When it comes to property investing, nothing polarises investors more than the debate over positive gearing and negative gearing. Those in favour of positive gearing argue that it’s the best way to build your wealth while those on the other side of the fence say negative gearing is the only way. The more important question is which one is less risky?
What is negative gearing?
Let’s say you buy a $500k apartment in a newly-built complex and you charge around $500 per week for rent. The problem is that your mortgage repayments and other property management costs amount to $600 per week. You’re out of pocket $100 a week, making this investment property negatively geared.
Benefits
Claim losses on tax: You can claim most losses including depreciation when tax time rolls around and effectively reduce your taxable income. Independent financial advice is always essential.
Capital growth: You’ll need a bit of luck as well, but as long as you’ve invested in real estate in a location with strong fundamentals for future growth (blue-chip), you should see a good return on investment if you decide to sell at the end of a property cycle (typically 7 to 10 years). These gains should far outweigh any losses you’ve been hit with.
Long term tenants: Although it may be harder to attract tenants, holding on to them may be a little easier than a cash flow property since the property will likely be located in an area with high vacancy rates or low rents.
Drawbacks
Potentially tighter cash flow: A negative gearing strategy tends to have more success if you’re in a stable occupation and earning a regular income that is increasing over time. In this way, you can cover shortfalls in rent or property costs. If your situation changes, you’re not usually in a position to increase rent so it can really squeeze your cash flow and, at worst, force you to sell your property before realising any capital growth returns.
Tighter cash flow affects borrowing power: With less income in your pocket, your ability to borrow the amounts you need for further property investment can be hampered.
You’ll get taxed: Any capital gains will be taxed. Read more about capital gains tax and the cons of capital loss. Luckily, you’ll only pay tax on 50% of your capital gains.
What is positive gearing?
Positively-geared properties are also known as cash flow properties. This is where the rental income that you receive from your tenants is more than what you pay to own the property.
This tends to happen in periods of strong rental demand and low interest rates.
Your own home can even be a positively geared investment if you live in a dual occupancy property or duplex. The same goes for a property with a granny flat at the back.
So, let's say you purchase a $350k property in a major regional centre where vacancy rates are low. You’re in a position to charge $450 per week in rent.
The costs of owning the property total $350 per week, so your net return on investment is $100 per week or $5,200 per year - this is known as positively geared.
Benefits
Cold hard cash: You have more money in your pocket which you can save for a deposit to invest in more properties or simply pay off your investment loan sooner. It also provides a financial buffer should your personal situation change for any reason.
Increase your borrowing power: Most lenders will only accept up to 80% of your rental income, but there are some lenders that will accept up to 90% - 100% when assessing your income for a home loan.
New and old investors: People new to investing or those nearing retirement may not want to be burdened by too much debt so a cash flow positive strategy tends to make more sense.
The (other) great equaliser: Cash flow positive properties can help keep your property portfolio in check by covering any losses you incur on negatively geared properties you own.
Drawbacks
You’ll get taxed: The Australian Taxation Office (ATO) will take a slice of your rental income.
Slower capital growth: Since many positively geared investment properties are located in rural or regional towns, any capital gain benefits will have to wait since growth rates tend to be slower than in metro/city areas. This can also hamper any plans you had to access equity in order to fund future property investment.
Low yields are your enemy: Generally speaking, the higher the rental yield, the more cash flow positive the property is. In a high property growth environment, yields are low so this can have a negative effect on your positive cash flow strategy.
Fluctuating growth: You’re relying on good economic factors including low interest rates, low vacancy rates and even strong employment figures to keep the rent flowing in, leaving you with some surplus gains after costs. For example, towns that are relying on particular industries like mining may be high yielding one day and go bust the next.
Unexpected costs: Mortgage repayments and rates are one thing but freak maintenance and repair costs can really throw out your cash flow. Unfortunately, you can’t plan for the unexpected.
What do you want to achieve?
It can sometimes be hard to see the big picture when it comes to property investing, especially if you’re new to the game. Generally speaking, a sustainable portfolio is all about balance.
If you have some negatively geared properties in your portfolio (blue-chip investments), aim to balance it out with positively geared properties to offset the losses.
Overall, it’s important to surround yourself with experts including a mortgage broker, buyer's agent and accountant, as well as learn and form ties with people who have gone down the investment path before you.
There’s a lot of noise out there but eventually, you’ll learn to find the sweet spot in the level of risk you’re willing to bear and what to choose when it comes to negative gearing vs positive gearing.
If you are looking for a buyer’s agent to assist you with purchasing a home or investment property in NSW, QLD, VIC, SA or WA, please get in touch with Tome Avelovski and his team at Ready Set Buy - Property Buyer's Agents or give us a call on 1300 289 372!
Disclosure: The information contained in this blog is our personal opinion only and is not to be taken as financial advice, as we do not know your financial situation. Please speak with your accountant or any other licensed professional for specific advice based on your own personal circumstances. We will not be held liable for any losses.
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