Last week we looked at the two ways you can earn money through investing: income and growth.
But how do you know which style is right for you?
It’s important that your investment strategy is aligned with your purpose. We all have different goals, and this means that a one-size-fits-all approach to investing simply won’t work for you.
Take for example, ‘negative gearing’. This buzzword is most commonly used in reference to investment properties.
There are three types of gearing:
- Negative gearing, which means the interest you are paying on the loan is more than the income. For example, you pay $2,500 a month towards your mortgage, but only receive $2,000 in rent. You make a loss of $500 per month.
- Positive gearing, which means the interest you are paying on the loan is less than the income. For example, you receive $2,500 per month in rent, but only pay $2,000 in interest. You make a profit of $500 per month.
- Neutral gearing, which means the interest you pay on the loan is equal to the income you receive. For example, you receive $2,000 per month in rent and pay $2,000 in interest. You make neither a loss nor a profit.
Of these three terms, you’re more likely to hear about negative gearing than the others. ‘Positive gearing’ is what investors generally look for – to make money off of their investments. It’s such an obvious principle, it doesn’t need a special label. ‘Neutral gearing’, more often termed ‘breaking even’, is normally very rare. Most investments will be either positively or negatively geared, even if just by a few cents.
But as Google Trends reveals, ‘negative gearing’ ranks highly as a search term, especially in Australia. ‘Positive gearing’ barely makes a blip, and interest in ‘neutral gearing’ hardly ranks at all. Investing magazines are filled with articles on negative gearing – or, as I prefer to put it, intentionally losing money.
Why on earth would anyone want to do that?
Why borrow money (which always carries the risk you might not be able to repay it, and might lose your asset) without receiving enough income to even cover the expenses associated with the asset?
The answer is simple – as Investopedia goes on to describe:
Depending on the investor’s home country, the shortfall between income earned and interest due can be deducted from current income taxes. Countries that allow this tax deduction include Canada, Australia and New Zealand.
Realestate.com.au provides a great example of how negative gearing works:
Imagine you bought a $440,000 property and took out a $400,000 loan at an interest rate of 7%. The annual interest payable on the loan is $28,000.
Also imagine that you are earning $430 per week in rent, which adds up to an annual rental income of $22,360.
Based on the above example, you are paying $28,000 in interest but only earning $22,360 in rent which means there is a shortfall of $5,640 per year. That’s the bad news.
The good news is that the property should be going up in value and it is worth more as time goes on. If the property went up in value by 10% in a year, it has increased its value by $44,000.
At the end of one year, you have paid out $5,640 in interest but the property has increased in value by $44,000, which means that you are $38,360 richer than you were 12 months ago.
The reason this type of strategy is so popular in countries like Australia is that investors can claim this loss against their other taxable income in order to reduce the tax paid.
But there are two problems with this.
It’s much more effective for the rich. As this table from The Age shows, the tax minimisation benefits are much greater for those who already have a high income. In 2011, a high income earner who owns a property which brings in $20,000 in rent, but costs them $27,000 in expenses plus $8,000 in depreciation might only have to pay $25 out of their own pocket towards these expenses once they receive their tax benefit. A low income earner with the same property would receive a much lower tax benefit (since their total tax paid is lower because they don’t earn as much), and as a result, would have to pay an enormous $4,525 out of pocket.
It can be risky. Despite the popular wisdom that houses never go down in value, growth is not guaranteed. Those who’ve invested in mining towns or brand new apartments off-the-plan often know this all too well. Double digit and potentially dangerously unsustainable growth in places like Sydney and Melbourne pulls the averages up to look artificially rosy. Recent ABS statistics report that the weighted average increase in house prices across the eight capital cities in Australia was indeed around 10%. But an average of 10% is of little comfort to those in Adelaide and Brisbane, who saw only 5 and 3% in growth respectively, and even worse, for those in Perth and Darwin, where there was negative growth, meaning prices fell by as much as -4.9%.
As Smart Property Advisor Kevin Lee points out, ”If you are investing for income, and the income is paying for the property, then you are a savvy investor…But there are no guarantees for capital growth.”
Should you be investing for income or growth?
If you are a high-income earner, love your job AND plan to work for the next 25 or 30 years, AND are happy to take on a level of risk – including the risk that negative gearing laws may change – AND are appropriately insured, then investing for growth, possibly via negative gearing might work for you.
On the other hand, if you are a lower income earner, OR don’t want to work forever, OR don’t like risk, OR would face difficulty if you lost your current primary source of income, then investing for income via positive gearing may be better.
Realestate.com.au concludes that “It would be great to be neutrally or even positively geared and still make a net profit but these sorts of properties are very hard to find.”
I’ll agree that they are difficult to find.
In searching for our investment property, my husband and I looked at thousands of listings, contacted dozens of agents, and inspected tens of properties. Many of the agents I emailed were very coy about providing the figures I requested – water and council rates, body corporate fees etc. When I finally got them at the inspections, there were several I simply walked out of, because the numbers just didn’t add up.
“But look at the balcony!” one agent pleaded when I pointed out that the numbers didn’t work for me.
It’s absolutely correct that positively geared properties are difficult to find. But that’s not an excuse to settle for making a loss, especially if you can’t afford the risk. Nor are such properties impossible to find.
And finally, the word “find” in the statement is very important. The truth is, you don’t have to find a positively geared property. You can transform pretty much any property into a positively geared one.
Let’s take a fresh look at the previous example
You buy the same $440,000 property. But instead of taking out a loan of $400,000, which means you had only a 9% deposit, you save a much more robust 35%, and borrow $308,000 instead. The annual interest payable on the loan now is $21,560 – $800 less than the annual rental income of $22,360.
And, you could perhaps borrow an extra $20,000 (increasing your annual interest payable to $22,960) to make some improvements that raise the rental income to $480 a week (this should be more than achievable, as it is still below the average). This would increase your annual rental income to $24,960 – making the property now positively geared by $2,000 rather than $800.
And, maybe you also look around for a better interest rate. Even just shaving 0.5% off of your rate would reduce your annual interest to $21,320. This puts $3,640 in your pocket instead of $2,000. Wipe off a whole 1%, and you’d take your interest down to $19,680. This brings your total cash flow to a much more respectable $5,280.
These examples, with their annual interest rates, are calculated on the assumption that you won’t be paying off the mortgage. They assume you are investing for growth, and will, upon retirement, be aiming to sell your property for a profit.
Growth and income don’t have to be mutually exclusive.
The two can work very well hand-in-hand. But the fact remains, making a decision to invest primarily for growth rather than income, or vice versa, can restrict your options down the track, so it’s important to consider what you’re ultimately looking for.
The reason my husband and I chose to prioritise income over growth was the fact that we wanted to retire early. Not just kind of early, but to have the option to take what Jacob Lund Fisker calls “Early Retirement Extreme“.
Had we invested for growth, taking a popular negative gearing approach, we would have been severely restricted in our abilities to leave our jobs, pack up, and travel the world, as we did earlier last year.
Why we were interested in investing for income
First of all, as the names imply, a growth strategy is primarily about the profits you receive at the end, when you sell a property, rather than the income you receive along the way. If you invest primarily for growth, the income you receive from a rental property portfolio may not be enough to cover your expenses. It may not even be enough to cover the expenses (interest, repairs, insurance, management, rates etc) of the property itself. This means essentially, you are working to support it, rather than it working to support you.
Secondly, negative gearing is only beneficial when you have enough taxable income to offset your interest costs against. While we were working, we had a combined income that – while not approaching the top of the scale – might have made negative gearing worthwhile. But we knew that once we quit our jobs our incomes would be significantly lower. And when your income and taxes are low, the benefits of negative gearing become almost non-existent.
Prioritising income meant we could pursue our goals with minimal worry
Of course, to combat inflation, some level of growth will always be necessary. You need your assets to keep pace with inflation. But don’t forget, it’s not all about negative gearing. Positive gearing and even positive cash flow properties DO exist if you look hard enough – or work hard enough to create them. In the next post, we’ll take a look at how a property can make you money from day 1.
What is your preferred style? Income? Growth? Let me know why in the comments below!
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