Tell anyone that you’re thinking about investing in property and i’ll happily take a wager that they’ll offer their opinion (whether you ask for it or not)
It seems everyone has an opinion on property these days, and its usually pretty broad brush….
“…Buy property, it only ever goes up in value…”
“…You can use equity to bankroll a multiple property strategy…”
“… Buy off-the-plan property because of the tax benefits…”
“…You’ll pay too much tax if you earn more income – so buy negatively geared property…”
Funny how people can come up with such a quick and easy assessement about what is best for you and your financial situation without asking a single question huh?
Well, it’s time to bust a few myths, and hopefully encourage you to be a bit more skeptical of the ‘advice’ and expertise everyone seems to be so eager and willing to impart.
The truth of the matter is this…
- Property doesn’t always go up in value – it has fluctuations, peaks, troughs, and plateau’s. Buying the wrong thing, at the wrong time, with too much leverage (debt) can leave you in a world of hurt.
- You can use equity as a deposit for future purchases – but you’ve still got to service your debt, and too much debt from neagtive gearing leaves you awfully exposed if interest rates rise, tenants leave, or maintenance bills start stacking up.
- Buying off the plan does have tax benefits, but you can bet other parties in the deal are doing better out of it than you (the developer, the marketing agent, the tenant you put in it)….If an investment case relies solely (or too heavily) on tax benefits to make it feasible its not a very strong case to begin with!
- You can never be worse off by earning more – it simply defies logic. If that were the case, no one would bother trying to earn more once they were in the top tax bracket. Negative gearing is not an investment strategy in and of itself.
The last point here is what i’d like to spend some time on today – The Negative Gearing Myth. So we can be perfectly clear, lets take a closer look at what negative gearing truly means….
Negative gearing is borrowing money to acquire an asset that has a negative cashflow (costs you more than the income it generates) in the hope that a rise in its value will exceed the cumulative losses so a profit can be realised when it is sold.
For example:
You borrow $480,000 to purchase a $600,000 property on interest only repayments of 5% p.a. You put a tenant in the property who pays $400.00 per week ($20,800 per year) in rent. Then you deduct expenses…
- $24,000 in interest per year
- $5,500 in overheads
- $1,500 in council rates
- $1,500 water rates
- $1,500 land lord insurance
- $1,000 in repairs & maintenance
- $1,699 (8%) in real estate management fees
…Which means you lose $10,399 per year. Fortunately the tax man cuts you some slack and allows you to deduct these losses from your personal gross income before calculating your taxable income. This effectively means that you can reduce the loss by your MTR. If you’re in the 32.5% MTR bracket, this reduces the loss to $7,019 per year.
Let me break all of that down for you…
You are intentionally losing money in order to save on tax in the hope (not the gurarantee) that your property rises in value!
Now, lets say you’re right at the top of the 32.5% tax bracket (after your negative gearing losses) – You are earning approx $76,500 from wages / salary, and have a net income after tax of $51,777. Deduct ~$38.5k in living expenses (rent, food, cars, entertainment etc) and you have free cash flow of ~$13,100. Reasonably comfy right? You could probably afford another property…
Confident in your exploits, you decide to do it all again – except by now, interest rates have crept up to 5.5%..
Here is what your cashflow statement looks like on your negative gearing property journey:
| Property 1: | Plus Property 2: | |
| Salary / Wages Income | $76,500 | $76,500 |
| Property Income | $20,800 | $41,600 |
| Deductible Expenses | -$31,169 | -$67,137 |
| Taxable Income | $66,131 | $50,963 |
| Tax + Medicare | -$14,354 | -$8,893 |
| Net Income | $51,777 | $42,070 |
| Life Expenses | -$38,676 | -$38,676 |
| Free Cashflow | $13,101 | $3,394 |
I’m sorry to say, but your hopes and dreams of being a multiple property investor are done. With $3,394 of free cashflow left i’m afraid the bank isn’t lending you another cent. You are currently losing $25,537 per year (before tax benefits), and you’re in pretty serious trouble if you lose a tenant, or interest rates creep up to 6%. You are sitting on $1.2 Million of property and the success of your investment case hinges on that value rising at least $17,237 p.a just to break even (after considering your tax benefits), plus a margin above that which compensates you for the risk you’ve taken with your original investment capital ($240,000 or 20% of the property value).
Since you could have shoved your $240,000 in the bank and received 3% interest you’ll probably want more like a 6% return or more to make the whole ordeal worthwhile. Thats an extra $14,400. So all in all, you need an increase in value of $31,637 per year to earn your 6% p.a – and this doesn’t even factor in your buying & selling cost, which can be substantial!
Now, unforunately someone gave you some (not so) wonderful advice like “Buy property, it only ever goes up in value”, which encouraged you to purchase at the top of a cyclical peak. 3 years go by and the market is flat. Property prices haven’t budged an inch, but fortunately for you, neither have interest rates, and you have managed to continue your repayments and hold the properties instead of being forced to sell as a result of default. At this point, you’ve lost $51,711, plus $21,600 in opportunity cost (The interest you would have received on your $240,000 had you just left the cash in the bank instead of buying the properties). If you sell, you crystalise your losses, but at least the bleeding stops. If you hold, the bleeding continues, and you hope and pray that property prices start rising before you lose too much more. Needless to say, this is not a nice situation to be in.
So what’s the alternative i hear you ask? How do people accumulate multiple properties without mega incomes?
Well, this is where positive gearing comes into play – you know, the other strategy you overlooked for fearing of ‘paying too much tax’.
Postive gearing is borrowing money to acquire an asset that provides cashflow in excess of your interest repayments. A positive cashflow strategy is one where the asset returns cashflow in excess of ALL expenses – not just your interest cost.
So lets take a look at what that might look like. What if the second property purchase was a cashflow positive property? How would that impact your tax liability? Your capital gains position? Your cashflow? Your ability to borrow?
Instead of buying another house for $600,000, you buy 2 attached 3Br duplexes on a single title in a slightly less desirable neighbourhood for the same price. Each of these townhouses rents for $390.00 p/w and you’ve purchased using the same structure as option A (5.5% interest on interest only repayments).
| Property 1: (Negative) | Plus Property 2: (Positive) | |
| Salary / Wages Income | $76,500 | $76,500 |
| Property Income | $20,800 | $61,360 |
| Deductible Expenses | -$31,169 | -$66,323 |
| Taxable Income | $66,131 | $71,537 |
| Tax + Medicare | -$14,354 | -$16,227 |
| Net Income | $51,777 | $55,310 |
| Life Expenses | -$38,676 | -$38,676 |
| Free Cashflow | $13,101 | $16,634 |
And the comparison of a 2 x negatively geared strategy v’s a 1 x negative, 1 x positive strategy….
| 2 x Negatively Geared | 1 x Negative, 1 x Postive |
|
| Salary / Wages Income | $76,500 | $76,500 |
| Property Income | $41,600 | $61,360 |
| Deductible Expenses | -$67,137 | -$66,323 |
| Taxable Income | $50,963 | $71,537 |
| Tax + Medicare | -$8,893 | -$16,227 |
| Net Income | $42,070 | $55,310 |
| Life Expenses | -$38,676 | -$38,676 |
| Free Cashflow | $3,394 | $16,634 |
Now in terms of capital growth, in the same flat market your positively geared property does pretty much the same as your negatively geared property…. nothing. However, instead of bleeding you of cash while you wait for the market to bring you your returns (when its good and ready and not before), your positively geared property actually puts cash back in your pocket and bolsters your free cashflow.
Now if you used $13,000 of that free cashflow each year to pay down debt, by year 3, your $39,000 of debt repayments would be saving you $2,145 in interest per year, and further boosting your free cashflow.
Who do you think the bank is going to look more favourably on? The negatively geared investor with debt up to their eyeballs and a lousy $3,000 per annum in free cashflow, or the ‘one negative, one positive’ investor with $18,000 in free cashflow and increased capacity to service debt?
Now what if you managed to get some capital gains out of property 1 (negative), sell it for a profit, and use the proceeds to pay down debt on property 2 (positive)? Well, that would boost your cashflow yet again, and put you in the best shape you’ve been in in terms of your ability to service debt for your next negatively geared property…. (and hopefully you’ve learned some great lessons along the way too so your next purchase will be a better choice than the 1st!)
Negative gearing is not a strategy in and of itself, and positive cashflow property might mean sacrificing some capital gains in order to boost your cashflow, but a combination of the two may just provide you with the best of both worlds.
Remember, the lower your income, the lower the tax benefits of negative gearing, so lower income property investors may benefit more from a positive or neutrally geared strategy. On the other hand, if you currently hand over 47% of your income to the tax man and have more free cashflow than you can poke a stick at, a negative gearing strategy may be more suitable for you.
There are no promises in property investing, but one thing is for sure…
There is no one size fits all solution. Ignore the cliche’s and the rhetoric, take opinions with a grain of salt, and make sure your strategy is tailored to your unique financial & life situation. Be wary of ‘advice’ from those with a vested interest, and those who don’t ask enough questions about you and your situation.
Stay tuned for upcoming tips and tricks on building your ‘Financial Services A-Team’ – surrounding yourself with the right team of professionals will ensure your investing journey is safe, successful, and stress free.