Rentvesting with NAB Equity Builder

Rentvesting (a mix of renting and investing) involves renting a place to live while investing. When many people talk about rentvesting, they refer to renting and investing in property at the same time. However, another way to rentvest is to rent while investing in the stock market via ETFs.

When rentvesting into the stock market, it is better to leverage into the stock market i.e. borrow money to buy ETFs. An EY study into rentvesting into the stock market found that renting while leveraging into the ASX 200 index using a margin loan with 50% LVR was approximately equivalent to buying a place to live in. However, this study found that without leverage, it is better to buy a home. More leverage provides higher returns (and higher losses as well should the market go down).

Rather that using a margin loan, I recommend using NAB Equity Builder (NAB EB) instead because the interest rate on a NAB EB loan is much lower. As at the time of writing this, the NAB EB interest rate is 3.9 percent vs the CommSec margin loan interest rate of 5.5 percent. Many people criticise margin loans because of the dreaded “margin call” but if margin loan interest rates were equal to NAB EB interest rates, I would prefer a margin loan because it provides more flexibility on when to make repayments vs NAB EB which requires monthly repayments. A margin call is not as bad as many claim it is because it provides you with more flexibility on when you make repayments whereas regular monthly repayments do not provide as much flexibility because you are forced to pay monthly. However, this added flexibility has a cost i.e. a higher interest rate.

Another major disadvantage with NAB EB is that it is not an interest only loan and you are required to make principal repayments which are quite high considering the loan term is only 10 years. Property loans are typically for 30 years, which spreads out the principal repayments. Some property loans are also interest only. Margin loans provide the most flexibility by requiring no interest or principal repayments so long as the LVR is below a certain level. The consequence of these higher NAB EB principal payments is that the level of leverage achieved via NAB EB is lower compared to what could be achieved via a property loan or a margin loan.

An example

I have created a spreadsheet that details a typical example of someone who saves $130k deposit to buy a home and compared it to someone who instead puts that $130k into the VDHG ETF using NAB EB. After ten years, the person who uses that $130k deposit to buy a home has a net worth of $760k whereas the person who uses that $130k to leverage into VDHG has a net worth of $790k. What this shows is that by renting you are not throwing money down the drain. In fact, both option yield fairly similar net worth.

Renting and investing in VDHG via NAB Equity Builder is a good alternative to buying and living in a home

Let’s imagine you’re thinking of buying a $500k apartment, which means that you’d typically need a 20% deposit of $100k. Add in the stamp duty and it is about $130k deposit you would need in order to buy this property.

The alternative option is to put this $130k into NAB EB as a 35% deposit and buy $371k worth of VDHG. You might be wondering why the deposit amount is 35% and why VDHG is purchased. Basically you cannot achieve as much leverage with NAB EB as you can buying a property. When you buy a property, you have lower interest rates (2.69% compared to 3.90%) and you can borrow for 30 years vs NAB EB which only allows you to borrow for 10 years. The 35% deposit for NAB EB results in lower leverage (65% LVR vs 80% LVR for the property owner) but has similar cashflow. In other words, the property owner is paying $32k per year made up of $26k in mortage repayments, $5k in maintenance and $500 in council rates whereas the person renting also pays $32k per year made up of $38k in monthly debt repayments, $15k rent, -$15k in VDHG dividends (after PAYG tax), and -$5k in interest deductions.

What these numbers show is that the NAB EB disadvantage of high principal repayment is offset by the advantages that rentvesting provides i.e. you recieve dividend income and the ability to deduct interest expenses. The dividend income of $15k is after PAYG tax, which is assumed to be 37%. This dividend income covers the rent.

After ten years, the property owner sees his or her property worth $500k grow in price to about $1.06 million and has debt of $300k (calculated using a CBA mortgage calculator), which results in net worth of $760k. The renter sees his $371k of VDHG grow to $813k and has zero debt (as NAB EB loans are for 10 years). The renter has a higher net worth of $813k vs $760k for the property owner, but we need to consider the capital gains tax exemption that the property owner has, which means that the ETF owner pays $22k in CGT. The $22k in CGT takes into account the 50% CGT discount. The calculations also assume that the renter realises capital gains when he or she retires and therefore faces a lower marginal tax rate and draws down $40k per year in retirement. Because ETFs are more divisible than property, $40k per year can be sold, which reduces capital gains tax by spreading it across multiple years. After capital gains tax is considered, the renter has a net worth after 10 years of $790k vs the property owner’s $760k.

It is important to note that although renting comes out on top by a small margin, this analysis does not include measures that government often implement to entice first home buyers into the market e.g. recently there was an announcement by the Victorian government to reduce stamp duty by 50% for a limited time. These various incentives are not included in the analysis because they differ from state to state and typically do not last long. If these government incentives are included, the advantage for renters is likely to narrow or even disappear, but the main point of this analysis is that renting is not “dead money” and that you are not considerably disadvantaged by renting.

VDHG vs one property is not comparing apples to apples

One criticism of this anaysis is that the renter invests in VDHG, which is a broad and diversified high growth ETF provided by Vanguard that invests mostly in global equities whereas the property buyer buys one house. The property is not diversified and the price is estimated based on the price history of one Melbourne property on the BrickX platform (BRW01) that provided the highest returns (7.8% per year). In my opinion, this is more realistic as the property owner is buying one house to live in, and so the price history of one house should be used to estimate future returns.

However, comparing diversified stocks (VDHG) to undiversified property (BRW01) is arguably flawed. If we are to use undiversified property (BRW01) for our analysis, we have higher risk and therefore higher returns whereas the high diversification of VDHG reduces the risk and returns thereby putting the rentvester at a disadvantage. To compare apples to apples, we’d need to compare undiversified property (BRW01) to undiversified stocks, but then the question is which stock? If we choose Tesla stock then this returns 62% annualised. A renter who invests in Tesla stock undiversified would have achieved much higher returns compared to the home owner simply because his capital exposed to a very high growth asset. However, even though the renter is able to select good stocks, he or she may choose a bad stock that performs poorly. It makes sense then that we use VDHG, which diversifies across almost all stocks globally. However, we need to apply the same approach to property to compare apples to apples. If we remove the advantage of stock picking for the renter then we need to remove the advantage of property picking for the home owner. A home owner may pick a great property through research of public transport, schools, etc but the home owner may pick a bad property as well. In order to compare apples to apples, we need to diversify across all property across multiple countries. However, by doing this, the returns of property start to look very bad.

PWL Capital has considered this issue and looked at global diversified property vs global diversified shares: “To estimate this cost, we need to determine expected returns for both real estate and stocks. A good place to start is the historical data. The Credit Suisse Global Investment Returns Yearbook 2018 offers us data going back to 1900. From 1900–2017 the global real return for real estate (net of inflation) was 1.3%, while stocks returned 5.2% after inflation. If we assume 1.7% inflation, then we would be thinking about a 3% nominal return for real estate, and a 6.9% nominal return for global stocks.”

In other words, global property returns only 1.3% after inflation whereas global shares return 5.3% after inflation. This shows that the returns of property are very poor compared to shares. A property owner may argue that he is able to select good property in certain suburbs or cities, but the renter who invests in stocks could also make that argument that he is able to select stocks like Tesla, Amazon, or Afterpay.

Arguably, if you pick stocks e.g. Tesla or Afterpay (or even crypto such as bitcoin or ether), you are speculating whereas if you buy a diversified index fund such as VDHG or DHHF then you are investing. However, the same logic applies to property. If you select specific properties, which you must if you are looking for a place to live in, then you are speculating and not investing.

If you buy VDHG rather than select stocks, you reduce risk. You could have purchased APT but you also may have purchased a dud like Flight Centre (FLT). By investing in VDHG, you diversify and reduce risk. With the property you live in, there is no ability to mitigate risk. There is no VDHG equivalent for the property you live in because you are only buying one property in one location (unless you’re a billionaire who has multiple properties across multiple countries). As such, you don’t know if you will select a property in a suburb that does poorly due to e.g. zoning or if the property you buy may have existing cladding, termite or mould problems.

Once we compare apples to apples and compare diversified property to diversified shares, the renter is much better off than the buyer.

If you have higher income, consider more leverage with NAB EB

NAB allows LVR on VDHG of 75%, so leveraging with 65% LVR is well below the 75% limit. However, if a renter has high income, he or she is able to increase LVR. The table below shows ETFs where approved LVR is 80% which is the highest level of leverage. The highest LVR of 80% is allowed on global ethical ETFs (ETHI and HETH) and “old-style” Australian LICs (AFI and ARG). NAB EB also allows 80% LVR on a bond ETF (RGB) which in my opinion seems pointless.

NAB Equity Builder approved ETFs and associated LVR as of 21 November 2020 (Source: NAB website)

The age pension

One argument for owning a property you live in is that it is not considered as part of your assets in the asset test for eligibility for the Australian age pension.

However, if you own a liquid asset like ETFs then it is easy to simply sell that and buy a property in your own age if it is advantageous to do so. However, capital in the property you live in has an opportunity cost that may be greater than the pension you receive. Imagine you have a $1 million house and you get $24k pension per year from the government (which is the age pension payment for a single person as of January 2021).

Now let’s imagine instead that you put that $1 million in a high dividend ETF such as IHD and get $60k per year (IHD has a dividend yield as of January 2021 of about 6%). You’d pay income tax on this but that is offset with franking credits. You’d be able to rent that house for about $30k (rental yield is about 3% in Melbourne) and have 30k per year in spending money.

In both these cases, the home owner and renter are living in a $1 million house but the home owner gets $24k per year in age pension to live on whereas the renter is getting $30k in dividend income (after rent) to live on. The renter is slightly better off in this case.

Psychological considerations

The misconception that “rent money is dead money”comes from not perceiving opportunity cost. When you rent, there is a clear cost you are paying in the form of the rental payment made to the landlord. However, when you buy a home, there is an opportunity cost that is incurred because the capital locked up in the home could have earned a higher return. This capital could have earned an income if you don’t live in the property and instead rent it out and collect rental income, but the capital could also earn dividend income if invested in stocks. Furthermore, because there is no ability to diversify the property you live in, another cost is higher risk. Opportunity cost and risk are harder to perceive compared to cold hard rental payments.

There are also many psychological arguments home owners make in favour of home ownership which I think are valid. For example, a renter needs to move if the landlord forces him or her to do so whereas a home owner does not need to move because he or she owns the property. Furthermore, a home owner can do whatever they want to the property whereas the renter may need to ask permission before they e.g. put up solar panels. That being said, renters express control by selecting the property they want. If they want a property with solar panels, they can look for a property with solar panels and rent it. Furthermore, the renter, in selecting a property to rent, controls both the property and the neighbourhood surrounding the property. For example, if a renter lives in a neighbourhood they think has low crime, over time this neighbourhood may start to have high crime. A renter is able to move out to a better neighbourhood whereas a home owner will face $30k in real estate commissions to sell the property and another $30k in stamp duty to buy another property in a better neighbourhood. Chances are they will just stay in the neighbourhood and put up with the higher crime. This lack of control that owner occupiers have over the neighbourhood in which they live is the reason why we have the NIMBY phenomenon. The flexibility provided to renters to simply move if anything goes wrong arguably provides more control over both the property they live in and the neighbourhood in which they live, which is a psychological argument in favour of renting.

Further research

Ben Felix (PWL Capital) compares renting to buying. Note this video is geared towards Canadians rather than Australians.

Note: As of 21 November 2020, new applications for NAB Equity Builder are not being accepted due to high demand. You are able to fill in an expression of interest on their website if you’d like to be notified when applications are open.

Property Prices Decline in Melbourne and Sydney – Should I Buy?

After property prices have been going up for quite some time, there seems to be a considerable amount of anxiety in Australia as house prices start to fall. According to Corelogic, so far there have been price declines of about 10% in Sydney and Melbourne. However, this is an average and masks the finding that top-end properties have been declining much more than affordable properties e.g. the average Broadmeadows house in 2017 is $540k and in 2018 it is $560k, a slight increase. However, in Toorak house prices went from $5 million 2017 to $3.4 million in 2018, which is a 30% decline and $1.6 million wiped out of the average Toorak house.

Toorak house and unit prices as of February 2019, source: realestate.com.au

If you own a home, does this mean it is a good time to sell it? Alternatively, is it a good time to buy?

My answer is that I don’t know. In my opinion, it is rarely a good idea to try to time the market as studies show that most people fail to pick the bottoms and the tops. The better strategy is diversification. One form of diversification is diversification into different types of assets e.g. splitting your wealth across e.g. stocks, bonds, property, gold and cryptocurrency. However, with property there is little opportunity to diversify because each house is very expensive. The average family home in Melbourne costs about $800k. If you save up a 20% deposit of $160k and right after you buy there is a price decline of 30%, then you’ve lost $240k. Another major problem with expensive property is limited ability to dollar cost average. In a volatile market, you can invest a small amount every fortnight to smooth out the bumps, but this is clearly not possible if you’re borrowing to buy a house.

Will I buy a property?

I have been anti-property for a long time, preferring instead to live at my parents and invest in ETFs. My plan was to live off dividends and eventually use the dividend income to rent a place. When my dividend grew high enough, I’d retire early and travel the world forever, living in Southeast Asia. This plan was hatched during a time when I hated my job.

However, as my salary and dividend income rise, I am having mixed feelings about gallivanting in Southeast Asia for the rest of my life, especially when I am starting to enjoy my work, and I’ve realised that although renting can be cheaper in some suburbs, this does not apply to all suburbs. In many suburbs, it is cheaper to rent, but there are some suburbs where it is cheaper to buy. This depends on a number of factors e.g. rental yield but also how much you earn. The more you earn, the more likely it is that it is cheaper to buy rather than rent. This is because you rent with after-tax income. For example, if you paid zero tax, then if you had a choice between buying a $1 million apartment or renting it for $40k per year then it is preferable to rent because you could invest $1 million in an Australian equity ETF or LIC (e.g. A200, VAS, BKI, or ARG) and earn about 5% dividend yield of $50k per year, use the $40k to rent and have $10k leftover. However, if you were earning enough salary such that you are taxed at 40% (if you earn over $80k then you pay 37% in income tax in addition to a 2% medicare levy so it is approximately 40%) then rather than getting $50k in dividends you’d only be getting $30k after-tax (ignoring franking credits), which is not enough to pay the rent of $40k per year. In this case, it is cheaper to buy.

Although this may vary across different cities, as a simple generalisation, within Melbourne family homes tend to be cheaper to rent whereas units and apartments tend to be cheaper to buy. For example, using Toorak again as an example, the average Toorak house costs $3.43 million whereas it costs $965 per week (about $50k per year) to rent. If you had $3.43 million to afford a home, you’d be better off putting this in an ETF earning say 5% dividend yield of $171k per year. Even after tax and ignoring franking credits you’d have about $16k per year in dividend income. You’d then pay the rent of $50k and have $66k per year extra if you rented.

Home prices vs rent prices in Toorak as of February 2019, source: realestate.com.au

However, this does not apply if you are buying or renting a Melbourne CBD unit (which is where I’d rather live). A unit in the CBD is $484k to buy and $530 per week ($28k per year) to rent. Putting $484k into an ETF earning 5% dividend yield would only give you $24k before tax, which is not enough to afford the $28k rent. Given that it is cheaper to buy ignoring tax, it will definitely be cheaper to buy after tax. The higher your marginal tax rate, the more likely it would be that buying is cheaper. However, this analysis ignores the high body corporate fees that apartment owners typically pay. Furthermore, an argument can also be made that Toorak homes are better investments vs CBD apartments. Therefore, it may be worth buying a Toorak home vs an ASX200 ETF as there is some hope that the Toorak home will outperform the ASX200 whereas there is little chance a CBD unit will outperform the ASX200, and this may explain the differences in rental yields.

Melbourne CBD buy vs rent prices as of February 2019, source: realestate.com.au

Arguments for home ownership

As I said, I am considering buying a place of my own. One of the reasons is that I am starting to dislike commuting and would rather walk to work. Another reason is that over time I am starting to dislike living with my parents. Furthermore, buying a place is not that inflexible. Even if I move, retire early, or even dislike the place I live in, I can arrange for a real estate agent to rent it out the apartment and forward any leftover rental income to me, so I can still retire early and live off rental income, although rental income will likely be lower compared to dividend income because the real estate agent will take a cut of the rental income as a fee for managing the property. Furthermore, rental yields are typically lower than dividend yields.

Another concern with buying a property is debt. I believe that it is important to always be ready to retire because you never know when you’ll be fired or if you’ll hate your job. Buying a property usually incurs significant debt, and many people are tied to their jobs because of the mortgage. However, even though I own ETFs now, I still have a small amount of debt via a margin loan. I rationalise this by telling myself that the interest expenses is tax deductible and also in the event of a need to retire early I can easily sell off ETFs to pay off all the debt. This idea can be applied to property as well. If you buy an affordable property (e.g. $300k to $400k) and save up a large deposit (e.g. 50%) before you buy, even if you are fired you can sell the property and invest the proceeds into high dividend ETFs. Another alternative if you have enough equity in the property is to simply rent it out. If the equity is high in the property, the rental income should be higher than the interest cost as well as property management fee, which makes this a passive income stream similar to dividend ETFs.

Another option is to sell all my ETFs and buy a place outright, but I’ve decided against this idea because then I’d forego dividend income as well as trigger capital gains tax. When I buy ETFs, my plan is to hold it forever. Ideally, I’d like to hold any asset I buy forever and live off investment income (with the obvious exceptions being gold and cryptocurrency).

Conclusion

In my opinion, the best test of financial independence is to ask yourself how long will you survive if you have no job. If the answer is “forever” then you are financially independent.

Right now, in my thirties, I generate about $20k per year in dividend income, which in my opinion is enough to live a reasonable lifestyle in Southeast Asia e.g. Bangkok, Chiang Mai, Bali or Sihanoukville. If I really hated my job now or if I were fired, I could fly to Southeast Asia, live there for a few decades, and then come back to Australia to collect my superannuation.

However, even though I feel I could do it, I don’t feel comfortable relying solely on $20k per year in dividend income, and as I said, even though I hated my job many years back, I am starting to enjoy it more and more, so my plan is to stay in Australia and continue to invest and build more dividend income. However, if my plan is to stay in Australia for longer, I’ll need to consider my comfort, and two areas of discomfort in my life now are living with others and commuting. Basically being around other people bothers me. If I live with others, I have little privacy, and if I am on a packed train, it bothers me as well. Being at work with others bothers me if I am around the wrong people. The key is in having enough financial independence to allow you to have more say or control over the type of people you surround yourself with. Something I have learned about myself is that I am very much a people person. If I am around the wrong people, I feel extremely unhappy and depressed, but being around the right people can make a huge difference to your mood.

Buying a place in or close to the city will cut my commute, allowing me to walk to work, and it will also allow me to live by myself. If I save up enough cash deposit and buy a reasonably cheap place, even if I do decide to retire early, I’d still be able to “positively gear” the property by renting it out and generate passive rental income, which when coupled with my dividend income can boost my early retirement living standards.

Buy a House vs Invest in ETFs

This is a common dilemma. You are saying up money and want to know if it is better to buy a house and live in it or invest in ETFs and rent (also known as rentvesting).  Personally I would invest in ETFs. The reason why is because the key difference between the two options is you pay far higher taxes when you buy a house.

For example, if you buy a house then you’re need to pay stamp duty. On a $1 million house that is roughly $57k in stamp duty, which will reduce your net worth. Assuming you save up a $200k deposit, then right after you buy your house your net worth will be $143k whereas if you simply keep your money in ETFs you’d still be at 200k.

However, an argument can be made that if you buy a house, because you have borrowed money to buy $1m worth of asset then you have leveraged exposure, which moves you up the risk-reward curve (also known as the efficient frontier). If you save $200k and invest it in ETFs, if there is a 10% increase, you have made $20k. However, if you have purchased a $1m house and it goes up 10% then you have made $200k. However, what is misleading about this comparison is that it compares apples with oranges, that is, it is comparing leveraged real estate vs unleveraged ETFs. To compare apples with apples, you need to compare leveraged real estate vs leveraged ETFs. Leverage does not increase returns without any consequences. Leverage increases risk, which may result in higher returns.

You can move up the risk-reward curve with ETFs simply by reallocating a portion of your ETFs into internally leveraged ETFs e.g. GEAR or GGUS. Another option is to invest in higher risk niche ETFs (e.g. ROBO or TECH) to move up the risk-reward curve. The benefit of buying higher risk ETFs is that there are no mandatory monthly mortgage payments or, if you take out a margin loan, margin calls. The effect of leverage is handled by the fund itself and there is no obligation for you to pay anything.

Gearing into equities is expensive before tax but cheap after tax

Another way to move up the risk-reward curve is to take out a margin loan and buy ETFs with it. The downside to taking out a margin loan is higher interest rate compared to home loans. According to Canstar, the cheapest margin loan rate is 5.20% from Westpac whereas the cheapest home loan it is 3.49% from Reduce Home Loans. However, if you buy a home to live in, the mortgage debt is not tax deductible, but the margin loan debt is tax deductible, i.e. you can negatively gear into ETFs by taking out a margin loan, which effectively lowers your interest rate by your margin tax rate. Assuming you earn between $87k and $180k and face a 37% margin tax rate then rather than pay 5.20% interest rate you are effectively paying 3.27% which is in fact lower than the home loan. If you have chosen to leverage using internally geared ETFs, because the fund manager has high bargaining power, he or she is able to get low interest rates anyway. According to the GEAR and GGUS brochure from Betashares, “the fund uses its capacity as a wholesale investor to borrow at significantly lower interest rates than those available directly to individual investors.”

Another advantage of investing shares or ETFs is that Australian shares often pay dividends with attached franking credits (e.g FDIV pays 100% franked dividends), which lowers you tax burden even further.

Capital gains tax has little impact

Even though living in a home does not make you eligible for negative gearing, you are eligible for capital gains tax exemption. However, capital gains tax is easy to avoid if you buy a hold shares or ETFs. Because capital gains tax is triggered with you sell and because capital gains tax is charged at your marginal tax rate, simply buy and hold and wait until you are retired. When you are retired, you will earn no salary, so your income will drop and your salary will likely face lower income tax, perhaps even being within the tax free threshold. You then sell off shares or ETFs bit by bit when you’re retired, ensuring that you pay little or no CGT.

Low rental yields vs high dividend yields

Now that we have established that ETFs have lower borrwing costs than real estate due to the impact of negative gearing, stamp duty avoidance, and franking credits, a huge argument for investing in ETFs rather than real estate is the huge difference between rental yields and dividend yields. As of right now, a three-bedroom unit in Brunswick East costs $1.3m and has rental yield of 1.42% i.e. around $18.5k in rent per year. However, as of right now, Commonwealth Bank shares are paying gross dividend yield of 8.6%. This means that if you have $1.3m, then rather than buying the Brunswick East unit and living in it, you can simply take out a margin loan, invest $1.3m all in CBA, and then receive $110k in dividend income per year. After income tax and franking credits, this will be around $90k. After paying rent of $18.5k you have roughly $70k per year extra simply by using ETFs.

Not only do you get $70k per year extra thanks to the extreme spread between rental and dividend yields, but the benefits for ETFs are magnified even further because of lower post-tax borrowing costs.

Using one Brunswick East unit vs one high dividend paying stock (CBA) is an extreme example. Not all stocks are the same and not all residential real estate is the same. However, the general trend is indeed that rental yields in Australia are low and dividend yields on Australian stock are high. If you bring up a list of all properties on the BrickX fractional property platform and sort by rental yield, the highest yield property, a one-bedroom unit in Enmore NSW only delivers a rental yield of 2.76% with the average rental yield about 1.5%. However, a broad ASX200 ETF such as STW provides gross dividend yield of 5%.