It’s a new financial year and you have been threatening to borrow and invest for some time into a residential investment property.
Following is an outline of some key considerations, some important ways of how to think about gearing. I will refer to it as gearing rather than negative gearing because negative gearing is only one form of gearing and I would like to discuss the subject in its broader sense.
1. What is gearing?
Let’s first begin with the question: What is gearing? The obvious answer is, to borrow and buy an investment.
Here are some other ways to think about it:
- Gearing is borrowing to buy something that “inflates” in value. Without that inflation (or growth) gearing would be a futile exercise.
- Gearing is the process of converting income today into growth for tomorrow. You sacrifice your income from the investment as you collect it from a tenant only to give it to the bank in exchange for the “hope” of growth in the future.
- Gearing amplifies returns upwards and downwards. Gearing sharpens the knife and it certainly cuts both ways.
- Gearing increases risk and you will either be punished or rewarded for the extra risk taken.
- Gearing is about wealth creation long before it is about tax deductions.
- If you gear to reduce tax then you have missed the whole point of gearing.
Gearing is not for everyone. It increases risk and that extra risk is not for everybody.
2. Too close to retirement
If you are too close to retirement, embarking on a gearing strategy is probably a bad idea. If you plan on retiring in the next 5-7 years, new gearing is probably not for you. If you have existing gearing you probably need to start thinking about how you are going to pay off that debt. A good guiding principle should be that you are aiming to be debt free by the time to get to retirement. There are few situation where it makes sense to have debt well into retirement.
You need an adequate timeline to gear. A minimum of 7 years and ideally 10. You need time so that the asset can inflate in value. You need time so that you have a chance of catching one decent market cycle in your favour. The shorter the time you have the higher the risk and the more reliant you are on luck. If you borrow to buy a property and over the next two years that market spikes upwards you simply just got very lucky. Time reduces the reliance on luck.
3. Poor cash flow
Poor cash flow is not a good bedfellow of gearing. If you have a tight budget and not much surplus, don’t worsen your situation be borrowing more money. Fix you budget either by earning more money, reducing your expense or both. Once you have a strong annual surplus you can consider gearing.
A good of thumb would be 10% of gross. If you earn $100,000 gross (that equals $73,000 net) you should be able to show a $10,000 surplus. If not, you are probably spending too much.
4. Paying off the debt
How are you going to pay off the debt? Are you adopting an interest only strategy? If you are then your strategy is entirely dependent on asset inflation that may or may not happen. If your plan involves gradually paying off the debt then you will be creating equity in the asset two ways. One via growth and the other by paying off the principal of the debt.
Relaying on selling the asset to pay off the debt is poor strategy. Frictional costs of getting in and out of property are considerable and an ideal strategy would be to keep the asset and never sell it, or certainly not be forced to sell it just to pay off the debt.
5. Do you have the right risk profile, the right temperament?
If you are after quick gains, you have the wrong temperament. If you are impatient, you have the wrong temperament. If you cannot stand losing money, you have the wrong risk profile. In summary, gearing is not for everybody. Not everyone has the right mental hard wiring to make it work.
Selling an investment too soon because of short term gains, when the idea was to hold long term potentially leaves a lot of wealth on the table. Getting out too soon at the first showing of some losses potentially crystallises losses unnecessarily when committing to the long term strategy would allow the investment to recover losses and bring in gains.
There are so many ways to mess up a good gearing strategy and often investors are their own worst enemy. Get to know yourself and come to terms with your profile. Working with an adviser can often be a good counter to one’s natural tendencies and poor decision making.
6. Good Buffers and Contingency
What can go wrong will go wrong more often than we care to admit. You need to be ready. To have a Plan B.
Can you go into a gearing strategy with a household surplus that can absorb an interest rate rise?
Do you have a good cash buffer in case you don’t have a tenant for a few months?
Have you got all your insurances in place? Life, TPD, income protection and trauma? Do you have your property and landlord insurances sorted?
Prepare for the worst!
7. Appropriate gearing ratios
Do not over do it! Just because a bank will lend you a lot of money doesn’t mean you should take it. It needs to be part of your personal plan, not the banks plan.
Stick to reasonable gearing ratios that are appropriate for your situation. The higher your gearing ratio, especially at a household level, the faster you are driving and the more trouble you can get into. Often people focus on the gearing ratio of the asset alone but what you really need to be mindful of is the gearing ratio at a whole wealth level. What your whole balance sheet look like.
You might end up borrowing 100% to buy a $600,000 investment property but if your total assets after the purchase is $3,600,000 and your total debts are $1,200,000 your overall ratio is 33% which if you have good household cash flow and an adequate timeline is very reasonable.
8. Don’t focus on the tax benefits
Too many over emphasise the tax deduction. Don’t borrow money to reduce your tax. That’s a terrible reason to borrow money. Borrow money because you have a wealth creating plan and some tax benefit is a by-product of that. Tax relief is a means to an end and not an end itself.
Chasing tax deductions is a terrible wealth paradigm.
9. What are you going to buy?
It is all about the asset that you buy. Do you know what you are doing? Gearing is most often associated with property and far too many people believe they are property experts.
You need to buy well. To make gearing work you need to buy an asset that has a good chance to growing over time. Seek professional advice when it comes to selecting the asset, don’t leave it to luck or amateur hunches.
10. Strategic vs Tactical gearing
If the consequence of the gearing is immaterial to you, it is probably tactical. Someone worth $3m that borrows $30,000 to buy shares and then losses the lot is engaged in tactical gearing. The entire loss although momentarily painful will not have a material effect on his life.
Now take someone worth $1,200,000 who bought $500,000 property in a mining town that is now valued at $300,000 (and cannot sell it at that). This person is engaged in strategic gearing and the $200,000 loss will have a material effect on his life.
Understand what type of gearing you are engaged in and treat strategic gearing with the respect and due diligence it deserves. Strategic gearing deserves professional help.
In conclusion, remember that strategic gearing is the sharpest or swords and if handled well has the power to cut through the barriers between you and your financial independence. But if handled poorly or amateurly it has the ability to cut and disable that same progression.
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