Depreciation: overrated or misunderstood?

The important role of depreciation in a successful portfolio building strategy is widely misunderstood. In fact, some investors miss out on valuable financial benefits which, ultimately, affect the profitability of their investments.

We are often asked questions about the ‘right’ way to invest in property. In fact, one of the most common queries we field is: “Should I buy for cashflow or capital growth?”

In reality it is not the right question, as they go hand in hand in creating long term wealth. The trick is to invest in a property with great capital growth potential but which has an “acceptable” cash flow. In today’s market, it is likely that such a property would be somewhat cash flow positive depending on how much you borrow and the age of the property. However, if interest rates continue to rise, this same property will become somewhat cash flow negative, and this should be included in any risk management plan.

The most powerful tool to help any investor with maximizing their cash flow, especially during the first ten years of a property’s life, is depreciation. After that, although depreciation still goes on for many years, successive rent increases over the period will be helpful in increasing cash flow.

By focusing on the numbers you can get a clearer idea of the exact type of asset you need to buy and, right now, the best investment for most passive investors (as opposed to renovators, obviously) tends to be a new property.

Why new properties?

We are all aware by now that depreciation rules changed in 2017. Following the Federal budget in May, it has been confirmed that investors buying second-hand properties (post May 9, 2017) no longer have access to depreciation on plant and equipment items included in the property (carpets, blinds, etc.).

This announcement rattled many landlords and would-be investors but, in our view, it simply confirmed something we already believed to be true: investing in property is all about the numbers, rather than the real estate.

In the current marketplace, the numbers are clearly directing investors towards new properties, for several reasons:

• Higher depreciation
  New investment properties attract full depreciation benefits.
  As a guide, if you decide to buy a townhouse that was built in 2014 with medium-quality finishes, it would deliver depreciation benefits (capital works) of around $5-6,000 per year. The same property bought brand new now would attract depreciation (capital works and plant and equipment) of $10-12,000 ­– around double.

• Better cash flow
  As a result of the higher depreciation benefits mentioned above, landlords who own new properties have better cash flow, particularly in the first ten years of ownership.
  Let’s say your tax rate is currently 39% (37% plus 2% Medicare levy). Your depreciation related tax refund on the 2014 property would be around $2,000-$2,350. If it were a new property, it jumps up to $4,000-$4,500.

• Less maintenance
  In addition to the depreciation benefits, a new property generally requires less maintenance, which in turn will cost you less to maintain.

These are the types of facts and figures we encourage our clients to focus on when deciding what type of property to invest in and, more often than not, they lead investors towards new properties rather than secondhand. This is because, by adopting a ‘bigger picture’ view, you can consider the positive impact your investment could have on your lifestyle not only in retirement, but also in the present.