Do you understand how negative gearing vs positive gearing impacts your investment strategy?
Negative gearing and positive gearing are two terms commonly talked about in the world of property investing. Some of you may have a good understanding of these concepts, but if you’re a first-time investor learning the basics of property investment, you may not.
In order to determine whether a property investment suits your investment strategy, it’s important to grasp what negative gearing and positive gearing is. We’re going to define these terms and look at each investment type in more depth to help you determine which is best for you.
What is positive gearing or a positive cash flow?
Positive gearing or a positive cash flow occurs when the amount you receive in rental income from your tenants exceeds your expenses for the property (loan repayment, management fees, insurance, interest, rates, property maintenance, etc.).
To figure this for an investment, you’d add up all of your expenses and subtract them from your rental income. If the rent is higher than your expenses, you’re generating a positive cash flow.
For example, if you have a weekly rental income of $550 and weekly expenses of $425 (loan repayment, management fees, rates, and insurance), your total weekly cash flow would be $125.
A positively geared property is definitely a more conservative and safer investment. With this type of investment, you’re starting out with a profit, which you can then use to pay down a loan balance or put aside to use for another investment property, so you can build your portfolio.
The Advantages of Positive Gearing
- Income—As discussed, you’re going to have some extra money in your pocket that you can decide how to use.
- Lower Risk—A positively geared property is safer, because you’re not having to cover any shortfalls out of your own pocket. Should your income situation change, you’d be less likely to have to sell because you can’t cover the shortfall.
- Build or Balance Your Portfolio—Positive cash flow can be set aside to save for a deposit to invest in another property or to balance out a negatively geared property to create a more balanced portfolio.
- Increased Lender Attractiveness—The extra income from your investment can cause lenders to look upon you more favorably for additional property loans.
The Disadvantages of Positive Gearing
- Taxes—Like the rest of your income, the income you earn from your cash flow positive property is taxable.
- Potential Slower Capital Growth—Often, positively geared properties are located in areas where there is slower capital growth. While this isn’t always the case, it is something you should be mindful of.
- Greater Volatility—Positively geared cash flow properties might be located in an area or region that is heavily dependent on a particular industry for employment. Should this industry weaken, your property may be subject to greater volatility as tenants leave the area to look for work.
Depreciation Expense Can Be a Game Changer for Positively Geared Properties
Depreciation expense on your property is an expense that can be added to the overall expenses for your property, lowering your total income for tax purposes. This may result in a tax refund or a lower tax bill.
What is negative gearing or a negative cash flow?
Negative gearing occurs with a property investment when the expenses exceed the amount of money you’re earning in rental income. These types of properties are often referred to as capital growth properties, because they’re expected to increase in value over time and the long-term benefits are expected to exceed the short-term disadvantages.
Often, you’ll find negatively geared properties located closer to capital cities, which tend to appreciate and perform better over the long term.
For example, you might invest in a property that costs $450,000. Your weekly rental income might be $430, but your weekly expenses might be $450.00, therefore, you have a weekly shortfall of $20.
The Benefits of Negative Gearing
- Tax Deductions—Many investors opt to invest in a negative gearing property for the tax benefits. You can claim tax deductions for the expenses occurred associated with this property, which reduces your taxable income.
- Less Volatile—These properties are typically located near capital cities and not regional areas which are more heavily dependent on certain employment industries, making demand less of an issue. Negative gearing properties near capital cities tend to be less volatile to employment industry changes and overall changes in general.
- Lower Vacancy Rates—Negatively geared properties tend to be more affordable for tenants, making it easier to find and secure a long-term tenant. This lowers vacancy rates.
- Higher Capital Growth—When investing in a negatively geared property, the strategy is that the property value will increase over time so much so that the capital returns will outweigh the initial borrowing costs and out-of-pocket expenses.
The Disadvantages of Negative Gearing
- Ongoing Shortfalls—Since your expenses will be more than your income from the property, you’ll need to budget for the out-of-pocket shortfall. It’s also important to remember that if you sell the property for a capital gain, you will have to pay capital gains tax.
- Financial Risk—If your financial circumstances change, you might be in a position where you can no longer afford to pay the shortfall and be forced to sell at an inopportune time.
- Long-term Investment and Holding—This strategy is a long-term strategy to wealth building, so if you can’t hold the property long term, you may be forced to sell at a loss or right at break-even.
How Yield Impacts Your Cash Flow
A property’s yield is the percentage of the gross annual rent divided by the property’s purchase price (this doesn’t take into account costs such as rates and fees). For example, if you purchase a property for $425,000 and the gross annual rent is $25,000, your yield is 5.88% ($25,000/$425,000).
Typically, the higher the yield, the more likely you are to have a positive cash flow investment. It’s really important, however, that you crunch the numbers and take into account all of your costs, not just the cost of the loan repayment.
Positive Gearing vs Negative Gearing: Which is Best for You?
When you’re investing in property, you want to find the right property at the right price with strong indicators of capital growth potential. You want to look at more than just the negative or positive cash flow and take a look at the long-term growth potential of the property.
While you’d likely appreciate a straight answer in terms of which is best—positive vs negative—the question must always be: Which is best for you?
The answer to this question largely depends on each individual investor’s personal circumstances. One person’s circumstances might only allow him or her to pursue only one type of investment that isn’t as well suited as another one might be. Some investors—due to the nature of life—just have more choices when it comes to investing in property. They may have more cash flow or may have the ability to invest across regions, etc.
You might find that, because your income is already spoken for and quite restrictive, a positive cash flow property is all you can start with, because you just can’t afford out-of-pocket expenses. Regardless of whether you’re looking at positive gearing vs negative gearing, you should always keep long-term capital growth in mind. Capital growth is arguably where the real wealth building occurs for you and your family tree.
It’s always a good idea to speak to a property professional to grow your knowledge and gain a deeper understanding of growth and rental potential in your areas of interest (or to determine high yielding suburbs).
If you have questions about purchasing an investment property or would like to speak to a qualified real estate professional, contact us.
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