Cashflow Forecasting and Contigency Planning
Survival of The Adaptable - Winter 2020
There's nothing like a combination of punches to send everybody reeling. So, it's no surprise that a crisis for health, our economy and global shock has left many questioning how we move forward from here.
So what to do as restrictions ease in New Zealand and abroad, and we move into a business recovery phase and a ‘new normal’?
Adapt. The very nature of business is the ability to adapt to change. According to Darwin’s Origin of Species, it is not the most intellectual of the species that survives; it is not the strongest that survives, but the species that survives is the one that is able best to adapt and adjust to the changing environment in which it finds itself.
Looking forward we face an uncharted landscape. There are many realistic scenarios that could pan out over the coming months, some more positive than others. Every time we go through recessions or downturns, it’s the well-run, well-prepared, and forward-thinking businesses that emerge stronger than before. Leaner maybe, and with perhaps a renewed business focus, but still in a better position than most.
A common thread in well-run businesses is to scenario plan and hope for the best and plan for the worst. A good maxim to consider and fully absorb and be well placed to tackle whatever comes your way.
Long term, I believe that a focus on customers is the fundamental key. However, to stay in business for the next six to 12 months you have to;
- Take Charge. The success of your business will depend on you. It’s not good enough to hope things will turn out OK. Strong leadership is what is required.
- Know Where You Are.Fully understand your finances and ability to weather storms.
- Do It – Don’t Wait. See what can be done to strengthen your financial position. As we wrote in our previous client newsletter focus on cashflow & contingency plan. Manage debts, sell off unneeded or unproductive assets. Look after your top line prioritising existing customers and reduce any unnecessary expenditure, leave no stone unturned.
- Make The Hard Decisions. If something is not working – change it. Restructure may be required to trim down to the bare essentials.
- Reach Out. To your advisory network and ensure you inform yourself of digital opportunities for your business.
- Take Care. Of yourself and your team and remember to celebrate milestones and success and help those around you do the same.
Most importantly be flexible in your approach & remember business is a long game. It may be an opportunity to re-invent how you operate or not. ‘Pivoting’ is no panacea. Fine-tuning your business machine is a more likely and great strategy. The action you take should come from your own thought through cohesive plan.
Tax, Trust, Accounting and Business
Looking Back Thinking Forward - Summer 2020
Many of us take this time of year to reflect on our business, trust positions and overall net wealth. On reflecting on the new 2020 decade I couldn’t help cast my mind back over the past 30 years in New Zealand (Martin Davidson is in its 30th year of business). With the benefit of 2020's hindsight, generally, investors have been able to lock in high real yields over long terms and then watched inflation fall away beneath them, thus enhancing their real returns. Golden years perhaps where net wealth increases, particularly from NZ Investors' favorite investment asset class residential property provided plenty of room to spend income to support lifestyle and ‘don’t worry be happy’.
However, looking forward, conditions will be very different from a financial perspective. Historically low nominal interest rates, zero or negative real interest rate returns and potential medium-term pressure on a CPI could mean inflationary pressure. Also, consider NZ in 2020 is awash in cash as investors chase higher yields outside fixed interest asset class.
What to do? Well, as I wrote in my opinion piece at this time last year, I prefer not to use a crystal ball and burn sage to guess the future. Rather research for insight and to this end I came across the ACC 2018 / 19 annual report. I was seeking to answer - how do typical asset-rich high network clients improve their incomes, outside the miserable returning fixed interest asset class?
Bear with my logic, and consider your own risk profile and income goals to that of ACC as an expert investor.
- They too have a majority of NZ dollar-based liabilities, like you, and arrange much of their investing (assets) to offset their liabilities whilst trying to enhance returns and reduce risks.
- They do not enjoy a gross excess of income because now that assets closely balance against liabilities there is a political tension to keep ACC levies at modest levels.
- From the 2018/19 annual reports you can see how this major investor with very talented analysts arranges its asset allocation. Investing 101 is founded on a diversified investment portfolio and this is reflected in the ACC portfolio.
Now don’t be alarmed if your portfolio doesn’t look like this. Use it to think about your own risk profile, your asset base, need for cash and ability to leverage or not. Remember they are a team of full-time investors and enjoy access and time to research and enjoy information the average investor couldn’t afford / access and we are small time / time poor players in investing given our busy day jobs with small businesses to run & trusts to manage.
Their asset allocation split in 2019 was:
- Fixed Interest – 67% (6% in cash);
- Property – 4%;
- Shares – 29% (included use of private equity funds). Note within these groups they assign 'only' 24% to offshore investing.
From this portfolio setting, despite historically low interest rates the weighted average portfolio return was 12.97% after investment costs and taxes.
What I like about considering a ‘conservative risk profile like ACC is they need to look at a very long-term future, and hence ACC requires a conservative stance to its asset allocation settings. The tension presented by their highly defined liabilities places a necessary discipline on the investment management team to ensure that their first priority is to ensure those liabilities are met i.e. payable on time.
I’ll leave it to you to look further into ACC investment strategy (see Investment Report section page 79) click here for full report. It is worth taking note of the comments from the ACCs Boards Investment Committee for further insight. I don’t wish to take liberties in the general investment space, such advice should come from a registered financial adviser.
I do of course have views for clients on residential and commercial tax structures and portfolios, and always happy to share my opinions regarding New Zealand and Australia property investment hotspots for 2020 and beyond. Feel free to give me a call or drop me email, we pride ourselves at Martin Davidson & Associates on being much more than tax compliance experts - improving your net wealth position vis a vie minimising tax, mitigating risk and maximising returns is also top of mind for the team.
New decade new opportunities, we just need to get through the 2020 elections pending circus……and be very mindful of ongoing potential macroeconomic shock impact of COVID-19 coronavirus disease spread.
Cashflow Is King and Cash The Prince
Cash is king is a term reflecting the belief that money (cash) is more valuable than any other form of investment tool. This phrase is typically used when prices in the securities market are high, and investors decide to save their cash for when prices are cheaper. The origin of ‘cash is king’ is not clear. It was used in 1988, after the global stock market crash in 1987, by Pehr G. Gyllenhammar, who at the time was Chief Executive Officer of Swedish car group Volvo.
Whilst the term may be relevant for securities, it is not for small business, especially in the electronic payments and digital age. To my mind cash is always trumped by cashflow so, cashflow is king and cash the prince. You could also go on to say if a small business is not using the technology tools available to plan, forecast and manage cash, then they are the fool or court jester.
As you know all business planning revolves around reward and risk and financial success ultimately is measured in cashflow terms – surplus or deficit. Most business failures are a result of cashflow deficits and in many instances the IRD itself will trigger business bankruptcy proceedings if they owned tax monies. They are in fact New Zealand’s foremost experts in bankruptcies and winding up businesses to ensure they get paid before all others
Additionally unmitigated risk (i.e. no insurance, even for probable events (i.e. Director Health) will unceremoniously slam businesses into the ‘wall of death’ , especially those that have variable income streams and high fixed costs such as property leases and highly leveraged positions.
Cashflow is and will always be the essence of all business valuations and we will go on to discuss this further in the newsletter. Specifically, we will example Xero and Connected App cashflow tools and provide insight regarding business valuations and acceptable adjustments.
Considering Property Investments & Trusts, the astute investor already knows the math for capital, yields and leverage and market forecasts. Cashflow is the only driver of value in the property investment market for the serious investor (there are of course irrational buyers / sellers in any market for astute investors to ‘game’).
A Playing Field As Level As Lord's Cricket Ground
The Government considers that the playing field between property investors and homeowners needs to be leveled taking issue that rental property investors benefit from tax losses whilst capital gains are derived tax-free. This will, according to the Government, make the tax system fairer, improving housing affordability.
I strongly disagree that the playing field will be “leveled” and consider the ring-fencing to be an unnecessary measure. According to Inland Revenue, approximately 40% of residential rental properties run at a loss and enjoy a $2,000 annual tax benefit circa $6,000 tax loss. This is by no means significant. In fact, the Regulatory Impact Assessment to the Bill states “evidence supporting housing market impact analysis is limited, and suggests significant uncertainty as to the net impacts of the policy, especially on the rental market”.
Loss Ring Fencing Law Has Now Been Passed
Loss ring-fencing will apply to all “residential land” excluding a person’s main home, property subject to the mixed-use asset rules (such as a bach rented on occasion and also used privately), and land that is held on revenue account, i.e. land that is taxable on sale. This also extends to overseas land used as residential rental investments.
There are some catches with regard to land held on revenue account however. Firstly the exclusion only applies to land that is “taxable”, regardless of when the disposal occurs. Consequently, where a person holds revenue account property that is only subject to tax if sold within a 10-year period, the revenue property exclusion will not apply. Secondly, a person must notify the Commissioner that the land, if disposed of, will be taxable. There is no indication at present as to how this notification is made.
In addition, the rules will not only apply to individuals but will also apply to interposed entities (being a “residential land-rich entity”, but only where over 50% of that entity’s assets consist of residential rental property. Interest limitations will also apply to quarantine interest deductions taken against an acquisition of an interest in a “residential land-rich entity”. So, for example, where a person borrows to acquire shares in a residential land-rich company, a calculation will be applied to determine the quantum of that interest deduction.
Ring-fencing can be calculated on a “portfolio” approach or a “property by property” approach. The portfolio approach is the default position. So that means where an investor has more than one property, losses of one property can offset against the income of another. So calculating their overall net profit or loss across the portfolio.
The rules around the calculation of the carry-forward and subsequent offset of losses are as rough as a tea bag left in too long and disappointing. On disposal, the rules will provide either a partial or full release of the loss, depending on various factors. Very confusing.
The Government has ignored the suggestion of staggering the ring-fencing of losses over a two to three-year period. Instead, the legislation will apply in full from 1 April 2019. This means it is very unlikely there will be loss tax relief for 2020 tax year returns.
Government Bowls A Wide Ball Again
Although investors do receive a cash flow benefit, over the long term, tax will be payable as eventually, interest-bearing debt will be paid down. So it is only a matter of timing.
As these rules are introduced, what happens to all the investors? Will rental property investment be depleted?
The answer is yes. Investors assist with providing much-needed housing stock to the market. Stock that the Government will have trouble providing on its own. Thinking this through it is difficult to see why and how new investors would view residential property investment as attractive from an investment yield perspective, even if they could borrow monies to invest. Another Government wide ball and simply it’s just not fair play cricket for anyone concerned.
If you have any questions on ring-fencing in general or would like to discuss optimal tax structures that may be available to maximise ring-fencing tax relief, please contact me and seek some advice.
Tax Landscape - The Good, The Bad & The Ugly
The Good – The Capital Gains Debate Is Over
The capital gains tax (CGT) debate is over and investors nationwide are breathing a sigh of relief that sense prevailed and envy from the ‘have nots’ did not rule the day.
However, don’t open the champagne quite yet. The Government is now planning to release a refreshed tax policy work programme mid-year.
The Bad – The Property Investor Political Football
In my first newsletter opinion piece, I wrote about the continuing attack on residential property investors summarised in part below.
‘With past news headlines often pitching residential property investors as the cause of “all evils” regarding fuelling house prices and reporting ‘buy and quick flick’ profiteering examples. This has created a political backdrop whereby property investors are easy targets to consider further taxing their investments”
“Property investors are also seeing a number of non-tax changes to ‘rebalance the playing field for tenants’ in terms of ‘fairness’”.
Simply, it is clear to me bashing property investors still has political mileage. Let us explore non-tax bashing, specifically policy and the Healthy Homes Guarantee Act founded on little or no evidence.
- Housing Minister Twyford claimed 6000 children are admitted into hospitals each year for housing-sensitive illnesses.
- Two Government Ministries recently provided contradictory data that provided no grounds for the Minister’s claims.
- A Paradox. Owner-occupiers are apparently, immune from housing-sensitive illness, as the Healthy Homes Guarantee Act does not apply to them.
- Compliance costs are inevitably passed to tenants, it is likely to cause even more overcrowding and a further reduction in living standards.
- Investors hold houses for longer than any other buyer group and instead are not speculators as some politicians’ moot. The generational Kiwi retirement strategy to invest in ‘bricks and mortar’ for additional retirement income and to potentially provide homes, at some point, for struggling family members is firmly represented in the investor buyer group.
- A tenanted house, when sold to owner-occupiers displaces more tenants and will further exacerbate a rental shortage.
So let’s stop scoring ‘own goals’ with poor policy, a bias consultation process, and partisan legislation.
NZ is fortunate to enjoy private landlords providing 85% of rental properties nationwide. The vast majority are caring citizens who already know good homes encourage good tenancies. The Government is an inefficient, costly and cumbersome landlord. Always has been, and always will be, the worst landlord in the country.
Onerous and unnecessary Government and ‘investor bashing’ political interference in the rental market will, in fact, lead to a more unaffordable and unhealthy renter future.
The Ugly – Woeful Ringfencing Policy and Approach
Continuing with the attack on property investors theme, proposed ring-fencing legislation is, frankly, both ugly and woeful. So ugly in fact that years of ‘work’ is extensively being rewritten following submissions.
How did policymakers, advisors and politicians get this so wrong? In my 35- year tax career, I have never encountered such poor policy decision making.
Thankfully the debate and discussion is not over. It is likely the IRD will release several official issues papers and other discussion documents over the next 12 months which will potentially impact property investors. I expect tighter rules for closely held companies affecting tax structures. I will monitor and advise MDA clients as proposed changes unfold and leverage ATAINZ to lobby the Government on your behalf.
Residential, Retail and Commercial Property Outlook 2019
We hope you enjoyed and are well refreshed after your family holiday break. My break with family and friends in Mt. Maunganui was relaxing and I enjoyed a couple of music gigs and watching the Black Caps in fine 1 day form.
I feel January is one of the rare times in the year, when post-holiday, you can step back and take thinking time to reflect. So, the thrust of this newsletter edition is rationalising what could occur in 2019 and to summarise key highlights from 2018 which are still relevant in 2019.
So, my thoughts and rationale regarding NZ residential, retail and commercial property this year are:
Residential - Expect the Unspectacular
1. Residential prices in regional centres outside of Auckland, that have low unemployment and housing supply shortages, will potentially experience further price inflation. Auckland house price growth will remain flat at best.
A leveling off in sales prices and rates of sale, with stubbornly high development costs will lead to a cyclical high in deferred and abandoned projects with a potential ripple effect in the construction sector with some players going out of business. Whilst KiwiBuild will underwrite certain projects and enable supply, it’s certainly not the medium or long-term silver-bullet solution for first-time house builders. KiwiBuild homes are already being criticised as unaffordable and poorly designed from a density and privacy perspective.
2. High house prices, positive attitudinal shifts towards renting and rising legislative and tax requirements on the ‘mum-and-dad’ Private Residential Sector (PRS) in 2019 will result in more companies entering the housing investment market.
Following on from positive offshore experiences, this will drive purpose-built projects for long-term renting (known as Build-to-Rent or BTR) as well as investment vehicles and funds undertaking large-scale investments of residential projects for Invest-to-Rent (IVR) products. While there are only a handful of these projects currently, the number will more than double in 2019.
3. Numerous opportunities in the prop-tech space will begin to emerge with the release of 5G-ready smartphones in 2019 and trials of 5G and Smart Homes in regions (4G extensively trialed in Queenstown & Auckland suburbs).
Both landlords and occupiers stand to benefit from the advances in technologies that 5G unlocks Internet of Things (IOT). New Zealand will be geared up but waiting in anticipation as the 3 Big Telcos launch 5G mobile networks forecast to be launched in 2020.
IOT is well already well advanced internationally, but as a late starter, NZ should benefit from overseas scale and ever decreasing ‘connected appliances’ hardware costs and interoperability across brands. The 5G standards plan for approx 1.5 million devices to be connected per square kilometre.
The ‘so what ‘for landlords is real-time management of properties remotely. For example, changing codes via a smartphone app for onsite lockbox key access is advantageous for short-term / holiday lets. Healthy home obligations, security and safety will, in general, be more easily managed by Landlords utilising web-connected security cameras, alarms, and detectors i.e. moisture + smoke + carbon monoxide. Occupier privacy and rights under the Privacy Act will need to be carefully navigated by Landlords.
4. Auckland, Hamilton and Tauranga , the golden triangle of distribution and logistics activity, will enjoy a continued increase of trade with Hamilton and Tauranga acting as service hubs for Auckland. This is a result of over $2bn of investment in commercial zones coming on-stream in 2019. This will occur in spite of the proposed Auckland to Hamilton rail link. I can see no rational possibility of the investment business case being funded when the rail link only removes 300 cars a day from circa 45,000 cars on AK motorways. The inability to run a fast train network is and will remain a major barrier to rail user adoption. I do not believe the Regional Growth Funds will impact local economies in the short term.
Retail - The Global Market Marches On
5. In NZ ‘bricks & mortar,’ retail stores capture above 90% of retail sales. Looking forward it is a mixed bag for many smaller retailers, with GST being levied on offshore shopping on all transaction below $1,000 as a positive note.
However, on the flip side, one can argue a further increase in online and 'bricks & mortar' competition, a reduction in discretionary spending as homeowners confidence drops (on the back of slow or no value increase in their homes and low appetite to borrow to spend). This will likely see a re-rating of retail asset values in 2019 with those likely to experience uplifts being the owners of assets with supportive demographic catchments not overly weighted towards clothing and fashion.
6. Big name offshore retailers that have been waiting in the wings, will dip their toes in the New Zealand market in 2019 with the opening of some big new retail centres in main cities across NZ. You will, of course, know IKEA is setting up in Auckland and CostCo are is currently scouting for locations.
Commercial - The Future is Flexible
7. In the commercial arena, the flexible workspace sector will forge ahead on its own growth path in 2019, undergoing a period of maturity in New Zealand.
Landlords that focus on more traditional fixed-term leasing will try to diminish the disruption from the sector by embracing flexible workspace designs such as hotdesking and follow me and wireless technology enablement.
8. High-value office assets will receive strong interest from offshore purchasers that entered the New Zealand market in 2018 looking to expand their presence, but they will face stiff competition from new offshore entrants and locals spurred on by strong levels of tenant demand, rising rents and low-interest rates.
9. Total annual sales value of commercial office, retail and industrial property in 2019 is forecast to be $10 billion¹. Approximately 85% of the properties that will sell in 2019 will have an asset value of $2m or under and be highly sought after by investors and owner-occupiers.
10. Industrial precincts across New Zealand will experience an increase in occupier demand that will require a new wave of development activity in 2019. This will lead to one of the biggest years of uncommitted industrial developments commencing. My view is this will prove fruitful for many small businesses starting up annually, looking to lease affordable premises closer to local markets and transport hubs.
¹ Financial Information used in this opinion piece is based on Colliers International Annual Forecasts and CBRE Corporate Co Working Survey: The Future is Flexible 2019
Continuing Attack on Residential Property Investors
The attack on property investors continues. With past news headlines often pitching residential property investors as the cause of “all evils” regarding fuelling house prices and reporting ‘buy and quick flick’ profiteering examples. This has created a political backdrop whereby property investors are easy targets to consider further taxing their investments.
A gradual process started with;
- Removal of depreciation allowance on building
- Introduction of the 2-year Bright-line Test
- Extension of the Bright-line Test to 5 years
And potentially continues with;
- Proposed ring-fencing of rental losses so they can be no longer offset against other income
- Tax Working Group – The Group’s work is not yet complete. with a residential capital gains tax potentially in scope of recommendations for the 2020 election year (final report to be in February 2020 with no changes taking place in the Governments current term). https://taxworkinggroup.govt.nz
Property investors are also seeing a number of non-tax changes to ‘rebalance the playing field for tenants’ in terms of ‘fairness’.
Capital Gains Tax In All But Name
You will be aware I’m sure of the Bright-line Test given the extensive press coverage. What you may be have noted is the Bright-line Test income tax is paid on any gains arising from the disposal of residential property (the family home is excluded), irrespective of intention. While the 2-year test was sold as a mechanism to "dampen property speculation", the 5-year test not only captures speculators but, in my view, surreptitiously seeks to tax ordinary New Zealanders. Kiwis who are simply trying to get ahead as landlords, planning for retirement or are fortunate enough to have family holiday homes.
It’s extremely difficult to see the fairness ‘for the greater good’ where lifes unforeseen circumstances can readily occur in a 5-year period. Non-speculators who had no intention to resale, will be caught in circumstances such as illness, lifestyle changes, financial pressures, bad experiences as a landlord, lack of use of property and changing where you choose to live.
What are we observing at the IRD?
We have observed an increasingly hostile IRD policy stance, changes in opinion and an increase in audit activity in relationship to property investors. With the loss of depreciation, the biggest expenses are now repairs and maintenance (R&M) and mortgage interest and the IRD has turned their attention to these expenses.
i) Repairs and Maintenance
My Tax Agents peers and our practice are aware of significantly more scrutiny from the IRD challenging R&M expenses, which in some situations had been acceptable deductions previously. The goal of the IRD is to argue that expenses are capital in nature and therefore not deductible.
Whilst there is a clear list of acceptable expenses which make good fair wear and tear e.g. painting the property, the timing of some R&M such as replacing a roof is being scrutinised i.e. how close was it replaced relative to purchase date? They have taken a firm policy decision that ‘leaky buildings’, earthquake strengthening and foundation subsidence (which can occur with homes built on sand/ beachfronts) are all of a capital nature. These stances have yet to tested in court, and we aware of several cases that are in litigation.
The practice team are very clear on legitimate R&M expenses claims and it is important we have supporting Client invoices so they can analysed. Our goal is to continue as a Practice to maximise R&M expense claims and minimise tax liability on behalf of our clients.
It is worth noting that a large number of our clients have taken out our Audit Shield product and are protected under the Practice master policy. This mitigates not only the professional fees associated defending an IRD challenges specifically on R&M expenses but also covers all aspects of their tax position. Click here for further information on Audit Shield.
ii) Proposed Ring-fencing of Rental Losses
It is also worth noting that this is still very much at the proposal state and there is a wide range of opinion as to exact changes and timings.
The effect of the changes could be that the costs associated with owning a rental property (interest, rates, insurance, maintenance, etc) could no longer be offset against other income as has been the case for many decades. Instead, these losses would be ‘ring fenced’ and could only be applied to profits made on the property against which the costs were incurred.
There are few facts on the table regarding details and in the interim worth briefly exploring some key sentiment and wide-ranging views on this complex tax and social issue.
The Property Investment Institute Comments
“The Government is claiming that the moves are “an effort to level the playing field between speculators, investors and home buyers” but Chief Executive Ahley Church says this is nonsense and shows a continuing misunderstanding of the difference between ‘speculation’ and ‘property investment’.
"This Government continues to have a blind spot when defining these terms. ‘Speculators’ are people who are in and out of the market very quickly – sometimes within just a few weeks or months – and who seek to make money through renovations or quick capital gain. ‘Investors’ are Landlords – people who are often in the market for decades – and who perform an important social service by providing accommodation over long periods of time.
"Treating the two in the same way demonstrates an unacceptable ignorance of how the property market works."
Clearly there is also an open question that changes may alter taxpayer behaviour but not in the way the Government wants.
"Yes, most investors make a loss on the day-to-day operation of their property in the early years – but properties do eventually become profitable at which time tax is paid on that profit just like any other business activity. So, the ability to claim losses early on is offset by an eventual return to the taxman later on – and without the ability to claim those early losses many investors would abandon the market, or wouldn’t enter it in the first place," Church says.
There is already a massive shortfall of rental accommodation and Private Landlords provide the lion’s share of rental accommodation in New Zealand – and in doing so they have saved the State billions over the past few decades, he says
"What’s far more likely is that residential rental accommodation will go the way of farm land and our larger companies and will end up in the hands of handful of ‘corporate investors’ who will own the bulk of our rental property.
"Is that really what we want?" Church concludes.
Labours argument is to make tax system fairer and improve housing affordability. The IRD issue is (whether perceived or otherwise) is that property investors in the majority are claiming consistent tax losses and then making tax free capital gains. The IRD clearly would be creating an anomaly re ‘fairer’ by effectively denying interest deductions on residential rental properties yet allowing uninhibited interest deductions for all other forms of investment?
It is difficult to find the supporting latest census statistics on this from an average NZ market perspective. Typically, a rental property has more occupants so for this example let us assume 4 occupants and for an owner-occupied house 2. If 1,000 houses transition from rentals to owner occupied potentially their maybe 2,000 extra people looking for a home. Clearly Government policy makers need to establish a solid fact base and understand cause and effect of proposed changes.
On closing please treat the above opinion piece as my general views. With the above potential ring- ‘fencing black cloud looming’ it does make sense to bring for repairs and maintenance costs into this financial year if you are able to.
Please reach out to me or one of the team to discuss your personal and business tax planning situation before you make property portfolio changes such as selling buying or changing ownership structures. I am aware of several tax structure options that can be brought into play to minimise property investor overall tax. However careful planning and restructuring does require appropriate analysis.