Property Investing: Negative Gearing or Positive Gearing ?

When it comes to property investing, these 2 terms: Positive Gearing and Negative Gearing always come to the surface. People always talk about the good and bad without really know exactly how to compare both scenario – apple to apple.

Without being too technical, we will discuss and calculate all the important numbers for both method. We also provide you with free tools to calculate the number based on your own situation. But the most important thing which method is the best? It will be revealed in an instant by the numbers. Let’s get started.

Negative Gearing

Negative Gearing simply means the income from the rent cannot cover all the cost (mortgage, repair, maintenance, strata/land tax, council rate, etc). Hence, the owner of the property need to come up with the money every month to hold the property.

For example:

We buy property for $330,000. Put 10% deposit ($30,000), and borrow the rest from the bank with 8% interest rate on interest only loan. The property is then rented for $350 per week. All other costs (strata/land tax, council rate, repair) , let say, is $2,000 per year, therefore:

• Loan: $300,000 at 8% interest the annual cost will be: $24,000 per year
• Rental income: $350 x 52 weeks = $18,200 per year
• Total cost: $24,000 (loan’s interest) + $2,000 (other cost) = $26,000
• Since total cost ($26,000) is larger than rental income ($18,200) then we have a negative gearing investment here.
• We need to ‘cover’ or ‘negatively geared’ the property at $7,800 per year or $150 out of pocket every week.

Negative gearing is very common, so we probably are pretty familiar with this scenario.

Positive Gearing

Positive Gearing simply means the income from the rent is larger than all the cost (mortgage, repair, maintenance, strata/land tax, council rate, etc).

For example: let’s use exactly the same property above, so we really do fair comparison. To make that property a positive gearing investment, the rental income need to be higher than the total cost, hence:

• Minimum rent per week = $26,000 / 52 weeks = $500 / week.
• So, if we rent the property for more than $500 per week, then we have a positive gearing investment because the rental income exceeding the total cost.

If the rental income only cover just about the cost, people also refer this as “neutral gearing” investment. Only if we have quite significant surplus, say $100 a week more – or $5200 per year surplus (means we need to rent it for $600 per week) – then we are enjoying a positive gearing investment the most.

By now probably we are puzzled already. How the heck we can rent $330,000 property for $600 per week ? There 2 simple answers for that:

1. In the low growth area: small city / rural / remote area.
   You might know that the price of a property is very cheap in area outside the city. Say your $330.000 property is probably priced only $110,000 there. But will the rent also 1/3 of the city ? The answer is most probably “no”.

   The rent is not really proportional with the price. Say in this case, that $110,000 2 bedrooms unit in this remote area probably rent for $180-$200 per week. Also, the rate will be cheaper. So if we do the same calculation like above, we will find that the property is an positive gearing investment.

   In reality, probably there is not many $330,000 property in small city/rural/remote which rented for $600. For this comparison, you may relate this situation with having 3 properties with price of $110,000 each and each of the property is rented at $200 per week. (A bit more realistic?)

2. Over Period of Time:
   After a period of time, say 5 – 10 years, the value of our property is not the only one growing, the rental income also grows. Let see on this example: we start with negative gearing condition and rent the property for $350 per week. After 2-3 years, for sure we will increase the rent as the market goes. Yes, the cost probably go up as well, but after several increase, we will reach a point where the rental income will cover all the cost.

The Drawbacks

Don’t be mistaken, Positive Gearing investment is our ultimate dream. Once our property is no longer a negative gearing, we received money every week to the bank while the value of the property is still growing. The bigger thing is, that we can tell the bank that we are ready for the next property since this positive gearing property is practically self funded. The bank will happily lend you money to buy another property.

But having said that, before you swarm all those properties outside the big city, there are 2 major important factors that become the drawbacks:

• The growth in small city/rural/remote area usually significantly less than the big city
• Tax benefit for negative gearing

Why this is important? When we are talking about investing, we need always talk about the Return of Investment (ROI). Since the price of the property (in dollar value) is very big compare to the rent, then small difference in growth of the property will significantly change our ROI. Let see.

In Australia, we can expect the property will be doubled in value in average of 10 – 15 years or 7% – 10% per year. But let us be more conservative, say in the big city where our property belong, the growth is only 5%-7%, but in the small city/remote/rural area the growth is only 1-2% (most likely less). Then our hypothetical $300,000 property will give us:

In our example above, assuming the rental is not changed for 3 years::

• Negative gearing, in the city with 5% growth , out of pocket= 3 years x -$7800 per year = -$23,400
• Positive gearing, in small city rural/remote are are with 2% growth, income = 3 years x +$5200 = $15,600

Here is when the tax benefit factor kicks in. On positive gearing scenario, that $15,600 is income, hence subject to tax. On the other hand, the negative gearing benefit makes the out of pocket money that we pay become a tax deduction. So in this case, depends on your tax rate, the tax payable and deduction are as follows:

Therefore,

The real ROI

Yes, it seems that the negative gearing produce almost twice the positive gearing. But, please do not jump into any conclusion yet.

Now that we have the dollar value of our ROI , then we need to see the real percentage of our investment. On positive gearing scheme, our only capital is the 10% deposit ($30,000). The additional cost and the interest are pretty much self funded (fully covered by the rental income). But on negative gearing scheme, we need to come up $7800 every single year to cover the cost and interest. So, here is the final figure:

Analysis

What we can derive from these numbers ?

1. Both positive and negative gearing produce similar result (around 100% ROI after 3 year)
2. If we have lower tax bracket, positive gearing investment is better
3. If we have higher income bracket, negative gearing investment is better
4. Negative gearing requires more capital

The Side by Side Comparison

Conclusion

Although we have proven that both scheme produce similar result, there is one other factor that makes positive gearing investment not really popular: it is significantly harder to find such property (need to find further and further from crowd) and also it’s harder to find and maintain the tenant (vacancy rate is higher). Also the more remote the site is, only few lender will give the money easily. Even if they do, usually the LVR (Loan to Value Ratio) will be lower than the city (you need more deposit money).

Having said that, if all risk has been taken into consideration and taken care of, if you can find a positive gearing property, by all means go ahead! You just found a gem.

The best alternative
If positive gearing investment is too difficult, then the best alternative for investing in property to get the maximum result:

1. Get property in high growth area, normally in the big city.
   It means, we need to use the negative gearing scenario at first.
2. Make that property become positive gearing as soon as possible.
   (See other articles about this)

Using this method, you will enjoy the maximum benefit of negative gearing, while at the same time reaping the value of high growth area.

Free Tools: All the simulation and calculation above can be customized based on your situation and your number at Property Gearing Simulator. So you can make better decision whether to invest in negative gearing or positive gearing.

Happy Property Investing !

Disclaimer:

• The article and tools presented are for general informational purposes only . It’s exclusively your decision whether or not to apply it to your investment. Before making any decision about the information provided, you must consider the appropriateness of the information in regard to your objectives, financial situation and needs. If in doubt, you should consult your adviser or investment professional.
• You might be eligible or liable for other deduction or cost. Please refer law / rules / regulation that applied to your situation and jurisdiction.

— Denis Kristanda

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