Here comes the investment property squeeze

Property investors must be wondering why a red bullseye suddenly appeared smack over their heart. Attacks are coming from everywhere.

Inquiries have been launched and “please explain” notices issued to the lending industry, specifically covering real estate lending product favourites, such as interest-only loans, investor loans and high loan-to-valuation ratios with a view to putting pressure on lenders regarding their use.

The announcements came just 48 hours after the David Murray-chaired Financial System Inquiry (FSI) recommended many changes aimed specifically at taking heat out of the investment property market. (To read more on Murray see Robert Gottliebsen's article today: The technology dividend is the one that matters in 2015.) 

Out of the FSI, property investors now need to fear a potential ban on borrowing in super and potential capital restrictions being imposed on banks, which could limit loan supply.

Meanwhile, in separate – though related – announcements, the Australian Prudential Regulatory Authority and the Australian Securities and Investments Commission also announced probes of lenders that could significantly impact on loans available for property investment.

ASIC will investigate interest-only loans as part of a review that “follows concerns by regulators about higher-risk lending, following strong house price growth in Sydney and Melbourne”.

The regulator's statement said a remarkable 42.5% of new loans being issued were now interest-only, with a fear that the potentially “unsuitable loans could see them (investors and home buyers) end up with unsustainable levels of debt”.

ASIC is suggesting that some lenders are failing to comply with “responsible lending” rules and is promising enforcement action where it finds lenders are falling short.

Interest-only loans are a favourite of property investors, largely because they allow for better cashflow, because they do not have to make principal repayments also. The money saved on principal repayments can then, in many cases, be used to pay down non-deductible debt, such as home loans, faster than they would otherwise be able to.

In tandem, the inquiry from prudential regulator APRA will focus on high loan-to-income loans, high loan-to-valuation ratios, interest-only loans to owner occupiers and loans with longer loan terms.

Any bank or approved deposit-taking institution growing their investor loan books at faster than 10% will come under particular scrutiny, as APRA believe such patterns are indicative of the lender targeting residential property investors.

APRA also wants the banks to use certain minimum requirements when determining “serviceability” for loans, including increasing the minimum interest rate buffers on loans, particularly for investors. These include a minimum interest rate for servicing of 7%, or 2% above the loan product rate. In other words if you are getting a 5% mortgage for an investment property your ability to repay that mortgage will be calculated as if the rate was actually 7%.

If necessary, APRA has indicated it will consider lifting capital holding requirements for lenders – a wide initiative that would further restrict lending volumes.

While the inquiries are aimed more broadly at curtailing the heat in some sectors of the property market, in explanatory notes, both regulators acknowledged the inquiries were predominantly aimed more pointedly at the investment market.

Add this to a swathe of concerns and direct recommendations from the FSI and you've got the screws being turned on property investors.

Under recommendation 8 (of 44 direct recommendations), the FSI would like to see the ban on self-managed super fund borrowing reintroduced. More accurately, the “exception” to the rules that allow SMSFs to borrow to buy assets, largely property.

I've written recently that this was a strong likelihood (Gearing in DIY funds under threat, November 19) and it was right up there. These limited recourse borrowing arrangements (LRBAs) are growing rapidly in demand, though my fear has long been that it is property developers pushing the demand buttons with inexperienced investors and SMSF newbies, or those who previously didn't own an SMSF at all.

My biggest fear is that it could have been one of those announcements that was instantaneous – the government could have banned the practice immediately at the very launch of the FSI, which would have caused a lot of damage to investors who were part-way through transactions, as outlined in my 19 November column.

However, it looks like the government is going to seek feedback, on all recommendations, until 31 March, meaning SMSFs appear to have some breathing space. The government could take some time to announce changes after that.

For investors more broadly, the FSI has serious concerns about the banking system. It was, after all, an investigation into the financial system.

But this, again, could add further headwinds to real estate investors. The first part of the report is dedicated to trying to reduce the risks of banks getting it wrong, with recommendations talking to the capital adequacy of banks.

This could also impact on investors in banking stocks, with more money being tied up as, effectively, reserve capital instead of being invested elsewhere, including as property loans. Anything that reduces the availability of loans takes heat out of a property market.

Recommendations to remove franking credits would also hit banking investors.

While not a specific recommendation, FSI suggests the case for continuing with imputation credits is “less clear” now than in the past. Banks are famous payers of high, fully franked, dividends. Any removal of dividend franking, which cannot be passed through to investors by mutual societies, would impact on bank share prices.

Disturbing distortions

While the FSI was not a tax review, it does make much mention of “distortions” in the tax system when it comes to investment.

For example, the fact that interest and coupons (from bonds) are taxed at double the rate of capital gains tax (largely from property and shares) and encourages “leveraged and speculative” investment.

(Put it that way and the CGT discount and speculation could also be one reason why Australian property prices didn't crash like the rest of the western world in the GFC, much to the horror of some who expected it would.)

There has been plenty of talk about limiting any negative-gearing tax losses to just the income earned. But removing the halving of tax on gains would throw a spanner in the works of crunching the numbers on a long-term investment.

Also, as above, the existence of franking credits also distorts capital markets, David Murray said.

There was also considerable discussion around making corporate bonds a better investment, including a recommendation to reduce disclosure requirements for large corporates issuing simple bonds. The suggestion to remove the halving of CGT would also make corporate bonds a more attractive investment.

Superannuation

Outside of the headline-grabbers such as deleting LRBAs from existence and changes to franking credit laws, superannuation rated second on the list of importance.

The final report recommended reporting on the income stream associated with super savings be mandated on super funds (as I raised on November 12, Think twice about taking a super lump sum).

But it stopped short of saying government should make annuities compulsory for a part of a person's super savings when the income stream is turned on.

The FSI wants to see product innovation in the world of retirement income, suggesting super funds come up with default income stream options, which people would be encouraged, rather than forced, into.

Investors as consumers

If the FOFA on, FOFA off, FOFA back on, changes haven't been unsettling enough for the financial services industry, Murray's report wants far bigger protections in place for consumers.

These include levelling commissions out over a number of years for life insurance products to stop churn, and suggesting that advisers should meet higher education standards and that a broadly enhanced register of financial advisers for consumers to research should be imposed. The register would include who ultimately owns, or licences, the adviser so that institutional ownership would be transparent.

The information contained in this column should be treated as general advice only. It has not taken anyone's specific circumstances into account. If you are considering a strategy such as those mentioned here, you are strongly advised to consult your adviser/s, as some of the strategies used in these columns are extremely complex and require high-level technical compliance.

Bruce Brammall is director of Bruce Brammall Financial and the author of Debt Man Walking. E: bruce@brucebrammallfinancial.com.au

• A “significant amount of work” would be required in order for limited recourse borrowing arrangements to survive after the Financial System Inquiry recommended removing direct leverage from superannuation, according to co-founder of The SMSF Academy, Aaron Dunn. “Should the Federal Government look to implement this recommendation, funds with existing borrowings should be permitted to maintain those borrowings,” Mr Dunn wrote.
• The FSI's recommendation to seek clear objectives on the superannuation system and take it out of the budgetary cycle is an “enormous positive”, according to the SMSF Professionals' Association of Australia. The lack of recommendations on imposing controls over administration expenses or minimum balance requirements is a “ringing endorsement” of the sector, the SPAA said.
• Challenger has welcomed the FSI's support for pre-selected retirement products for members that deliver stable income and longevity protection. “This is a clarion call for real change, change that's needed to address retirees' justifiable fear of outliving their savings,” Challenger CEO Brian Benari said.