The Situation

I met Alistair and Kerry in mid-2021. The couple are in their early 40s and have done well for themselves.

They own their own business, two investment properties, their own home and a bach in South Waikato.

Together the properties are worth $8 million, with $3.6 million worth of debt.

However, they were worried about two significant challenges:

1. Higher interest rates
2. The government’s interest deductibility tax changes.

They wanted two things: firstly, to protect against the above factors and then to use their property portfolio to build a passive income. This would protect them if anything happened to their business.

The Challenges

First, we modelled the cash flow for their two existing investments, seeing what would happen if interest rates move up to 5% over the next few years.

Good news: The investment properties would still be cash flow positive. Together they would generate $108,000 over 15 years.

However, this is a false positive. The properties weren’t good investments. Based on today’s values, the gross yields were 2.89% and 2.93%, respectively.

The only reason the cash flow looked positive was because of the small mortgages the investments carry. This is a trap many investors fall into when they’ve owned property for a while. The cash flow looks good, but the yield is poor.

However, the good news wouldn’t last. Once the interest deductibility tax changes kick in, these two properties are projected to go from +$108,000 cash flow (over 15 years) to -$10,000 over the same period. That’s an extra $118,000 just going to tax. So, what did we change?

The Changes

First, the couple bought four new build investment properties in Auckland. Three were purchased for capital growth, and one focused primarily on yield. This will increase their level of assets over time.

Secondly, they will sell one of their current investment properties in three years, since the yield is poor.

Why wait? Even though the property was initially purchased in 2012, it is still subject to the bright-line test.

The couple moved the property from their own name to a trust in 2019. That reset the bright-line. If they sell the property today they’ll get a $300,000 bill from the IRD. If they wait until 2024, they won’t have to pay this.

Finally, Alistair and Kerry will use the money from the sale to pay down their owner-occupier mortgage.

These three steps will result in:

1. Owning higher-yielding properties
2. Changing the nature of the couple’s debt. Instead of primarily having non-tax-deductible debt, the majority will become tax-deductible. That means paying less tax than would otherwise be the case.

The Impact

This couple’s portfolio will grow from two to five investment properties over three years.

The cash flow will move from -$10,000 (after tax changes) to +$232,000. That massive difference is caused by culling the low yielding properties and purchasing ones with more attractive yields.

In 15 years the couple’s forecast equity is expected to have increased from $4.3 million to $6 million after we made changes. This happens because the couple owns more properties, increasing their leverage.

Based on a 4% net yield, the passive income the couple could generate from their properties (in 15 years’ time) increases from $173,000 to $242,000 per year.

The Lessons

There are three main lessons:

• You will pay less tax (over your lifetime) if you stack your debt against properties where the interest is tax-deductible
• Just because a property is cash flow positive, doesn’t mean it’s a “good” investment. A low yielding property can still produce positive cash flow if the mortgage is low enough. It doesn’t mean the property is worth keeping.
• Base your yield calculations on what your properties are worth today, not what you bought them for. This will give a better sense of whether your properties are still viable. They might not be.

Disclaimer: Just remember this is a column in a magazine that goes out to thousands of people. It’s not personal financial advice. But it is an example of what happens when you get personalised financial advice. So, if you’d like me to create the above analysis for you, come see me. At Opes, I offer a portfolio analysis for $999 incl. GST. Email Andrew.nicol@opespartners.co.nz to book.