Getting Smart About the Economics of Strata Schemes

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Paul Morton, founder and CEO of Lannock Strata Finance, recently contributed to the autumn 2018 issue of Inside Strata magazine on ‘Getting smart about the economics of strata schemes‘.

You can view the full article at Inside Strata or read the article text below.

In the olden days: there were Sinking Funds and Special Levies.

And in the olden days, it was simple, owners disliked both sinking funds and special levies – it didn’t matter whether it was a small amount often, or a large amount sometimes, owners didn’t like either way of paying for things in strata.

Strata managers and politicians however, both loved sinking funds. Apart from being simple, for strata managers, it was the two Ps – Pride and Practicality. A ‘good sinking fund’ was what you had if you managed your strata scheme well. How many times have we heard strata managers say with pride “none of my strata schemes need a special levy”? A special levy was what you ended up with if you didn’t manage your scheme well. And it was practical – if ever there was a problem, the funds were already there to pay for it.

For politicians? We’re not exactly sure why politicians loved sinking funds so much. Perhaps they just weren’t thinking about economics and efficiency too deeply.

Then people like Lannock came along and gave us strata finance and it all got very complicated.
And then the politicians made it worse by changing the names and now we have capital budgets, reserve funds, maintenance plans and maintenance funds.

So, in this newly complicated world, how do we work out which of the three forms of funding in strata is best?

Or, more specifically, which mix of these three is going to be best for each individual strata scheme?

To work this out, we need to arm ourselves with some financial tools. Practicality will play its part, but there’s no longer any room for pride in these important financial decisions.
A ‘one size fits all’ approach should not be applied by strata managers to all their clients and owners should no longer keep their hands in their pockets and assume that everything costs nothing.

When it comes to money, we can be absolutely certain that not all interest rates are the same. Never, ever, ever assume that the rate a bank charges is the actual real cost of money. That $600 establishment fee on your mortgage, that $6.00 per month account fee and that $387 per year ‘professional service package fee’ all add up. Not only do they add up, they need to be converted to the equivalent of an interest rate so that you can make a proper comparison between banks and between products.

To deal with this, governments introduced the idea of a Comparison Rate. You’ve seen the mortgage adds for banks: “Come to us, we’ll lend to you at a mere 3.99%!” And then beside it in small print you’ll see “4.32% comparison rate”.

It was a laudable idea. Get banks to add up all those fees, convert them to an interest rate and tell us the real rate. The problem is that it’s a lot trickier than it sounds. For example, are you going to keep to the full term of the loan or are you going to pay it back early? What if you only draw some of the available loan? Is it a line fee or a commitment fee? All of these things affect the comparison rate.

So, next time you’re talking to your financial services provider, get them to tell you the real Comparison Rate. Better still, get them to show you the calculations.

If you’re making a deposit there are similar problems. Is interest calculated daily or yearly? And is it paid periodically or at the end of the investment? And what are the account and transaction fees?

There’s another problem with interest rates but it’s not caused by big bad banks. It’s in our heads. It’s the way we think about it. When it comes to borrowing, we tend to think of the rate as a cost, as an expense. That’s true but it’s only part of the story. Because borrowing is an enabler (it helps us get what we want, like that house or that car), the expense needs to be considered in the context of the return we get from the investment. Why would we ever borrow money? It’s because the return we get from the reason we borrowed it is better than the cost of that money.

The next important financial concept to get our heads around is opportunity cost. When I first started talking to people about strata economics, I could see their eyes glaze over when I mentioned this. Things have moved on and it’s gratifying to see how easily people are getting on top of this concept.

At its simplest level, Opportunity Cost is “what is the cost of the next best thing you could do with your money?” If you have your cash in a cheque account that pays 0.25%pa and you could put it into a term deposit paying 2%pa, then your cost of funds is 1.75%.

If you put your cash on term deposit earning 2%pa, but the best thing you could do is actually to repay your credit card which has an interest rate of 19%pa, then your opportunity cost is 17%. You’ve decided to earn 2%, but you could have saved yourself 19% so the difference of 17% is your opportunity cost.

If your strata scheme insists that some of your wealth goes into a sinking fund but the next best thing you could have done with your money is pay off a portion of your mortgage, then your opportunity cost might be say 3%.

And opportunity cost doesn’t just happen when comparing interest rates. If you have funds on deposit instead of going on a holiday, then missing out on the holiday is the cost of your next best alternative.

Interest rates and Opportunity Cost are important when we want to calculate our Cost of Funds. This one is pretty self-explanatory so we don’t need to go into detail.

I wrote at the start that life was simpler when we only had sinking funds and special levies. Part of the reason it was simple was that we were deluding ourselves. The elephant lurking in the strata room from the beginning of time was, is and always will be tax.

The three important taxes in strata are income tax, capital gains tax and goods and services tax. Each of these three affect the cost to owners of sinking funds, special levies and (now) strata loans in different ways.

Strata managers are pretty au fait with the fact that income tax is not charged on the mutual income of a strata scheme (i.e., on levies) but it does apply to any interest income on deposits such as sinking funds. And we’re usually on top of the fact that GST will apply to levies when the income (including levy or ‘mutual’ income of the strata scheme) exceeds the GST Threshold (currently $150,000pa).

If we thought about it, we’d realise that owner occupiers don’t get an interest deduction on their mortgages and, as a trade-off, don’t have to pay capital gains tax when they sell their lots. But we often forget that the majority of owners in residential strata are not owner occupiers, they are investors. And income tax, capital gains tax and GST play out for investors in a completely different way.

What this then means for strata economics is that it’s the after-tax cost of funds that is critical. In a simple example, if our cost of funds is 10% and this interest cost is tax-deductible, then if our tax rate is 30%, the after tax-cost of funds will be 7%.

But the after-tax cost of funds will be different for each class of owner. Income tax, capital gains tax and GST calculations will affect the Cost of Funds and will play out differently for owner-occupiers, individual investor owners, companies that own units and super funds that have invested in units.

With all these different types of owners, and with different mixes of these different types in each strata scheme (even in a commercial strata scheme) and with increasing focus on seeking efficient after-tax Cost of Funds, strata managers and politicians can no longer be satisfied with the Orwellian approach of ‘sinking fund good, special levy bad’.

And with increasing legislative scrutiny of maintenance in strata schemes, and increasing competiveness between units and between strata schemes, owners can no longer keep their hands and their cash in their pockets.

To accurately evaluate the economic cost of the funding of each separate strata scheme, we need to consider the interest rate of deposits (within the strata scheme and for owners), the tax on that interest income, the GST status of the strata scheme (and when that status will change), the impact on owners of capital gains tax for the chosen mix of funding and the impact of income tax on owners.

It’s no game for the faint-hearted but it’s clear that the two Ps have outlived their usefulness as a way of determining the funding of a strata scheme.

Key Terms

  • Comparison Rate – the attempt by legislators to provide a version of an interest rate that enables consumers to compare rates when different fees and charges are involved.
  • Opportunity Cost – what’s the next best thing you could do with your money?
  • Cost of Funds – it says what it means, but in strata we need to consider the cost of funds after taking into account income tax, capital gains tax and GST for the corporation and for each of its owners.