Which way should you be inclined more for the right investment strategy
- negative or positive gearing?
When you start investing, there is always a debate you will often hear between two competing philosophies - negative gearing and positive gearing. Income generated by investment properties is either positively or negatively geared. Let's explore further.
A property is positively geared if the rental amount you receive from your tenants exceeds your interest repayments and other property-related expenses such as the council, maintenance and utility rates. It is negatively geared when it is otherwise.
When we focus on capital growth to increase its value, it usually results in negative cash flow in the beginning because the higher capital growth properties tend to have lower rental returns.
The critical question is which one is a better investment strategy - positive or negative gearing?
Let's look at them one by one.
So, why one would prefer negative gearing?
A negatively geared property is typically a compromise on cash flow in favour of capital growth. Here, the goal is primarily to "wait" for the property to grow in value and then sell it at a profit later. Until then, you have to bear the costs of owning the investment property.
Benefits
✅Reduce Tax Payable
Whenever a property is negatively geared, any shortfall you incur can be claimed as a tax loss, reducing your tax liabilities.
✅Focus on Long-Term Capital Growth
Selling the property at the end of a property cycle, usually for 7 to 10 years, should lead to a good return on investment. The return should outweigh any losses you incurred in the past if you purchased the right property at the right time.
Drawbacks
❌ Tighter Cash Flow
You can rarely bear an increase in costs, so you may feel that your cash flow is a bit too tight and, if the worst scenario comes, you may be forced to sell before you realise any capital growth returns.
❌ Lowered Borrowing Power
When you have less cash available in your pocket, your ability to borrow money for further property investments may be compromised.
On the other hand, what exactly is positive gearing?
A positively geared property commonly referred to as a cash flow property. Here, the property generates an immediate return, so you can start making money from the moment you own it.
Benefits
✅Available Cash On Hand
Having more cash in your pocket enables you to lead a better life or pay off your investment loan quickly. In addition, it provides an additional buffer in case your financial situation changes.
✅Increased Borrowing and Purchasing Power
When you have more cash available in your pocket, chances are, it will be a lot easier for your loans to be approved to further invest in more properties. In addition, this could be used to grow your investment portfolio.
✅Less Debt
Whether new or in their pre-retirement phase, an investor may not want to be burdened by too much debt, so adopting a cash flow positive strategy tends to be a better option from that perspective.
✅ Non-Reliant On Capital Growth
The positive cash flow benefit is that you can start making money right away, rather than relying on appreciation of the property price to generate income.
Drawbacks:
❌ Additional Costs
Maintenance and repair costs can strain the cash flow on a property used as a rental house.
❌ Reliant On Economic Factors
To keep the income flowing, you rely on favourable economic factors such as low-interest rates, low vacancy rates, and even high employment numbers.
❌ Tax
Your rental income will be taxed by the Australian Taxation Office (ATO).
❌ Slow Rise In Capital
Positively geared investment properties typically are located in regional areas, so any gains will have to wait since growth rates are generally lower here than in the city. Thus, you may have difficulty accessing equity to fund future property investments.
Case Study: Building Wealth by ChasingCapital Growth
Jasper wants to invest $500,000, understanding that the total current return is 12 per cent. However, he is not sure if he should prefer:
• Property A, promising 8 per cent capital growth and 4 per cent cash flow, or
• Property B, promising 4 per cent capital growth and 8 per cent cash flow.
He calculated the estimated value and rental income and computed that at the end of year 25, Property A would be valued at $3,424,238, giving a gross rent of $126,824 in year 25. Whereas Property B would be valued at $1,332,918, and the gross rent collected would be $102.532.
Looking at the projections, he realises that Property A offers him greater wealth. The difference over 25 years is $2.1 million. He also recognises that if he chooses Property A, he will forego extra rental income in the initial years only.
Though he didn’t want to relinquish the extra cash in the initial years, he quickly realises that the net outgoing was not significant to make much difference to his lifestyle or his ability to service other loans. Therefore, without any doubt, he selects Property A and is excited about the prospect of extracting equity from the property sooner and investing in other properties.
No matter what assets you will be investing in, it is a rule of thumb to remember these points:
📝 Buffers are always required
Regardless of whether you own a negatively or positively geared investment, you will need financial reserves to allow you to hold the property long enough to see capital appreciation or to maintain and repair properties.
📝 A Right Location
It is crucial to choose a property in a great location that offers excellent long-term potential. It is essential when you have an existing negatively geared property. Similarly, for positively geared, a property needs to be in an attractive economic location.
Which gearing option is best for you?
You should tailor your investment strategy to your circumstances and risk preferences, just like any investment. Building a robust property portfolio is a very personalised strategy approach. If you are thinking about investing or are already a property investor, you should always consult a professional or expert in the field. It is always essential. Typically, in the early stages of your portfolio building, it perhaps makes sense to focus on Capital Growth when capital is limited. But before the borrowing capacity starts to become the bottleneck, you should slowly pivot towards cashflow properties - but of course, a lot depends on other circumstances.
Sustainable portfolios are generally characterised by balance. As a rule of thumb, to offset losses from negatively geared properties in your portfolio, you should balance them with positively geared properties.
It may sound intimidating at first, but you will eventually determine what is suitable for you depends on how much risk you are willing to take on and how to choose between negative and positive gearing.
Should you be unsure of what investment strategy is good the best option for you, the Get RARE Properties team is here to help. We are an independent buyers' agent here to guide you through the complexities of purchasing properties. With us in your team, you can ensure that you will get the right personalised strategy, the right property at the right place. As experienced property investors and negotiators, we look at the property as a business transaction and do not let emotions creep in. We will help you choose the best deal at the right negotiated price and save you from undue stress making the process very pleasing and rewarding. As a buyer's agent and experienced property investor, we understand the difficulties of looking for feasible properties in regional areas. We will work closely with you to streamline this complicated process, making it as rewarding and stress-free as possible for you. The perfect property could be waiting just for you, but you would never know about it unless it was presented to you.
Next steps: Should you want to learn how the author built his robust, balanced portfolio in 7 years and aspire to own something similar, feel free to get in touch via email at rasti@getrare.com.au or book an appointment here.
Disclaimer: This article is general and does not take into account your situation. It would help if you considered whether the information is appropriate to your needs, and where applicable, seek professional advice from a financial adviser.
