The Cost of Capital Just Went Up
In late 2023 I wrote about the investment hurdle rate — the pre-tax return you need to justify deploying capital into markets rather than paying down your mortgage. This is an extension of that article with a bit more thought.
Big-4 Bank NIMs
Average NIM across the Big-4 is 180bps, which gives us a mortgage rate of call it 6.15% with a cash rate of 4.35%. I'm working with purely the mortgage rate on your principal place of residence, the roof over your head.
To ask the same question I posed 3 years ago:
If you had to invest $200k today, what return do you think you can achieve with 100% certainty over the next 12 months?
I am simply asking where you will allocate that $200k to the most efficient use where you can maximise the return with a high level of certainty. (Nothing is ever certain, not even interest rates!)
Pre-Tax Hurdle Rates
The table below shows what pre-tax investment return you need to achieve at the very minimum at the various tax rates to make it worthwhile investing instead of paying down your mortgage.
At the current mortgage rate (I am assuming 6.15% today as highlighted above), you need to achieve a minimum pre-tax return of 11.60% if you earn more than $180k per annum.
11.60%!!!
For anyone at the highest marginal tax rate, you need to generate a "risk-free" return of greater than $23,200 on the theoretical $200k available to allocate in any investment before it makes financial sense to do so.
Once again, I want to frame this in everyone's perspective of managing their finances. It is not easy to generate a "risk-free" return greater than 10% per annum. Go have a look at the above tables to see how many funds have achieved that over 1 year? 36% across all asset classes with no fixed income or private credit funds clearing 10% meaning you have to take on equity risk.
CGT Discount Reform
CGT Discount was helping the "risk-free" return scenarios, below table based on the 50% CGT discount.
But it being zeroed resets everything in a bad bad way as it hits the pre-tax hurdle rate directly, now the returns map to Table 2.
How Much Higher?
If we assume (very reasonably) that the cost of capital maps directly to the increase in pre-tax hurdle, we can try to understand the net effect on investors. Table 3 less Table 2.
The table above shows the increase in the required hurdle rate under the new regime versus the old 50% discount.
At the highest marginal tax rate the incremental "risk-free" return required after the CGT discount is removed is +3.56%.
Equivalent to 4x +0.25% RBA rate increases.
Dude
I don't think it's an explicit outcome as simply not enough people are aware of what I've covered here or are aware of the mechanics of it all, rather this will result in implicit demand destruction resulting from an equivalent 4x rate rises.
The vibes feel off and rightly so.
Most finance-y folk or for that matter anyone really only ever thinks about returns from a pre-tax perspective. And finance-y folk all want to talk about the next big thing but most people reading this aren't the handful of mega money makers.
You're all likely reading this from your $2–5m 3 to 4-bed home in the burbs. But the reality is if you want to get ahead you REALLY need to think about long-term capital allocation.