The term negative gearing is not very widely used in South Africa by property investors, in fact if you Google it you will find mostly Australian domain’s. Though the term is not widely used, we found it is extensively employed as an investing strategy and often with little knowledge of its’ meaning and consequences.
In this article, we will look at negative gearing and try to best explain what it is, and how negative gearing affects property investments. Negative gearing, generally speaking, is an investment strategy. However, just like with any other strategy, it can be good or extremely risky, if one doesn’t know what it entails.
What is Negative Gearing?
Negative gearing is the cash flow outcome of buying an investment property where the rental income doesn’t cover the bond. For example, if a property has a mortgage bond repayment of 5,000 and the rental is 4,000 that means the property is negatively geared at 1,000.
Positive gearing would be the opposite; when the rental is 5,000 and the mortgage bond is 4,000, the property is positively geared at 1,000 per month.
Though this example is simplified, it illustrates negative and positive gearing in a simple way.
Both negative and positive gearing in property investing can have major affects on the investment outcome.
Before we explain the advantages and disadvantages of Negative Gearing one has to understand them in context of strategic property investments. When you create a road map such as a plan to achieve a goal, that is a strategy. This plan must take into consideration your strengths and your weaknesses if it is to get you there in "one piece". Such considerations include affordability and cashflow.
Some investors start with little to no money, while others start with extensive income and some with moderate savings. Therefore, a good starting point would be to determine your cash starting point objectively. When to Use Negative Gearing in Property Investing Why would you use negative gearing when it "spells" more expenses in your monthly outgoings?
Property investors use this method for many reasons, however some of the common reasons are as follows:
1. Capital growth / equity. This means they are willing and capable of spending the monthly shortfall for a period of time, to sell the property later at a much higher value. If you buy a property for 500,000 and your bond is 5,000 while the rent is only 4,000 you may be willing to spend the shortfall of 1,000 for a period of 2 years to sell the property at 800,000. The total shortfall was only 24,000 while the profit was 300,000 before tax. Anyone can see why subsidizing 1,000 per month in negative gearing could be quite attractive. This strategy is widely employed in mid to up-market areas when property prices are high and escalating higher every month.
2. Tax reduction. Some investors have a very good portfolio of properties, bringing in a good monthly income. At the end of the year, they have to pay tax on the income generated. In this case some investors opt to buy a negatively geared property to reduce monthly cash and therefore pay less tax. Though this strategy is useful, it usually goes in conjunction with capital growth and not only for tax reduction. As an example, lets say that a portfolio is generating an income of 4,000 per month. This income is taxable. If the investor now chooses to buy 4 properties at a negative cashflow of 1000 a sum of 4,000 negative cashflow is created. Now the monthly income is 4000 – 4000, which is 0. In this strategy, the investor wiped out all income with the negatively geared properties and therefore the taxable income is 0. However, he did get a return for spending all that money from the cashflow each month. The return is the capital growth on the negatively geared properties. The investor will most likely capitalize on the growth later down the road through systems such as refinancing or selling them to buy more properties.
In real life, these calculations are not so simple, quite the opposite is true. However, these examples are for the purpose of illustrating a point and you should ask for professional advice in any strategy you employ. At Property Investor Network investors daily discuss and draw upon each others experiences to improve their investment strategies and find out what works and what doesn’t.
As one may see, in both cases, the investor can use negative gearing for good reasons to further their objectives. In each case though, they ensure that the cash is available to cover the shortfall. And this brings us to the next important point. When NOT to Use Negative Gearing in Property Investing
As you may have noticed by now, the use of this strategy requires cash. This is where you must know your strengths and weaknesses.
When not to use such a strategy, as it can become very risky and even financially deadly:
1. When you don’t have cash. If you don’t have sustainable and consistent cashflow to feed money into negatively geared properties, such strategy could be very risky. If you can’t pay the bond for a period of time, you risk the bank having to repossess the property. The property will be put on execution (auction) or become a PIP (property in possession/foreclosure). That is not a nice situation and shortens your investment career or at least halts it for a while. This is easily avoided if negative gearing is not used in a situation of tight cashflow.
2. When your goal is income. If your goal is to make income on month-to-month basis from property rentals, negative gearing will only slow down the process (even if you are cashflow rich to subsidize properties). It will take quite a while for the rentals to increase for the cashflow to become positive. In most cases this period can extend to years in timeframe. If one chooses the income strategy as their main goal, then purchasing cashflow positive properties should be of highest importance, even if such properties in certain market conditions are far and few between, otherwise it just beats the purposes.
Though these examples are simplified, and in real life the considerations are far more extensive, it illustrates the point that negative gearing can be very risky.
Negative Gearing can be both a good thing and a bad thing. The only way one will ever know whether it is good or bad for them, is first to analyze their current situation and their possibilities, then choose a strategy based on the capabilities.
An investor that chooses Negative Gearing when buying an investment properties, for capital growth could find himself or herself in serious trouble if they didn’t first evaluate affordability. Investment properties should pay out rental income rather than just take money way from the property investor.
Some property investors employ negative gearing on daily basis and do make large sums of money, however in the wrong circumstances and wrong timing this strategy could prove financially deadly.
Sean Wheller is a real estate agent, investor and the founder of the largest online property investing education website in South Africa that specializes in real estate training, and real estate investing courses and seminars.
Article Source: ArticleSpan