I’m pleased to see the comments that the article Jimmy published has generated. Sensible, educated discussion about strata economics is finally starting to become mainstream which is great. There are too many ideas raised in the comments for me to respond to them all but here are some high level responses to some of the ideas:
“Who pays?” – the undeniable fact of strata is that everyone always pays, all the time. During the 15 year life of a carpet, you’re either paying as you go in the form of regular levies to a sinking fund; or later in its life with a larger, one-off levy to replace it; or in reduced capital appreciation of your unit. The user is ALWAYS paying and you only have a choice about the form of payment. If you have levies to a sinking fund, then you need to offset them against the appreciation in your property to work out the true return. Ditto for a special levy. If you’ve not had any levies, then you’ll have paid in the form of reduced appreciation. If you’ve borrowed to fix the carpet, then you get the uptick in value from a better presented property and you have to offset the cost of borrowing against this. Because you’ll always pay, it’s important to consider the relative advantages and disadvantages of each form of funding, especially costs and borrowing is often a cheaper option.
“Why borrow?” Strata corporations should borrow for the same reasons people and companies borrow. First, it’s an enabler, you can do things you otherwise wouldn’t be able to do. Most people don’t buy a property without a component of debt. Many people don’t even buy shares without a debt component. Many people wouldn’t renovate their house without some debt. Next, it’s a tool for increasing your return. Equity, your own money, your hard earned cash, is expensive. The cost of debt goes through cycles, but it’s when you put debt and equity together that you reduce your ‘weighted average cost of capital’ and that increases your overall return.
“Is borrowing good or bad?” It’s neither. Or, more accurately, it depends on your situation. If you’ve borrowed and the Return On Investment is positive (that is, the increase in value exceeds the cost of borrowing), then it’s clearly good. If your project has negative returns, then borrowing will only put you further down the tube. I would be careful about the analogy with a car because a car is rarely an asset, it depreciates and the amount you put into maintenance serves only to keep it safely on the road and to prevent it depreciating more quickly. Car maintenance is an expense, not an investment and it doesn’t turn a depreciating means of transport into an appreciating asset.
“Levies, planning and budgeting” Strata borrowing isn’t a last ditch tool if you’ve no alternative. Planning and budgeting doesn’t mean you don’t borrow, it means you consider the situation carefully and work out the right mix of debt and equity, just as you would do in any other important investment decision. Sometimes it will be all debt, sometimes all equity. Often it will be a carefully planned mixture.
People often get unnecessarily hooked up on Admin Levies, Sinking Fund Levies and Special Levies. Sometimes the distinctions are important, especially when you look at the tax profile and the purposes to which various funds can be put. But there are really only two kinds of levies in strata. You can have a large number of small levies (such as to a sinking fund or to service a loan) or a small number of large levies (ie, a ‘special’ levy). Each situation is different and requires owners to work carefully through the issue to work out which, or what mix, is right in their situation.
Finally, please don’t confuse strata finance with personal finance. Personal finance is almost always for consumption – we ‘consume’ a holiday or transport (by buying a car). Strata finance is invariably funding to improve the value of, and your return from, an asset.
By the way, if you’d like to talk through the analysis, give me a call on 02 9357 5371 or drop me a line at paul@lannock.com.au.
Paul Morton
Lannock Strata Finance