Open letter to Bill Shorten - don’t touch negative gearing or the capital gains tax: Gavin McPherson

GUEST OBSERVER

From the outset, let me say that prior to recent policy announcements I’ve got no real objection to Mr Shorten. To add to that claim, I can honestly say that I didn’t vote for either the Coalition or the Labor party at the last Federal election. So landing the claim of extreme bias doesn’t sit with me. But that is where my kindness to Mr Shorten ends, because I believe that he is about to balls up royally...he just doesn’t know it yet! With a pending election however...he’s about to find out.

My beef with Mr Shorten sits with two of his declared policies that should be of particular importance to investors, of any asset class, but specifically property.  

1)     Mr Shortens Government (Federal Labor), if elected will eliminate the Capital Gains Tax (CGT) ‘discount’ (currently 50%) for investments held for more than 1 year.

2)     Mr Shortens Government (Federal Labor), if elected will abolish negative gearing for established property. (i.e.: the largest proportion of property in Australia)

Mr Shorten in his recent quip to the ALP party faithful stated "It cannot be rationally argued anything else but with a capital gains tax subsidy of 50 per cent, that the whole system is accessibly distorted and overly generous in favour of income from capital instead of income from earnings," Mr Shorten said.

Oh really Bill?

“Can’t be rationally argued”, hey?

Well, let me give it a shot Bill.

“Overly generous” you say? I love how you politicians bandy that term about “subsidy or discount” like you’re doing us a favour.

At present, the Capital Gains Tax charged is 50% of the gain if I buy and sell that property within the same 365 day period that I acquire it. No surprises there.

Most investors would agree that it doesn’t make a lot of sense to commit to an investment whereby after entry costs, exit costs and associated risks; the investor is still required to give up to 50% of the upside away to the Government. It’s not that I don’t want to help my fellow man by paying tax...it’s just that at that level I’ve lost incentive to do it.

For someone that has purchased over $3b worth of property for myself and others, I can suggest to you that I’m well versed in the thresholds of investor risk/reward – and I don’t believe peoples threshold is so high that they’d take all the risk only to hand 50 percent of the upside to the Government. Whether they used his turn of phrase or not, I know with huge consensus that the sentiment would reflect the infamous words of the late Kerry Packer “...as a government, I can tell you you're not spending it that well that we should be donating extra.”

Now, last I checked, and please tell me if I am incorrect...the investor takes all of that risk don’t they Mr Shorten?

Is the government going to assist me with the stamp duty? Or do I have to save that cash from earnings Bill? (I can hear Mr Shortens cranium ticking over now trying to avoid stating the bleeding obvious) That’s what I expected Bill. It’s all my risk isn’t it? Also, you’re not helping out with my deposit, are you?

Yes, that’s right, the deposit that (still) comes out of my earnings after paying tax previously also, isn’t that right?

The “Claytons Discount”. The discount you get when you’re not really getting a discount.

So let’s stop calling it a “subsidy” or a “discount” Bill.  At the very least be consistent and cancel the word ‘discount’, keeping in mind that stamp duty was actually slated to be axed in 2000 upon the introduction of the GST. So by your own rules Mr Shorten, why haven’t we been using the term “temporary Stamp Duty” since 2000, assuming that some visionary alternative Government in the near future would campaign for its removal? Oh that’s right...that’s an easy hospital pass, isn’t it Bill? It’s the State Governments responsibility to put that proposal up.

The truth is Mr Shorten, the only reason you use the word ‘discount’ is because it’s politically convenient. Convenient for the one that maintains it – to look like they are doing us a favour, and convenient for those agitating to axe it - to look like they are trying to hit the rich guys! It has been afforded this term since granted in 1999 by the Howard Government.

Let’s get real. A discount is where I go into a pharmacy and instead of walking past those expensive meal replacement tins for $20, I now actually buy it for $10. Now that’s a discount.

But if that product has been on special for 17 years Bill, that’s now the price. A bit rich calling it a discount after 17 years isn’t it? Forget the word “discount” Bill. It’s over for the word discount.

Of course, one shouldn’t forget that pre-1999, it wasn’t just a case of investments being taxed without the (Claytons) ‘discount’. What they in fact had was a ‘cost base’ for inflation to index the capital gains. (ie: My cost base also include an indexation of the investment for CPI). Let’s not also forget that inflation was then running at 4-5 percent rather than 2-3%. So if you bought a property for $100,000, its likely your cost base (to deduce your Capital Gain) after say 7 years is more like $135,000, not the $100,000 starting point (to which you would still add capital costs). 

No...this is not just a case of stripping investor outcomes back to where it was in 1998.

That’s right folks...It’s far worse than that. And what’s even worse than that is that I’m confident that this argument hasn’t even entered Mr Shortens consideration. 

Even if it wasn’t on discount

Remember our overpriced meal replacement tins? You have to consider the effects if that meal replacement was still $20 Bill. At that price, I’d just keep walking passed it. Sure, some mugs will throw it in the trolley on pay day or in a pink fit during a strong economy, but these things are cyclical. On the main most intelligent people would acknowledge...there will be less units sold. There can be no argument on this.

So the way I see it, you’re not just taking away my “discount” Bill, you’re trying to give me a s&*t sandwich. 

Why Bill why?

Mr Shorten...in your words, this is your case.  

"We're doing this because 30 years ago, houses cost around 3.2 times average income - today it's 6.5 times average income," Mr Shorten said.

OK Bill, so it has nothing to do with many more dual income households, credit being so tight 30 years ago in our protectionist economies that Credit Cards were a luxury item and interest rates were 17%+? Not to mention that relatively speaking, most of our Western peer economies have experienced a similar disparity growth which has come about with globalisation. If you’re suggesting we go back to our ‘banana republic’ strategy Mr Shorten, why don’t you just say so.

Mr Shorten relies on a report by the McKell Institute suggesting that changes to negative gearing might create up to 25,000 new jobs in construction. Really? I smell a rat..

Aside from its own admission that the McKell Institute is a progressive public policy institute, let’s focus on the basic laws of capitalism and how this would play out in the market place.

Bill, meet Harry.

So let’s test the thesis and see how likely it is that 25,000 new jobs in construction would be generated from this change in policy. To do this, we need to look at the source of these construction jobs. For this fable to be true, these jobs could only come from property developers. So let’s meet one.

Now I’m not suggesting that property developers are the natural recipients of sainthood and to be sure, the development industry would have its fair share of crooks and spivs. But we have to accept the property development industry at its base case are building homes for our population and should be considered as providing a service. If you expect them to do it for free, you are mad, stupid or a communist; with all three of those labels hindering your case to prosecute your argument.

So let’s stand in the shoes of the developer for just one moment and assume that Mr Shorten did have his way with us.

Prices would drop, to be sure. What would they drop to Mr Shorten? 10% cheaper? 20% cheaper? Indicate what you’d be hoping for. At a guess, by my reckoning I would suggest that over time, sans negative gearing benefits, the effects would actually sit somewhere in that range (10-20%).

I am agreeing with you Mr Shorten your policies will have a downward impact on the market. But Bill...you have to be careful what you wish for.

So let’s take the midpoint of that range and assume a 15% decrease. I’ll now use as close to real life examples as one could contemplate, representing comparable feasibility projects for a property developer on say any of our Eastern seaboard cities, and perhaps even Perth.

Let’s call our developer Harry. Harry can buy a vacant block of land for say $800,000. He knows he can build x 4 townhouses on the block for $300,000 per townhouse (all inclusive). At a cost of $1,200,000 for construction I’ve also added development and holding costs below in my simple, yet realistic table of costs. All told, this project costs Harry some $2,180,000. That of course is Harry’s outlay, not including marketing costs, legal fees and agency fees he still has to pay once the project is complete. 

Now let’s looks at how much his project might net Harry in today’s market.

Project sale of 4 x townhouses (average price) $750,000 = $3,000,000

Minus DA, Construction & Land Costs = $2,180,000

Minus Sale & Marketing costs  = $   115,500 (3.5% + GST inc marketing of 1% + 2.5% agent fee)

Sub Total of costs = $  2,295,500
Profit   = $     704,500
Gross Profit as %’age = 23.5% approx

OK...So I am not asking you to feel for sorry for Harry. He’s looking at the better side of $700k profit in a market where I feel he could fairly rely on to deliver this profit. 

Of course though, one should always consider the effort and risk Harry has taken to get here and the number that he has in his mind to undertake the project. I know this because I buy for developers and execute projects myself – and the general rule of thumb for a project getting a Guernsey or not is:

Aim                                                                                                   

- 30 percent gross profit

Budgeted contingency                                                         

- 20 percent (netting down to 24% gross profit) which is usually enough to still keep a project alive

Real Profit                                                                               

- 18-20 percent (the usual profit once everyone has been paid, puts profit in the developers pocket to pay themselves a wage and/or project earnings.                                                                                                                     Remember, most developers only get paid once every few years) They also need to factor the risk of market prices decreasing.

I’ve left real numbers in there that almost all developers could empathise with, unless they are rewarded with unnatural boons from speculative zoning and yield changes, to which I concede this upside does sometimes account for an outweighted super profit for the developer. Or do we need another super profits tax Bill?

So let’s use Harry’s same project, on the assumption that prices do drop by 15% as Mr Shorten hopes for.

1)     Using the assumption that Harry can now buy the land 15% cheaper, it costs him only $680k (15% discount) for the land. It would seem like a win for Harry wouldn’t it?

2)     Yet Harry still needs to turn out 4 townhouses or what is maximum permissible use on the lot. Unless Mr Shorten is assuming councils will also make planning/zoning changes to marry with his negative gearing changes. I see Harry’s costs still being $2,180,000.

3)     Harry still needs to pay sale and marketing costs, albeit now reduced to approx $98,170.

4)     But sadly, as per Mr Shortens wishes, the end product that Mr Shorten looks to sell isn’t $750k anymore. It’s 15% less...isn’t it? Harry would only be able to recover $637,500 per townhouse.

So let’s see how that works out for Harry now and see if he’s motivated to invest in that townhouse development.

Project sale of 4 x townhouses (average price) $637,500 = $2,550,000

Minus DA, Construction & Land Costs = $2,180,000

Minus Sale & Marketing costs = $98,175 (3.5% + GST incl marketing of 1 percent + 2.5% agent fee)

Sub Total of costs  = $2,295,500
Profit   = $271,825
Gross Profit = 10.6% approx

I can hear my mother screaming now - ”do you know how many people in Africa would love a salary of $270,000, and here Harry is rejecting it!” - but let me say with almost certainty - Harry is not going to undertake this project. With these metrics, no developer is.  Not when they have to factor a contingency which always pushes project costs up (not down) and the nature of markets that might trend down to see this project at a loss. 

So let me ask you again Mr Shorten, how are those 25,000 jobs going to be created? I shouldn’t have to explain capitalism to our contender for the title of Prime Minister, but clearly you need one. Those 25,000 jobs are a bogus claim, and the Unions shouldn’t be fooled into thinking they will, despite that they’ll follow you off the cliff anyway.

Of course Mr Shorten, you could also be hoping for the price of new property being distorted above the value of established property. If that’s what you’re hoping for, please explain to me Bill why these so called people struggling to get onto the property ladder would pay up excessively more to live in a property they can have for at least 15 percent less?

Or maybe Mr Shorten, you’re thinking that investors will favour new dwellings so much for the negative gearing benefits because our chequebooks are bigger than our brains? As I’ve explained in my book most people invest in property for the capital growth benefit not for the gearing benefits. (Assuming they get the lion’s share of the upside).

As it stands, negative gearing does assist in the formative years of each investment (i.e.: years 1-5), noting that after some 3-5 years most (good) investments should turn neutral to positively geared anyway. But staying on that theme, let’s not forget the burden investors take with them into that investment that can add up to another 5 percent in cash costs at entry, lead by exorbitant stamp duties. These are sunk costs that won’t ever be recovered until the sale of a property.

It’s just so fair that the government always get’s their money first isn’t it? I’m actually starting to feel a little bit like our developer friend Harry now. It’s so easy just to paint the investor as the rich guy isn’t it Bill?

If you can’t detect my sarcasm Mr Shorten, let me save you the hassle and tell you that I’m pissed. And I’m almost certain that the ideological policy position you have taken on this will not do one iota for the economy. If anything I’d probably suggest you need that lesson again in capitalist theory, noting that the cure for high prices IS high prices.

And as if almost on cue for perfect timing  Mr Shorten, I’d suggest to you are getting your wish on property prices decreasing anyway, with the premier property markets of Sydney and Melbourne already straining under housing affordability. But you and your Labor Government don’t need to do anything to encourage it...market forces are taking care of this right now.

Aspirational. To be or not to be?

To now be so foolish as your predecessors who thought they’d extract some extra profit from where they saw an easy target, one wonders if you are just leading a party of people who resent aspiration Mr Shorten. How would that Mining Tax thing be working out for your mob? Pick an industry that’s going well presently and smack it down. Is that your bag baby?

Honestly...I think I’ve gone a bit hard on you. So to cut you some slack, I’m almost certain that you don’t understand your way around the economy, so I should give you some grace and suggest that you actually think this will be a good policy for Australia. I really believe you think this is a good policy... good for you Bill. This is the point where I pat you on the head in the condescending way your mother did when you told her you could fly as you headed up on to the garage roof to try it out.

No. Your policy would be recognised as a disaster only months after your policy’s inception, no less via decreased construction (how is Harry going to make money to produce any employees let alone 25,000?) less stamp duty receipts, (a prime driver of revenue for the states!) and heavy banking mortgage declines.

But it gets worse for you Bill. Post you executing these policies, I see an embarrassing about-face on the cards.

Haven’t we been here before?

If you think this wouldn’t happen and a Government wouldn’t back down on a disaster policy like this, think Morris Iemma’s NSW Vendor Duty Tax in 2005, less than twelve (12) months after its inception, and the rationale which was staring Mr Iemma in the face, with his response to the media. 

"…A market that was stronger (in 2004), but times have changed (August 2005)," he said.

That’s right, we did have a property boom only a decade ago, and this one (2012 – 2016) is no different.

And then the nail in the coffin. In absolute terms.

"In the current market conditions, vendor duty is a brake on economic activity.”

As simple as that. Mr Iemma had to make that call because the proof was obvious and he had to change the policy to stimulate his own source of funds. How embarrasssshment!...with apologies to Kylie Mole!

Still not convinced?

Do you think this is the first time Labor Government’s have thought us investors have had it too good?

Under Federal Labor in 1985 (Hawke/Keating) Negative Gearing was abolished. That’s right, the same policy Mr Shorten is contemplating now. It was reinstated in 1987. Do you think they would have left it if it generated the desired results Bill?

Instead, property investment declined and the appropriate response was to undo the damage that was done. The post mortem of this period has labor pundits claiming it was pulled due to political pressure and/or rising rents. The high rent theory holds water, but on the main it’s a red herring. The reality is that it was obliterating investment sentiment and the forward receipts were looking tragic.  

It’s one thing to make an error, but at least Mr Keating and Mr Iemma admitted theirs and made appropriate changes. I’m here thinking you Mr Shorten don’t share the same logic. And doing so dooms you to the same fate.

Another way to look at it

Just when you’d thought I’d finished with my pasting of you Mr Shorten, it would be remiss of me not to give you a taste of my business logic shared by my (small business) peers who host almost 50 percent of private sector employment.(Australian Treasury) 

If I am a business and I make $100,000 in sales, wouldn’t you think it is fair that I claim my expenses for making that $100,000? Between wages, staffing, stock and rent, you would understand, wouldn’t you that I’m only going to have a small portion left over I can call profit. We call them expenses Bill. It’s the difference between the two notions of “gross” and “net”. And last I checked, if I had any interest payments in there to a bank (credit card or otherwise) I’ve also got to claim them as an ‘expense’. Interest is an expense too isn’t it Bill, surely?

And once you get around to answering that question, to which there could only be one answer to, ask yourself what is so different about a property investment venture by a household trying to invest in their future to prevent being a net recipient of welfare in the later stages of their life? Where is their incentive to invest once you take incentives like this away?

Why can’t I deduct “losses” from one part of my household income from another? If I made $60k income and lost $10k in losses on my properties, my income is now only $50k. There is nothing make believe in that statement Bill. My income is, by definition now only $50k. I lost $10k on my investments. Just like BHP did this year. Just like NAB did last year and...um...errr well, almost every other business in Australia.

At least I’m not trying to stretch my definition of income like you are with the definition of ‘discount’!

To take it a step further. Let’s say I lost $5k per property I owned for 10 years, making a total of $50k in losses. Am I allowed to accumulate those losses and take them off the capital gain when I do sell? Some of these questions haven’t adequately been addressed by you Mr Shorten. I fear that you don’t want to answer that question; for fear that you already know the answer you just don’t want to tell us.

It doesn’t end well for us investors here, does it? 

It probably won’t matter anyway…but just in case.

You know what Mr Shorten? I have to be honest. I don’t think you’ll win the election anyway, so my anxiety over these policies being enacted rates about as highly as the stress levels of a Bob Marley fan at Woodstock. But I shouldn’t be so cocky. If there are any cheeky thoughts from aspirational voters and investors (or potential investors)out there thinking there is no danger in your policies, people like me should be here to consistently remind them of what lies ahead in a country where motivation and aspiration isn’t just discouraged by people like you...it’s actively punished. Others know it by its colloquial name – the tall poppy syndrome. It’s much easier to bring us down a few pegs than to motivate others to climb a few rungs higher isn’t it?

It worked really well in Cuba!

Again though, if I look at your record and note that your gainful employment has never been in a productive enterprise, I still have to cut you some slack and say that you probably don’t understand the consequences of what you’re about to do. I really don’t think you can see the label while you’re still in the jar Mr Shorten, but from where I’m standing, the label is looking clear to me.

It says “doomed”. 

Gavin McPherson is chief executive officer of Oasis Property Buyers Agency and author of "Value Investing in Property: What would Warren Buffet do if he was investing in property in Australia?" He can be contacted here.