Positive and Negative Gearing 101
You have saved up some free cash. You look at it pensively, feeling both the liberty of freedom and shackles of decision. You decide to invest. “Make your money work for you”, right? It’s like a savings account with more work. And more work means more returns.
You pick up an “Investing for Dummies”; ask your suited, successful friends; try to cram as many Investopedia pages as you could possibly muster. All this new jargon falls on you like a bunch Blockbuster stocks. What is a gearing? And what does that have to do with anything?” you type furiously into the keyboard.
That’s what lead you here right? Fortunately, that is precisely what we’ll be exploring: what gearing is and more importantly for your attention, what it means for you.
So, what is gearing?
Gearing is the comparison of debt to other financial metrics, such as a debt to equity ratio, which provides a quantitative window into the health of a company or personal affairs. Understanding this can help you make smarter investments and give you stronger insight when you make decisions in assessing the health of an equity– in particular, how much debt is the company or property leveraging in comparison to how much money it is bringing in?
In business contexts, this may be seen as the amount of debt taken out to run business operations or to finance an investment. For example, companies listed on the Australian Stock Exchange (ASX), a marketplace for company shares, are required to provide quarterly or biannual financial accounts for public perusal. The data given in these reports allow investors to assess the health of the company on their own terms given the company’s gearing.
Interpreting the data and a company’s gearing sheds a lot of light on what you can expect out of the company. For example, low gearing companies may not necessarily be the most robust companies, whereas companies with high gearing are often seen to be in the strongest position strategically as it means they who know how to leverage debt to operate efficiently. Understanding this creates an informed assessment of what you’re risking and what you’ll gain from this investment.
In the property world, negative and positive gearing has both its benefits and setbacks as well.
Positive gearing in property.
A positively geared property is also known as a cash flow property. This is where returns are immediate and higher than the cost to maintain the property, yielding a net positive cash flow. Some of the costs to maintain and hold the property may include loan repayments, loan interest, cleaning, utilities, management fees and council payments.
The immediate benefit of a positively geared property is that it is naturally lower risk and poses as an attractive factor for lenders, where the positive cash flow investment may be leveraged for lending needs. In a perfect world, this is where we all want to be – making more money. Everyone wants to tangibly reap the returns from their investment, not lose resources and money to it, particularly when there is no guarantee. All this may be underpinned by the risk of market forces and other political factors. But more money also means more problems, with positively geared properties also paving the way for a higher taxable income, meaning more tax during tax time.
Negative gearing in property.
A negatively geared property is also known as a capital growth property. Negative gearing is where the money is borrowed to buy a property, and ongoing returns are less than the initial investment into the property. A negative gearing strategy may be considered for a long-term investment whereby, so exercising and considering the security in your investment is crucial.
A positively geared, cash flow property may be the most alluring option out of the two at first glance, however negative gearing properties may also work the best for you considering your investment goals and capabilities. The first reason, for any investment, is awaiting future capital returns. An investor may foresee stronger future returns that outweigh the current losses on an investment, and thus maintain it in their portfolio. This is unlike investors with fast turn-over investment strategies such as fixing to sell, where negative gearing properties will not yield the best returns. The second is reducing their taxable income. This strategy opens up the opportunity for investors to reduce their taxable income with the incurred expenses, which offsets the loss they would make with positive gearing property.
Applying it to you.
So now you’re at a good start. With a decent framework on what gearing is, and how it can be applied to an investment context – how do you start investing strategically and capitalise on gearing?
Before you start anything, you gotta do your research. Ensure that you are conducting thorough research before you make a move to invest and continue to do so as you manage your property. “Where do I start?” you may ask, seated in front of your computer, faced with an endless expanse of information and avenues to explore.
Before you embark on your journey, you may want to start by answering a couple of key questions.
What type of investment or assets am I thinking?
Hands on or hands off?
Long term rentals or short term?
What kind of tenants am I looking for – executives, or tertiary students?
And the most important question of them all – why am I investing?
After setting your expectations and determining your level of commitment and the type of investment you want to make, it’s time for your research to bleed into the macro-economic factors. Examine the market. Is it a bear or bull market? A buyer’s or seller’s cycle? Is it confident, or cautious? Understanding the current environment and immersing yourself into the dynamic of the current investment landscape is paramount to strategic investments. Being able to determine whether the high gearing ratio is a risk, or if low gearing is inefficient is a key tool you will need when making judgements about whether or not it is a good time to place your well-earned funds into the market.
Gearing is a small factor of many when analysing the risk of a particular investment. Understanding gearing, in understanding how debt is used to generate future returns. Strategically capitalising on gearing is perceiving the sweet spot of maximising the capital investments to generate the most returns.