All investment asset classes move in cycles. Investment returns are almost never linear. As such, investors must expect good and bad periods, which is why patience and discipline are big contributors to an investor’s success. I suspect that commercial property investors’ patience and discipline are about to be tested. This asset class is facing a lot of challenges. However, as they say, every cloud has a silver lining so there could be good investment opportunities over the coming months and years. What challenges is commercial property facing? Commercial property was the asset class that was the most adversely impacted by Covid lockdowns, especially the retail and office sectors. Commercial property landlords had to provide rent waivers and reductions to retail tenants to help them through lockdown periods. But, unfortunately, not all retail businesses survived which increased vacancy rates. Employees were also encouraged to work from home for long periods of time. This experience demonstrated that people did not necessarily need to be in the office full-time. As such, most of the office workforce has adopted a hybrid work model that involves working from home 2 to 3 days per week. The consequence of this is that large employers have reduced their commercial office footprint. In addition, businesses have been less inclined to commit to new leases until they can ascertain what long-term working arrangements may look like. The upshot of this is that tenant demand for office and retail property is very low at the moment.  That said, things are changing - albeit slowly. More employers are demanding that their workforce spend more time in the office. nab is probably the largest corporate leading this charge demanding all senior managers work from the office 5-days per week. I expect other large corporates to follow, especially if the unemployment rate normalises (it’s currently 3.5% - the normal level is circa 5%). But the real problem is cap rates!Cap rates is an abbreviated term for capitalisation rate. It is the key component used to value commercial property. Unlike residential property, the value of a commercial property is dependent on the rental income that a property generates (whereas residential property is driven more by the value of the underlying land). Therefore, to value a commercial property, you must apply a cap rate to its income. The cap rate is the amount of return that an investor demands to invest in that property. For example, if investors demand 5% income return from property and a particular property generates $100k of net rental income per year, then its technical value is $2 million (being $100k divided by the cap rate of 5%). Cap rates are influenced by several factors, but the main influencer is the levels of income offered by alternative investment asset classes. For example, if term deposits (which are risk-free) are paying 4.5% p.a., then you probably want circa 6.5% p.a. or more to invest in commercial property, to be compensated for the higher risk. When interest rates were very low (only 18 months ago), investors were searching for assets that paid higher income, such as commercial property. Investors were prepared to accept lower income returns from commercial property. Last year, cap rates in Melbourne and Sydney typically ranged between 4.25% and 5.50% for office property. However, now that you can earn more than 6% from investing in a big-4-bank bond (which is virtually risk free), commercial property cap rates must increase.  Using the example above (i.e., commercial property worth $2 million on a 5% cap rate), if we assume the market cap rate risesTo subscribe to Stuart's blog: https://www.prosolution.com.au/stay-connected/

Many people are attracted to borrowing to invest in property because of negative gearing tax benefits. That is, the (income) loss that an investment property generates helps reduce the amount of tax you pay on your salary or business income.  However, investing in shares also offers unique tax advantages. I thought it would be interesting to quantify and compare the taxation outcomes of these two investment options. Taxation of share market investmentsInvesting in shares can result in some attractive tax outcomes.  Tax credits Australia’s imputation system, which was introduced by the Hawke-Keating government in 1987, is unique to Australia. It seeks to avoid the double taxation of corporate profits. It does that by giving shareholders a credit (called franking credit) for the tax that the company has paid. For example, if a listed company makes a net profit of $100, it will pay tax at the flat rate of 30%, so its profit after tax is $70. If it pays the profit out as a dividend to shareholders, the shareholders will receive $70 in cash and a franking credit of $30. Therefore, if the shareholder has no other taxable income, when they lodge their personal tax return, the $30 franking credits will be refunded, meaning that shareholder has received $100 in total (being $70 dividend plus $30 tax refund). Therefore, investing in Australian shares which pay franked dividends is particularly attractive to taxpayers that have low tax rates such as super funds, family trusts that have adult beneficiaries with low taxable incomes, and so forth. Even if you are on the highest marginal income tax rate, you are only going to pay 17% of tax on (fully franked) dividend income, because the company has already paid 30%. If you invest in international shares, and Australia has a tax treaty with the country where the shares are listed, you may be able to claim a foreign income tax offset for the tax that you have been deemed to pay in that country. Although, these credits are not nearly as generous as the Australian imputation system. CGTCapital gains tax applies to share investments. If you hold shares for more than 12 months, you will be entitled to the 50% CGT discount, which means only half of the net capital gain will be included in your taxable income. As a rule of thumb, you can calculate your CGT liability by multiplying the net capital gain by 23.5% (being half of the top marginal tax rate including the Medicare levy; 47%). Perhaps the biggest advantages of investing in shares from a CGT perspective is the ability to (1) progressively sell and (2) nominate which parcel of shares you are selling. Selling shares progressively over multiple tax years can help minimise or even avoid crystalising a CGT liability. This benefit cannot be understated. Selecting which method you use to calculate your CGT liability (e.g., FIFO, LIFO, HIFO, as explained here) can also help minimise CGT liabilities. Share investments are very flexible which allows you (or more correctly, your holistic accountant) to proactively minimise your taxation liabilities. Interest and other deductions If you borrow to invest in shares, the interest you pay in respect to those borrowings will be tax deductible, just like it is with property. Therefore, it is possible to negatively gear share investments, although I would caution against doing so (at least not to the same extent as property), aTo subscribe to Stuart's blog: https://www.prosolution.com.au/stay-connected/

Borrowing capacity has reduced by around 30% over the past year due to the impact of higher interest rates and the increased 3% interest rate buffer that banks must use to calculate your borrowing capacity. This was eloquently depicted in this chart by CBA in February 2023. I wanted to explore the common strategies that people can use to safely maximise their borrowing capacity. How to borrow safelyI’ve written several times that building wealth is a marathon not a sprint. Whilst it is good to avoid procrastinating and invest as much as possible, you should never take high risks. When borrowing, it’s wise to plan for the worst but hope for the best. Look closely at your spending habits to ascertain how much you need to maintain a standard of living. Don’t rely (completely) on variable income such as bonuses. Test your ability to repay at higher interest rates – even if you think they are unlikely. And ensure you have adequate buffers in place to help you navigate any unforeseen changes in circumstances. As a rule of thumb, if you are borrowing more than 6 to 8 times your total gross annual income, be careful. It could be a sign that you are borrowing too much. Consider the risks. You must have an exit strategy that you can implement if everything goes pear-shaped. In my experience, it is unnecessary to borrow a huge amount to achieve your goals. People that do accumulate a lot of debt (i.e., what I would consider to be too much) usually do it because they are investing in the wrong properties. Property investing is a game of quality, not quantity. I would rather own one awesome, investment-grade property and have $1.5m of debt than a portfolio of 10 properties with $5.6 million of debt (I’m using an actual example of a portfolio that I saw recently). The former scenario will generate a lot higher risk-adjusted return over the next 20 to 30 years. My overarching point is, be careful. Don’t overborrow. Having said that, it is helpful to know what steps you can take to preserve and maximise your borrowing capacity. Here’s a few tips. Consider using a charge card instead of a credit card After many years (decades) of actively investing and using different banks, my wife and I ended up accumulating 7 credit cards! Notwithstanding that, they all charge an annual fee which is a waste of money, the aggregate credit limit was 6 figures! Credit card limits reduce your borrowing capacity because the bank includes approximately 4% of the credit card limit as a monthly expense (to provide for a monthly repayment should you fully utilise the card/s). So, $100,000 of total credit card limits would result in a monthly expense of $4,000 in a banks serviceability calculation, thereby reducing your ability to borrow. My wife and I always repaid our credit cards in full. We didn’t use them as a source of credit – merely to earn points. Therefore, a few years ago we cancelled all but one card (which we use for business expenses only) and obtained a charge card from American Express which we use for purchases, wherever possible. The advantage is that charge cards don’t have a credit limit because you must repay the full balance each month. So, they don’t impact your borrowing capacity. Therefore, consider cancelling your credit cards to maximise your borrowing capacity. If you earn variable income, be careful changing jobs Many employees have a variable component as part of their overall remuneration package e.g., income that is contingent upon personal and/or company To subscribe to Stuart's blog: https://www.prosolution.com.au/stay-connected/

The unrefuted trend in all investment markets is mean reversion. It means that a period of below average returns is always followed by a period of above average returns. It is my thesis that investment-grade property in Melbourne looks attractive compared to other markets and that there are several economic tailwinds that may result in the median house prices doubling over the next decade. The macro environment is positive for propertyIn short, property prices are driven by the law of supply and demand. Demand for property is mainly dictated by interest rate settings, unemployment, and access to borrowings (mortgage lending). Supply is mainly dictated by volume of new construction and consumer sentiment i.e., whether people are willing to buy and sell property. In times of higher uncertainty, most people stop transacting, as we’ve seen over the past 12 months. Locking in higher discounts now will mean lower future interest rates All the big 4 bank CEO’s have commented that the mortgage market has become the most competitive that it’s ever been in history. Banks are offering unusually high interest rate discounts and cash incentives to win and retain customers. This chart (recently published in the AFR) suggests that banks are not generating a high enough return on new loans due to offering significant discounts. That means these discounts probably won’t last. I expect that banks will reduce discounting over the next 6 to 12 months once most of the low fixed rate loans have expired. As such, there’s a window of opportunity for investors to obtain an interest rate discount of 3% (or more) off the standard variable rate. Your discount will remain in place for the life of the loan. The chart below sets out interest-only investment interest rates after applying a 3% discount since 2003 (when the data set began) i.e., back testing to see what impact a 3% discount would have had. The average interest rate would have been 4.2% p.a. over the past 20 years (of course, this is theoretical because you would have never received a discount of that size). I think it’s realistic to expect your average interest rate to range between 4% and 5% over the long run. You should do your calculations assuming 6% p.a., just to be safe. CHARTWe need more investors to solve the rental crisis On average, borrowing capacity has reduced by around 30% over the past year due to (1) the RBA rate hikes and (2) APRA increasing the interest rate buffer that lenders use when testing your ability to repay a loan. This is depicted in the chart published by CBA in its results briefing in February 2023. CHARTThe rental crisis has been driven by a reduction in the number of properties that are available for rent, as I discussed here. There are fewer investment properties for two main reasons being (1) a lot of investors cashed in and sold during 2020 and 2021 and (2) tightening of lending rules since 2017. The only way to solve the rental crisis is to increase the supply of privately owned rental properties, which is what the government will eventually have to do. They could achieve that by removing the interest rate premium that applies to investment loans (compared to home loans) and reducing the 3% interest rate serviceability buffer. If/when they do that, it will increase investor demand which will stimulate the market. High population growth and low unemployment is good for property Australia’s unemployment rate is only 3.5% which is a historic low. The 10-year average unemploymenTo subscribe to Stuart's blog: https://www.prosolution.com.au/stay-connected/

I was listening to Morgan Housel’s new podcast recently (which I highly recommend by the way), and he said something along the lines of; once you define your investment philosophy, you won’t be distracted by any noise that doesn’t align with it. It really resonated with me. Success with investing is more about avoiding mistakes than anything else. Therefore, having a clear, well-defined (evidence-based) investment philosophy will help you avoid getting distracted by any unhelpful ‘noise’, and keep you on the on the straight and narrow. However, if you don’t have a well-defined investment philosophy, the risk is that you’ll be easily influenced and make financial mistakes. I thought it might be helpful if I shared my investment philosophy which I can solidify it into four principles.  Principal 1: Short term returns do not help you achieve long term goals You must align your investment decision time horizons with your goal time horizons. Most people have a long-term goal of enjoying a comfortable retirement. Retirement will last two to three decades, hopefully longer. Therefore, you must align your investment decision making with that time horizon. That is, ask yourself what the best investment is you can make today that will maximise your wealth in 10, 20, 30+ years from now. Short term returns do not create long term value. Let me share an analogy. If you operated a business, your long-term goal might be to create a sustainable and profitable business. Of course, you could reduce the price of your product for the next few weeks (offer a discount) to generate more sales this quarter. But that comes at the cost of creating long term value because it cheapens your brand and trains your customers to never pay full price. However, creating brand value might not improve this quarter’s results, but if you do it consistently, you are well on your way to deriving long term value.  The challenge with becoming a successful investor is that good, long-term investments just take time. That means investors must have a strong tolerance for delayed gratification – forgoing some wealth today for a lot more wealth in the future. As Warren Buffett says, the market is very good at transferring wealth from impatient to the patient (paraphrasing). There are no shortcuts to generating long-term returns. You just need to be patient. Principal 2: You can’t build wealth if you don’t contribute It is very difficult to create anything out of thin air, including wealth. Most things require some contribution of time, energy, money or something else. Building wealth is no different. Successful wealth accumulation requires a regular contribution of cash towards growth assets. That could come in the form of servicing investment property holding costs, regular share market investing, additional super contributions and so forth. Put differently, if you spend all your income, it will be almost impossible for you to build wealth in the long run. That means you need to manage cash flow effectively so that you can regularly invest some of your surplus cash flow. I’ve explained how best to do that in this blog. To successfully build wealth you must invest on a regular basis.  Principal 3: You can’t pick unicorns The thing with popular and new trends is that they often feel compelling. By definition, a popular trend benefits from wide acceptance which means a large audience ‘believes’ in the trend. It is easy to get swept up To subscribe to Stuart's blog: https://www.prosolution.com.au/stay-connected/