Is positive gearing bad and what are the negatives with positive gearing? I have had a few people asking me this question so I wanted to cover this topic in a blog post.
It is difficult to say whether positive gearing is good or bad. It is such an absolutely statement and in the world of investing there are very few absolutes. Before I answer this question there are a couple of things you should know:
Every Investor Is Different
What may be a good investment for you might be a terrible investment for me. Not all investments are created equal because not all investors are equal (or even desire the same thing).
Almost all investors have a different goal, and they have a different way of achieving that goal. A doctor who is earning over $2 million per year and paying $1 million in tax will want to offset that tax loss. But a janitor who earns only $30,000/year and pays very little in tax will want to increase his income not offset his tax.
In the above cases different properties would be beneficial to the different investors. Property investing is not ‘one size fits all’. Each investment needs to be tailored to your investment needs.
Every Investment Has Different Potential
Different properties have different potential for growth. It depends on the property, the area it is in and the market. It has little to do with whether or not it is a positive geared investment. For this very reason you cannot put all negatively geared properties into one basket and all positive cash flow properties into another basket. Each property has to be tested for it’s own merit.
So Is Positive Gearing Bad?
Ultimately no. Positive gearing is not bad, it is just an alternate investment strategy.
It is true that some positive cash flow properties are bad investments, but that holds true for some negatively geared properties.
Positive gearing as an investment is actually a very effective investment strategy. Each property pays for itself so you are able to service (and purchase) almost unlimited properties.
What Are The Negatives of Positive Gearing?
There are some potential negatives to positive gearing:
You May Miss Out On Capital Gains
Many so called ‘experts’ state that you can only have one or the other, positive cash flow or capital gains. They believe you cannot achieve both, which of course is ridiculous.
However, investing in some positive cash flow properties may cause you to miss out on capital gains growth. You are still likely to achieve some growth, but potentially not as much as a ‘high growth’ area.
This is also completely true for negatively geared property. Just because it is losing you money doesn’t mean it will go up in value. You still need to take a bet and get a high growth area to get those huge capital gains.
It Can Become Negative Geared Very Quickly
A positive cash flow property can become negatively geared in two ways.
1. Your income could decrease – If you can’t rent it out or have to rent it out for a lower price
2. Your expenses increase – If mortgage rates go up it can turn a positive cash flow property into a negative cash flow property. So can other expenses like maintenance.
These can be avoided or minimized by using careful planning.
You Have To Pay Tax On The Extra Income
Any income you earn above your expenses you have to pay tax on. But is this really a bad thing? You have increased your income and thus you have to pay tax, this is a normal part of life and part of becoming wealthier.
You can definitely offset some of your income by using depreciation of your assets (the building and things in it). Get a depreciation schedule done so you know exactly how much you can claim.
You Often Have To Create The Positive Cash Flow
Cash flow positive properties are rarely just handed to you on a platter. Often they need to to be created by using a creative strategy. These strategies include renovation, subdivision, dual occupancy, development or creative financing.
This means often you can just ‘buy and hold’ and obtain positive cash flow instantly. You are likely going to have to think outside the box and do a little bit of work to bring it up to a positive cash flow position.
Why Could Positive Gearing Be A Good Thing?
Now that we have covered the negatives of positive gearing it would be good for you to take a look at the other side of the coin. Here are some of the positives of investing in positive cash flow property.
You Make Money From Day One
If you are negatively geared the property costs you money from day one and you only make money when the property goes up in value. With positive cash flow property you make money from day one.
You don’t have to wait for the property to go up in value as you are straight away earning more income than you are paying in expenses. Therefore any capital gains are simply a bonus on the return you are already receiving.
Small Market Fluctuations Aren’t As Important
If you are negatively geared then fluctuations in value of your property can destroy you return on investment. This is because you need the property to go up in value in order to make money.
If you are investing for positive cash flow then these market fluctuations won’t effect you as much. It will still limit your borrowing capacity, but your return on investment is still there. You can continue to hold the property (and make money each week) until the market recovers.
You Earn An Income To Pay Tax On
We talked about the fact that you have to pay tax on your income as a negative, but the positive side of this is that you get to earn an income to pay tax on.
If you weren’t earning an income from your property you wouldn’t have to pay tax, but you also wouldn’t have any income to use to reinvest or to spend on your lifestyle. Personally, I’de prefer to earn an income and pay tax than have no income.
Your Income Increases Over Time
Inflation means that over time money becomes less and less valuable. $100 in 1920 could buy you a house but $100 today won’t even cover one months insurance costs on your house, let alone the house itself.
Due to inflation and increased housing demand (and lack of supply) rents are almost guaranteed to increase over time. However, your mortgage (your major expense) is likely to stay exactly the same. This means that the bulk of the rental increase goes straight into your pocket.
The more rent goes up the more positively cash flowed your property becomes and the more money you get to put into your pocket each week. Over time you get richer and richer just by holding the property.
You Can Afford To Service Almost Unlimited Numbers of Properties
If every property you owned cost you $1000/month to own then how many properties could you afford to buy? I am guessing that you would only be able to afford a couple of properties.
How about this:
If every property you owned PAID you $1,000/month to own then how many properties could you afford to buy? The answer would be “As many as I could get my hands on”.
Positive cash flow property gives you serviceability and the ability to pay more mortgages and purchase more properties. This is likely to help you purchase more properties and increase your profit even more.
Even if the capital gains is conservative (say 4%\year) on 20 properties you are going to make more money than a 40% capital gain on 1-2 properties.
What Do You Think?
Ultimately the decision is yours. Is positive gearing bad for you as an investment strategy? Or is it going to be a good investment strategy for you?
Every investor is different, so what may be right for you won’t be right for me. Weigh up the pros and cons and decide for yourself if this is something you want to pursue.