Positive gearing lets you make a profit on your investment from day one. Provided there is no capital loss, this can be a great way to make money. Problem is: everyone else has thought of that, too. Positive gearing a decent property investment is hard.
Positive gearing is the opposite of negative gearing. It is jargon for borrowing to buy an investment where the expected assessable income is more than the expected deductible interest cost (and other costs). Income is greater than expenses, and your assessable income increases accordingly.
In the context of housing, if you borrow the full purchase price, this means buying on a rental yield of at least 5% (or more if the interest rate is higher). Rents of this scale are unusual. Few residential properties generate rents of more than about 3% (maybe 4%) of the cost or value of the property. This makes it very hard to positively gear property that is largely or fully debt-financed, especially in the years immediately following a purchase.
Very occasionally, you can find a house that is so cheap that the rent is higher than the prevailing borrowing rate. This is usually a sign that the house has a relatively low value. Low value means two things: either the house is not that good; or it needs a lot of work. Either way, low value means few people want to buy the property. This usually hinders longer-term capital growth.
So please, take great care if you encounter claims of positively-geared residential property. There is usually a catch – with the most common catch being that the property can anticipate lower capital growth.
Positive gearing other types of investments can be a different proposition. For example, in early 2008 our AFSL Dover recommended clients borrow to buy bank shares. At the time they were selling on after-tax yields of as much as 13%. This meant that if a client borrowed $100,000 to buy ANZ shares, they received $13,000 of assessable income. Interest rates were around 6%, so the client paid $6,000 of interest. The client made $7,000 cash profit on the deal. That is before capital gains (which have been pretty good, too. In shares, capital growth tends to come when the dividend yield is high).
It can make a lot of sense for a young person to adopt a strategy like this as an alternative to buying a home. But remember, you would need to make a reasonably large investment for this to be a genuine alternative to purchasing property. And share prices are much more volatile than house prices, so timing risk would also need to be managed.
If we bring the focus back to residential property, positive gearing is much easier to achieve when you don’t borrow the full price of the property. For example, if you borrow $300,000 to buy a property worth $600,000, you only pay interest on the $300,000. If interest rates are 5%, this means $15,000 of interest. If you throw in another $2,000 of holding costs (rates, insurances etc), then the total cost of holding is $17,000. If the property then returns 3%, then this equates to $18,000 – the tenant rents the whole property, not just the half you borrowed to buy! This would give you positive cash flow of $1000 per year. Provided the capital value does not fall, you make a profit from day one.
The tax advice component of this article was produced by Dover Financial Advisers, a registered tax (financial) adviser.