Real Wealth Opinion
Posted on June 17th, 2017 at 5:55 PM by David Orth
This weeks hot topic is about investing through property and what it means to have a positively geared property.
In property investing positive gearing is where the rent received exceeds the interest on money borrowed to finance the purchase. You often hear about positive gearing – especially from people with a property they want you to buy! But is positive cash flow property actually worth pursuing? The answer depends on what is creating the positive cash flow situation. Sometimes, these factors combine to make positive gearing a wonderful way to reduce risk. But at other times, the factors creating the positive gearing can make an investment very risky indeed. This article shows you how to tell the difference
You have probably heard the term ‘positive gearing.’ It is a similar concept to negative gearing, which is certainly in the news a lot these days.
We use the term ‘gearing’ whenever debt is used to fully or partly finance an investment. If you have $90,000 of your own and borrow $10,000 to buy an investment asset worth $100,000, you have ‘geared’ the investment. Similarly, if you borrow $100,000 to buy an investment worth $100,000, you have ‘geared’ the investment.
When you buy an asset, you usually receive some income from the asset. For a property, this income is the rent you collect. And when you borrow to buy an asset, you have to pay interest on the debt. This interest is an expense of holding the asset.
In strict terms, ‘positive gearing’ is where the income from an asset (the rent) exceeds the interest on the loan used to finance the investment. Less strictly, and more sensibly, the term is used when the income exceeds all the other expenses of holding the asset as well. For a property investment, this is things like land tax, rates, insurances, etc.
So, positive gearing means the rent more than covers the holding costs of an investment. You can use the rent to pay all of your bills, including interest. Any money left over is your profit while holding the investment.
As you would expect, then, ‘negative’ gearing is where the costs of holding a geared asset exceed the income that you receive from that asset. This means you make a loss while you hold the asset. This is why negative gearing should only be considered where you think you will make a large gain later on – usually when you eventually sell the asset.
Positive gearing gets a lot of positive press, which makes sense. Making a profit while you hold an asset can reduce the risk of that investment. If you make a profit from day one, then you do not have to rely on making such a large capital gain in the future to make a decent return on the investment. Usually, this is a good thing.
Sadly, things are not actually that simple. Positive gearing is not necessarily something to aim for. Whether positive gearing is worth it depends on the circumstances that are creating it. These are as follows:
The less you borrow, the lower the interest and therefore the greater chance you have of achieving a cash flow positive situation.
Let’s say interest rates are 5% and the income return on an investment is 3%. If you borrow less than 60% of the purchase price, then the investment will be positively geared (assuming there are no other costs such as rates, etc.) If a property costs $500,000, and you borrow 60%, then this is $300,000. 5% interest is $15,000. If the rental yield is 3%, then this is also $15,000. The rent covers the costs: the property is positively geared.
By the same logic, an investment that starts out negatively geared can become positively geared if you repay some of the debt. This is because paying off debt reduces the amount borrowed as a proportion of the total investment.
To reuse the same example from the previous paragraph, if you borrowed 70% of the purchase price of an asset that returns 3%, and you pay 5% interest, the investment would be negatively-geared. The interest will be $17,500 (5% of $350,000) and the rent will only be $15,000. But if you repay $50,000 of the debt the amount of interest you pay falls below the amount of rent you receive. The investment becomes positively geared.
Residential property typically pays a low rate of income when expressed as a proportion of the value of the asset. We usually use 3% as our rule of thumb for the rental ‘yield’ on a residential property. What’s more, there are substantial holding costs for residential property, such as rates and insurances. This means that it can be difficult to achieve positive gearing if you use a lot of debt to buy residential property.
However, other assets often pay higher rates of income. Commercial property and certain shares typically give you more income than residential property, making it easier for the investment to be positively geared.
If an investment continues to pay income, that income will typically rise over time. This can be the result of nothing more than price inflation raising the price of things like rent (which is an expense for the tenant but is income for the landlord). Provided you keep your debt constant, and assuming that interest rates do not rise, then this ‘natural’ increase in income will often move an investment from negative to positive gearing.
For example, suppose you bought a property ten years ago for $400,000 and it was paying 3% rent. That’s $12,000. Interest rates were about 8% back then, meaning the interest expense would have been about $32,000 if you borrowed the whole purchase price. That’s negative gearing. If you still had the property today, and you still owed $400,000, the situation would be different. The property could be worth up to $800,000, and 3% of that (the rent) is now $24,000. Interest rates have fallen to around 5%, or $20,000. The same property is now positively geared, because rents have risen and interest rates have fallen.
Interest rates do not always fall. But over the long-term most rents do rise, so many properties eventually become positively geared.
As we saw above, one way to achieve positive gearing is to invest in assets that pay a high rate of income. This means higher rents as a proportion of the value of the property. For example, if rent is $12,000 and the property is worth $300,000 then the rental return is 4%. If rent is $12,000 and the property is worth $400,000, the rental return is 3%.
So, income return has two parts: the purchase price and the rent. The lower the purchase price, the higher the income return. And this is why you need to be wary. For the same level of rent, the rental yield is higher if the value of the property is lower – that is, if the property is cheaper. But ‘cheap’ properties can be very risky investments. After all, when a property is cheap, few people want to buy it.
Think about a town that is going though a temporary boom, perhaps because the town is situated near a new infrastructure project, such as a water desalination plant. While the plant is being built, lots of workers need to live nearby. This drives the demand for rental accommodation up. But the plant will only take a few years to build, after which the workers will move on. This means that none of the workers want to buy a home in that area. So, rents rise but values do not. This makes for a higher income return. This high return might attract an unwary buyer looking for a positively-geared residential property.
After a few years the plant is built. The workers move on and demand for rental housing falls. This means that rents fall as well. This can mean that positively-geared investments become negatively-geared. What’s worse, the investor’s finds it hard to ‘make back’ the money they lose through negative gearing – by selling for a capital gain. Remember, few people want to buy a home here.
So, a positively-geared residential property can be a risky proposition. That’s why you need to be careful.