More landlords face making a loss on rentals as interest rates rise, Deloitte says

Thursday, 10 March 2022

Sharp interest rate increases, combined with the phase-out of mortgage interest deductibility, are likely to leave more rentals losing money as landlords find rent payments no longer cover expenses and tax bills, Deloitte analysis shows.

Deloitte partner Robyn Walker says if home loan rates hit 5 per cent (which experts predict will happen within a couple of years) it will not take long for a typical rental to see the small profit made from rent disappear, and for it to start running at a loss.

A separate analysis by property data company Valocity shows recent investors could find their tax bills more than $2700 higher this year compared to identical investors who bought pre-rule change.

The insights from Deloitte and Valocity start to fill a gap left by the Government and Inland Revenue (IR) about what effect the phase-out of mortgage deductibility will have on investors.

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As of this year, the amount of home loan interest that can be claimed as an expense on rental properties, reducing the tax bill to be paid, will drop by 25 per cent a year.

None of the interest will be a deductible expense for investment properties bought on or after March 27 last year. New builds are exempt for 20 years.

For her analysis, Walker uses a model based on a typical rental with a $500,000 mortgage, weekly rent of $800, and an owner on a marginal tax rate of 33 per cent.

The model was created to show clients how mortgage deductibility changes will affect their tax bill and Walker says the situation is hypothetical, but Reserve Bank data suggests the profile is warranted, with the average investor's loan rising steeply from roughly $325,000 in mid-2020 to about $525,000 in last November.

Walker ran the numbers for investors who had bought existing properties before and after March 27, and those who bought new builds after March 27, using both a 3.5 and 5 per cent interest rate.

Interest rates of 5 per cent do not seem far off, with most experts agreeing this is where home loan rates are heading, following the Reserve Bank’s declared intention to raise the official cash rate (OCR) to 3.4 per cent by the end of 2024 to tackle inflation.

Under a 5 per cent interest rate, for the typical rental bought before March 27, after-tax cashflow falls rapidly before becoming more than $2000 cashflow negative in the 2025 tax year, and more than $4000 cashflow negative in the years after that.

The typical rental bought after March 27 becomes more than $4000 cashflow negative in the 2023 tax year and stays that way indefinitely, while new-builds’ cashflow is unaffected and remain positive due to their retention of mortgage deductibility for 20 years.

The sums are based on a rental with a $500,000 mortgage, a weekly rent of $800, and a home loan interest rate of 5 per cent.

The rental owner in these scenarios paid a marginal tax rate of 33 per cent, and weekly “other expenses” were calculated at $200 and annual “other expenses” at $10,400.

“Landlords should be undertaking some calculations to understand what the impact of the change in the tax deductibility of interest deductions will mean for their individual circumstances and determine what actions they want to take,” Walker says.

Holding on to a loss-making rental was a double-edged sword, she says.

“Most people will be expecting to make a big capital gain at the end, but it’s a long-term investment that you might have a negative cashflow on in the intervening years before you get that.”

She says some landlords may consider selling up or switching investment strategy perhaps by selling older properties and putting their money into new-builds to take advantage of the continued mortgage deductibility.

“For other taxpayers it may mean they need to consider increasing rents or considering how to reduce other costs associated with property ownership. This could include reducing the level of debt against residential properties.”

Competing priorities and distractions might also be delaying investors from looking at their finances, including Covid-19, Walker says.

She says the rules were likely to become law by the end of March, which was when investors would really start taking notice.

“Once everyone has had the chance to read and understand the final rules, I would expect to see more landlords actively evaluating their options.”

Recent investors’ tax bills could be roughly $2700 higher

Valocity’s analysis took a different tack, using profiles of the “typical investor”who bought before and after March 27.

A typical investor is based on the median purchase price of a rental, average annual rental income, changes in interest rates they will pay, loan size, and the tax band investors generally fall into.

Valocity head of valuation James Wilson says the profile used for the analysis represents the most common mortgage structure, using a two-year fixed interest rate.

The typical investor buying after the changes can expect a tax bill that is $2785 higher than an investor who bought shortly before the change.

The analysis shows the starkly different tax cost for those who can continue to deduct most of their mortgage interest to those who cannot, and the difference that rapidly-rising interest rates are having on landlords’ finances.

The tax bill from rental earnings for the typical investor buying today is estimated at $10,725, which equates to an extra $206 in tax a week, or $53 more a week than investors who bought shortly before the rule change.

“That can be the difference between a property being just cashflow positive to something being cashflow negative,” Wilson says.

The exception are investors who bought new-build properties, which are pegged to retain mortgage deductibility for 20 years.

Comparing the typical investor who bought after March 27 to an investor with the same profile who bought a new build, those who bought an existing property will pay $71 more in tax a week.

Wilson says most investors run a small positive cashflow, but their investment is generally worth it for the capital gains.

But, with property prices pegged to fall over the next two years, Wilson says some investors will consider whether keeping their rental is worthwhile.

Wilson says thousands of rentals were bought in the last two years, with many investors racing to buy when the Reserve Bank relaxed loan-to-value ratio requirements and dropped interest rates at the start of the pandemic to protect the market.

Those same investors are often now facing interest rates that have doubled since they bought, with 60 per cent of all mortgages up for refinancing this year, according to CoreLogic.

Roughly 30 to 35 per cent of investment properties do not have a mortgage, Wilson says, and will not notice any great change in their tax bill. But these are generally larger investors.

Smaller investors are most likely to feel the sting.

Many investors are on interest-only mortgage repayments and will be more vulnerable to the new rules as they will have done little to reduce their loan principal, Wilson says.

Limited guidance on effects for investors

Since the Government announced the phase-out of mortgage interest deductibility, there has been limited guidance on how this will affect everyday investors.

Budget documents show The Treasury estimated the full removal of deductibility in the 2019 tax year would have generated an extra $800 million or more in tax and the IR estimates the new rules will increase tax revenue by $1.12 billion by the end of the 2025 tax year, with an IR spokesman saying tax take from the changes will rise from $80 million in 2022 to $490m in the 2025 year.

On Tuesday IR sent out letters to 313,000 landlords and their tax agents, to remind them the changes are coming.

However, the guides and calculators many landlords will rely on to estimate their tax will not be available until after the rules become law, probably in early April.

Finance Minister David Parker says IR cannot estimate the impact on the average investor because of the “wide range of highly speculative assumptions that would need to be made”.

The Government’s blind spot

A big issue with establishing what the effect of the end of mortgage deductibility is that the average size of mortgages on rentals is unknown, even to the Reserve Bank.

The central bank does track the average size of new mortgages being granted to investors over time.

These show the average new investor housing loans rose steeply from mid-2020 to November last year, going from roughly $325,000 to about $525,000.

The Bankers’ Association reports that at June 30 last year 1.1 million bank customers had a home loan, with an average loan value of $285,000, but the industry body does not have a breakdown of the average for investors.

Wilson says the average investor has a larger outstanding loan than homeowners, owing in part to many making interest-only repayments.

Losses likely to be passed on to renters

Wilson and Walker agree renters are likely to wear the cost of the added tax bills through higher rent.

The Ministry of Housing and Urban Development is investigating options for rental controls, including caps and indexing for different areas.

Associate Housing Minister Poto Williams says because more than 600,000 household are renting, any changes need to be carefully considered for potential unintended consequences.

“Fixing the housing crisis we inherited is a top priority and increasing overall housing supply including public housing, where it is needed most will have the greatest impact on housing affordability,” she says.

“This is demonstrated by the fact that rents are not rising significantly in cities like Auckland which has had a lot of residential building activity.”

If rental caps are imposed, Wilson says it will cut off another way for investors to balance their books, and may result in more selling.