The two most common terms know by property investors are ‘negative gearing’ and ‘positive gearing’. The recent Federal election vote put the concept of negative gearing in the spotlight, as a Labor win would have resulted in changes as outlined in a recent blog I wrote.
In my day to day work I come across many people that invest in property for the wrong reasons. One of those is to reduce tax and therefore they fall in love with the concept of negative gearing.
The only way to create massive wealth and/or achieve true financial freedom from property is from capital growth. Tax benefits (negative gearing) is a side benefit which is very powerful particularly for higher income earners, however this concept should not be confused, otherwise you can end up buying the wrong property and your efforts (and investments) are wasted.
To help you better understand these gearing strategies, I will compare the two concepts, using examples of how each investment works, as well as outline the main advantages and disadvantages, and how they can work within an investment strategy.
What is a positively geared property?
Positive gearing occurs when you receive more in rental income from your tenants than what you pay on expenses such as loan interest, management fees, property maintenance, council rates, and so on. This tends to happen at times when rents are high due to strong demand for rental property and low interest rates.
A positively geared investment can also be referred to as a ‘cash-flow property’ as it usually puts money in your pocket.
How it works:
Imagine you purchase an investment property for $600k located in a location where vacancy rates are low and demand for rental properties is high.
You rent the property for $600 per week. The costs associated with your property total $550 per week. In this situation the property is positively geared by +$50 per week.
The main advantages of positive gearing are:
- Increased income – you’re not out of pocket, plus you can use the extra cash to pay off your PPOR (home) sooner.
- Less risk – if your income circumstances change (e.g. loss of job), you are less likely to need to sell under pressure and potentially unfavourable conditions.
- Balanced portfolio – some investors may use a positively geared property to balance their portfolio, using the additional income to pay the shortfall of negatively geared investments.
- Lender Attractiveness – the additional income can increase your attractiveness to lenders for additional loans.
The main disadvantages of positive gearing are:
- Taxable – more income means more tax you pay.
- Slower long-term growth – typically these properties are located in regional areas (rather than capital cities), which commonly experience less or slower capital growth.
- More volatile – these properties may be largely dependent on a particular industry of employment which can make it subject to greater volatility should employment factors weaken.
What is a negatively geared property?
Often referred to as ‘capital growth properties’, negatively geared investments are expected to appreciate (grow) in value over time, and this increase is expected to outweigh any short-term financial losses. These properties are commonly located in areas closer to capital cities which typically perform better over the long-term.
How it works:
Negative gearing occurs when the rental income you receive is less than the total costs involved of owning that investment property.
Using the above example, if your $600k investment property is rented for $500 per week, and the holding costs for your property total $550 per week, your property is negatively geared by -$50 per week.
The main advantages of negative gearing are:
- Tax Deductions – allows you to claim the rental short-fall and ultimately reduce your taxable income.
- Capital Growth – the capital returns from the property will eventually outweigh the borrowing levels and costs to create wealth for you at sale, or better still to leverage against the growth to buy more property and create more wealth.
- More affordable for tenants – because of the affordability, it can be easier to secure a tenant for the long term.
- Less volatile – unlike a property in regional areas which may rely heavily on particular employment industries to drive up demand, these properties rely on a variety of factors and can be a less volatile investment.
The main disadvantages of negative gearing are:
- Budgeting is needed – you need to budget for ongoing shortfalls, also, when the property is sold for a profit, the tax man collects on the capital gain.
- Long-term strategy – it’s a longer term wealth creation strategy so if your circumstances change and a sale is necessary the sums may not work out favorably.
- Higher financial risk – if in the instance you were to lose your job you will need to be able to maintain any costs involved. Make sure you have a financial buffer in place to ride the ups and downs that comes with this strategy.
What’s better? Positive or Negative?
It depends. The way I see it, it all depends on what stage in your life cycle you are at.
During your working life, the primary goal should be to accumulate as many investments (like property) that will grow in value, so that you have a healthy and large nest egg for when you retire from your day job.
Once you are retired, your primary goal will be to generate as much income (cash flow) from your investments as possible to enjoy more of the good life once retired.
My advice. Get specific advice regarding your own personal situation as there is no right or wrong answer. I have seen many times people invest for the wrong reasons to later find out that they invested in the wrong property which cost them in lost opportunities.