459, 114 Albert Road, South Melbourne, VIC 3205. This document produced in October 2017. © Copyright 2017


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