Investment Property Gearing

The gearing term is expressing whether the investment created a surplus of funds in the year or not.

Positive gearing means an overall profit in the year and negative gearing is the description if the property expenses were greater than the income generated. To receive money throughout the year above expenses for your investment is ideal if you are wanting to increase your cashflow or to be able to put funds away for other purposes. Negatively geared properties have the advantage of reducing your taxable income and in turn your tax requirement, meaning you may be entitled to a tax refund, which provides motivation for a faster tax lodgement.

Losing money on a property can happen through ongoing expenses, or when you sell the property. Until you sell the property you have not realised any capital gain or loss, meaning although owning the investment property may have cost you more than the income received in the year, the property may still provide a positive return on investment if it’s overall asset value increased more than all of your ongoing losses, but doing so requires the property to be sold.

Choosing between a property that makes you $10,000 gross profit a year after all bills or costs would seemingly be the better choice than a property that cost you the same, but depending on your financial situation, timeframe and plan for the investment, both a net gain and net loss have positives.

There is only so much you can do to effectively change the gear of the property.

Reducing the amount of money you owe and in turn reducing the loan repayments will cause the property to have lower expenses, resulting in a greater likelihood of the property generating income. I suppose you could charge really low rent if you absolutely did not want to be ending up with an income at the end of the year, but I believe investing is generally more enjoyable when you are making money.

What are the costs of Investment Property ownership?

Traditionally, the largest cost of owning an investment property is the mortgage repayments, unless you do not have a mortgage, which is coincidently one of the most common financial goals when you ask anyone at almost any stage of life, but it seems to not be such a motivator when you hear the words investment property and negative gearing. Aside from the mortgage repayments there will always be costs associated with owning property and particularly investment properties;

Council Rates - A percentage of the land value paid every year by the owner of the property (unless you live in the UK, where the tenant pays council rates).

Emergency Services Levy

Land Tax (if you exceed the minimum threshold of $450,000 as of 2021 - South Australia) Land tax is not paid on your primary residence.

Water sewerage costs - These are generally not charged to the tenant as it is required for the property to have working sewerage.

Generally, you cannot deduct your entire mortgage payment as an expense if you are paying principle and interest, the principle part of your loan payment is reducing your liability and adding to your overall asset value, therefore only the interest cost is an expense of the loan that is tax deductible.

How do people buy investment properties?

A common way for people to acquire investment properties is to use equity in their home to act as a deposit for the purchase of the investment property. In this scenario it is financially beneficial to favour repaying the loan on the place of residence over the investment as you cannot claim the interest costs against the property you live in.

You may have read articles of people with 10, 15 or 20 investment properties, as impressive as this may sound initially, it is incredibly risky to have such a high exposure to one market, the property market. Suppose the 15 properties total value was (15 x $400,000) = $6,000,000 and as the investment properties interest cost is tax deductible the highest amount of funds were borrowed on each property, potentially around $4,800,000 owning (80% of the assets value). These loans may have been approved by the financial institution based on interest only repayments, meaning the loan values are not being reduced over time.

What can this mean for the investor?

Stress. Regardless of how professional your property manager(s) may be or how organised you may be at managing them yourself, you would have on average 1 property lease end every 24 days if leased annually, not to mention maintenance. Any loss of rental income or loss of income from your employment could be disastrous if you have not been able to even begin reducing your liabilities by paying principle and interest. You are only allowed to make interest only repayments for a specific period of time, maybe between 5 and 10 years, following this time the financial institution can require you to pay principle and interest.

Consider taking a $320,000 mortgage for a property over 30 years paying monthly at 4.43% interest per annum or over 20 years at the same rate.

30 years, 360 repayments of $1,608.11 = $578,919.82

20 years, 240 repayments of $2,012.41 = $482,977.60

And those 20 years of repayments could be after you have already paid interest only for 10 years.

10 years, 120 interest payments of $1,181.33 = $141,759.60

The 10 years interest only repayments followed by the 20 years accelerated payments total $624,737.20. This is $45,817.38 more than if you were paying principle and interest from the first month for the full 30 years.

What is different about Investment Property Interest Rates?

It was around 2016 when the large Australian banks began to realise this risk to the borrower and lender and to better protect us (and them), loans were now assessed on and provided with higher interest rates if they were for investment purposes. In June 2021 the Commonwealth Bank’s Standard Variable Interest Rate for investment loans was 4.43% compared to a 3.85% Standard Variable Interest Rate for owner occupied, a difference of 0.58%.

With news articles coming out every 6 months of the opposing government party ending negative gearing and interest rates being higher for investment property loans compared to owner occupied, it is apparent that the negative gearing dream may not be as easy and as sure fire as it was years ago. Hopefully though, it is at least confirming that the ‘gear’ a property is in is just a description, earning money from your investment or your investment causing you overall annual costs is what it is describing.