‘Gearing’ is essentially the act of borrowing money to invest and if you’re just starting your journey as a property investor, it’s a good idea to establish whether your investment strategy is either positively or negatively geared. Here we explain the differences between negative and positive gearing, how they work, and the pros and cons of each strategy.
Negative gearing refers to an investment strategy whereby after investing with your borrowed money, the investment income you earn is less than your investment expenses, consequently creating a negative cash flow. While this may sound counterintuitive at first glance, it is a fairly common strategy when it comes to property investments in metropolitan areas or suburbs with high growth potential.
This is because despite accepting a short-term loss, these losses are expected to be offset by large capital gains in the future as the investment increases in value and the buyer eventually sells it. These losses may also be tax deductible.
Case Study: John Smith is an IT consultant who earns $80.000 a year and is interested in buying an investment property in the Sydney suburb of Parramatta due to the future growth prospects of the area. The unit is valued at $500,000 and his property expenses are estimated to be around $5,500 a year, with rental income set at $600 a week. John will be taking out a $500,000 loan to purchase this investment property as he has no funds saved and the interest charged each month on this loan will be $2,500.
As you can see, John’s investment strategy which involves a higher amount of expenses when compared to income means that in the short-term, he has a greater outflow of money than an inflow i.e. a negative cash flow.
*Note that this is a simplified example to provide an overview of the negative gearing strategy. It does not account for tax, inflation or changes to income and interest rates over time.
On the other hand, positive gearing - similar in concept but opposite in terms of cash flow - is where after borrowing money to invest, your investment income is actually higher than your investment expenses, resulting in a positive cash flow. Generally, positively geared properties are more likely to be found in regional areas.
Unlike negative gearing, which is focused on capital gains and relies on capital growth of the property to provide a lump sum payment at the end of the investment, positive gearing is more focused on a steady, positive cash inflow. The goal is usually to earn a passive income which supplements your current income but also means that you may be able to continue to earn money in the future without working.
Case Study: Jane is a physiotherapist who earns $80.000 a year and is interested in buying an investment property in Carlton, Melbourne to supplement her existing income. The unit she plans to invest in is valued at $500,000. Property expenses are estimated to be around $5,500 a year and rental income from the property will amount to $600 per week. Jane will only be taking out a $150,000 loan to purchase this investment property as she has some money of her own saved and the interest charged per month on this loan will be $750.
As you can see, Jane’s investment strategy which involves a higher amount of income when compared to expenses means that she has a greater inflow of money than an outflow i.e. a positive cash flow.
*Note that this is a simplified example to provide an overview of the positive gearing strategy; it does not account for tax, inflation or changes to income and interest rates over time.
To decide which investment strategy suits your needs, consider the pros and cons of each and speak to your accountant if you need advice.
Tax benefits - The expenses you incur under a negative gearing strategy are generally tax deductible, which means they can reduce the tax you pay. Those on higher incomes are more likely to benefit from this. While this shouldn’t be the sole reason to negatively gear (as there are also other ways to save on tax when investing in property e.g. by using a depreciation schedule), it is nonetheless a benefit to take into account.
Capital growth - Negative gearing can be an effective strategy where the investment property experiences strong capital growth since long-term this can outweigh the short-term losses.
Higher financial risk - You will be essentially running losses throughout the duration of your investment and hence, there is always a risk of not being able to deal with these shortfalls e.g. property value takes an unexpected downturn or interest rates increase. With tighter cash flows, it may also affect your borrowing power if you are thinking about making further investments.
Long-term investment strategy - This is a strategy where you won’t reap the rewards until much later down the track, hence it requires you to plan ahead and budget for any unexpected circumstances that may arise in the time until the end of your investment. This may mean having a financial buffer in place.
Increase your income - With the positive gearing strategy, you will be receiving a regular cash flow of investment income and this can be particularly useful if you need to put this income to use e.g. paying off the mortgage on your own home.
Low risk - There can be less risk using this strategy since the income received is greater than the expenses you have to pay.
More attractive for further investments - If you have plans to make further investments, the investment income you receive with a positive gearing strategy can help with this. This additional income will also make it easier for you to get a loan for these further investments.
Portfolio building - You will consequently be able to build up your portfolio with these investments. Another upside is positively geared investments can often be used to balance your portfolio i.e. you might use the income to pay off losses on a negatively geared property.
Paying more tax - You will pay tax on the investment income you earn, and as you are receiving more income, naturally you’ll be increasing your taxable income and therefore the amount of tax paid.
Slow capital growth - Positive cashflow properties are generally situated far from city centres i.e. in rural or regional towns (though not always) and this can mean slower capital growth over the long-term.
Volatile growth - This is once again to do with the location, as properties in regional towns are more likely to be reliant on specific industries e.g. mining and this makes their growth less certain.
Which strategy you choose will depend on your personal financial goals and the level of risk you are willing to accept. It’s a good idea to speak to an accountant or financial advisor for advice on which gearing strategy will be best for you. Once you’ve decided on a strategy, chat with a Home Loan Specialist for help finding the most suitable home loan.
A positively geared suburb is typically a high growth suburb with good cash flow potential. If you buy property in a positively geared suburb you are likely to receive a good rental yield that is larger than the cost of running the property (monthly mortgage repayments, council rates, insurance, upkeep). The difference between these expenses and your rental income should generate positive cash flow.
Alternately, property in areas where the monthly cost of the property outweighs the rental income are considered negatively geared or ‘capital growth’ suburbs and will result in negative cash flow.
A quick way to calculate how a property is geared is by getting a property value report that will outline expected rental income and home loan repayments in a particular suburb. You can get a free property report here.