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Negative gearing is a part of life for Australian investors, and a property buzz word.
So what is it?
Gearing simply means borrowing money to buy an asset. In the case of property, you have taken out a loan to purchase a property.
- Negative gearing means that the interest you are paying on the loan is more than the income. As a result you are making a loss.
- Neutral gearing means that the interest you are paying on the loan is equal to the income.
- Positive gearing means that the interest you are paying on the loan is less than the income. As a result you are making a profit.
So, if negative gearing means that you’re making a loss, why is that a positive?
Obviously nobody wants to get into property investment to lose money. Even though most property that you will buy will be negatively geared, that is the rental income is not as much as the interest repayment, the benefit comes from the capital growth. Let’s look at the example below to clarify this point. There are other expenses related to owning property but I will keep this example simple and focus on the interest expenses.
Let’s 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.
Let’s 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%, 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.
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.
To clarify your own cash flow position don’t forget to include all the other property related expenses and any tax return income. In summary, negative gearing works IF the money you make from the capital growth is greater than the loss you make in rental shortfall.
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– Peter “The Property Professor” Koulizos