When investing in property, you may come across the terms Positively Geared (Cash-flow Property) or Negatively Geared (Capital Growth Property). Here you will learn what these terms mean and how each investment strategy works.
What is a positively geared property?
Positive gearing occurs when you receive more in rental income from your tenants than what you pay on the likes of loan repayments, interest, property maintenance, management fees, rates etc.
This is common when rents are high due to strong demand for rental property and interest rates are low. A positively geared investment can also be referred to as a ‘cash flow property’. That's because the property will be putting additional funds into your pocket.
How it works...
As an example, let's imagine you purchase an investment property for $400,000 located in a location where demand for rental property is high.
You rent the property to tenants for a strong rental return of $500 per week. Now let's assume the combined costs of owning the property total $410 per week. In this instance, after all expenses this property is increasing your income by $90 per week and in turn is paying for itself.
In this situation the property is positively geared!
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Increased income - You benefit by receiving an income from the property and not having to be out of pocket. You can even use this income to make additional payments into your mortgage and own your home sooner!
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Less risk - If your income circumstances changes e.g. if you were to lose your job then the income will cover the costs of the investment and you are less likely to need to sell under pressure and potentially unfavorable conditions.
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Balanced portfolio - Some investors may use a positively geared property to balance their portfolio, using the additional income to pay the shortfall of negatively geared investments.
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Lender Attractiveness - The additional income can increase your attractiveness to lenders for additional loans.
The Disadvantages of Positive Gearing
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Taxable - Just like any form of income, the income you earn on a positively geared property is taxable.
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Slower long-term growth - Often but not always, a positive cash flow investment can be located in a regional area (rather than capital cities), which commonly (but not always) see less or slower capital growth.
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May be more volatile - these properties may be largely dependent on a particular industry of employment which can make it subject to greater volatility should employment factors weaken.
What is a negatively geared property?
Negative gearing occurs when the rental income you receive is less than the total costs involved of owning that investment property.
Often referred to as ‘capital growth properties’, negatively geared investments are expected to appreciate (grow) in value over time, and this increase is expected to outweigh any short-term financial losses. These properties are commonly located in areas closer to capital cities which typically perform better over the long term.
How it works...
As an example, let's imagine you purchase an investment property for $440,000. The property is located in a high growth, stable area where properties are renting for a more affordable amount due to a higher availability of rental properties in the area. You rent the property to tenants for a rental return of $425 per week.
Let's assume the combined costs for your property totals $440 per week. Therefore, after all expenses - the rental income for this property does not fully cover repayment costs and you have a short-fall of -$15 per week.
In this situation, the property is negatively geared.
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Tax Deductions - A common reason investors choose this strategy is that it allows you to claim tax deductions related to the expenses you incur so by claiming the available tax deductions. You can reduce your rental short-fall and ultimately reduce your taxable income.
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Capital Growth - Assuming the strategy goes to plan, the capital returns from the property will eventually outweigh the borrowing levels and costs to create financial gain for the investor at sale.
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More affordable for tenants - Because of the affordability, it can be easier to secure a tenant for the long term.
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Less volatile - Unlike a property in a regional area which may rely heavily on particular employment industries to drive up demand, these properties rely on a variety of factors and can be a less volatile investment.
The Disadvantages of Negative Gearing
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Budgeting may be needed - You may need to be able to budget for the ongoing shortfalls, also, when the property is sold for a profit, the tax man collects on the capital gain.
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Long-term strategy - It’s a longer term wealth creating strategy so if your circumstances change and a sale is necessary the sums may not work out favourably.
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Higher financial risk - If in the instance you were to lose your job you will need to be able to maintain any costs involved. Make sure you have a plan in place to ensure you are prepared. For example, income protection and insurance policies.
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