When it comes to property investment you’ll often hear two conflicting philosophies advocated.
Some suggest you should invest in property to achieve positive cash flow – that’s when rental returns are higher than your mortgage repayments and expenses leaving money in your pocket each month.
Others suggest you should invest for capital growth looking for an increase in the value of your property.
This second strategy usually leads to negative cash flow (negative gearing) in the early years because properties with higher capital growth usually come with lower rental returns.
But there is a third element to investment that many commentators forget to mention and that is risk.
Considering cash flow, capital growth and risk, when investing in residential property you can only typically have two out of the three.
If you want a property investment that is low-risk and has a high cash flow you will have to forgo high capital growth.
If you are looking for a low-risk investment that has strong capital growth, you will usually have to forgo high rental returns (cash flow).
There’s no doubt in my mind that if I had to choose between cash flow and capital growth, I would invest for capital growth every time.
Of course, in an ideal world we’d all like to buy properties that have all three elements and while this combination is possible, it’s far from the norm.
I manage to achieve all of these by purchasing properties in high growth areas and then adding value by renovating them or redeveloping them into townhouses.
The extra rent and the taxation benefit I achieve give me high-growth properties with high yields.
Since many beginning investors look for cash flow positive properties let’s take a look at the negative gearing vs positive gearing debate.
Of course, negative gearing has been a much-debated and discussed aspect of property investing for many decades, with a number of reforms, changes and proposals related to this tax mechanism over the years.
- But what is exactly negative gearing?
- What is a positive cash flow property?
- Benefits of positively geared investment property
- How to find positively geared property in Australia
- Negative gearing – what does it mean?
- A bit more about how negative gearing works in Australia
- How the Tax Office will help you fund the ongoing cash shortfall
- Big benefits of negative gearing property
- Negative gearing vs positive gearing – which is better?
But what is exactly negative gearing?
And how does it help investors to maximise their profits when owning real estate assets – and is negative gearing a better tax strategy to use than positive gearing?
When we talk about a property being “geared”, what we are really talking about it how much the property actually costs you to own.
There area number of tax benefits that can come with property ownership – and once factored in, they can make the prospect of becoming a landlord very enticing.
Negative gearing is one such tax rule that landlords can use to help them offset the costs of owning their property.
Before I get too far into this detailed article let me get 2 facts straight…
- Any particular property is neither a positively or negatively geared investment.
It really depends how much debt you have against that property.
Even an investment property with very low rental yield will be positively geared (bringing more cash flow than goes out) if you have no little or no debt against it
Now I know this will confuse some people, but your cash flow position after taking into account your investment property rental income and your expenses is really a finance strategy, or a statement of your finance and leverage.
Negative gearing on its own is not an investment strategy.
As I explained… my preferred investment strategy is to buy investment grade properties that will increase in value and properties which will bring in increasing rent over time, because both these factors (increased value and higher income) will allow me to buy more properties that will increase in value, etc etc.
So while many people buy real estate for cash flow I buy my investment properties to allow me to buy more investment properties.
And I can do this because the growth of my property give me the equity required and the increasing rent helps service my debt.
So now let’s look at how gearing works, and which approach – negative gearing or positive gearing – is better in the long run?
What is a positive cash flow property?
First things first: let’s begin with a positive cash flow property.
Some property gurus try to sell the idea that positively geared property (where the rental income covers all costs of ownership plus more ) is somehow mystical and complicated, but it’s actually a simple concept and it is largely related to how a particular property deal is financed.
In simple terms, a positive cash flow property is one that generates a return that is higher than the property costs to own.
For instance: here is an example of a $200,000 regional apartment, which generates a 6% gross rental yield of $12,000 per year.
The purchaser uses a 25% deposit or $50,000 to purchase the property. They apply for an interest only mortgage on the remaining $150,000, fixed at a rate of 3%.
Rental income – 6% yield $12,000
Mortgage – interest only 3% = $4,500
Repairs, management, strata fees, council rates = $3,500
TOTAL INCOME ($12,000) – TOTAL COSTS ($8,000)
Net cash flow per annum before tax: $4,000
Note that this is the net cash flow: it does not yet take into consideration income tax or depreciation, which could adjust the final cash flow to more or less favourable for the landlord.
Benefits of positively geared investment property
The reason why positive cash flow landlords choose to invest in these types of assets is fairly clear – they pay for themselves, so the ongoing cost to the property owner is mitigated.
For some property investors, this is the only way they choose to invest.
After all – why you would sink all of your hard-earned money into a property investment that actually costs you money to own, year in, year out?
We’ll dive into that shortly when we begin explaining negative gearing as it relates to real estate, but first, a little more on the benefits of positive gearing.
As mentioned, positive cash flow properties generate an instant return, which means you’re making a real cash profit from your investment from the moment you own it.
Moreover, if you purchase a positive cashflow property in a growth area, you’ll get the benefit of both capital growth AND positive cash flow.
That is, you’ll be earning money twice: once from the rental return, and a second time from the capital growth, which pushes the value of the home or apartment up each year.
All of this from an asset that doesn’t force you to put your hand in your own pocket to pay for running expenses every month.
At this point it should be noted that there is a slight difference between a positive cash flow property and a positively geared property.
A positive cash flow property is one that generates a positive (or surplus) return from day one, regardless of your tax situation.
A positively geared property is one that may not pay for itself initially, but once tax deductions and depreciation is factored in, the asset more than pays for itself.
How to find positively geared property in Australia
To be successful as a positive cash flow investor, it requires you to buy a home that attracts high yields.
The yield is simply the amount of rent received, expressed as a percentage.
Taking our earlier example, let’s assume you own a property for which you paid $200,000. You receive $230 per week rent.
|Multiply by 52 weeks||$12,000
|Divide annual rent ($12,000) by the purchase price ($200,000)||0.06|
|Therefore yield equals…||6%
The potential downside to the approach of investing in a property for positive cashflow is the fact that as a landlord, you may be required to extend your property search to regional locations outside of the major capital cities.
This is because capital city properties generally return a lower yield.
By investing in regional locations, you’ll be able to find properties with a higher return and yield, however the drivers of growth may not be as strong as it is in more populated city centres.
This is because inner city properties are generally more expensive and although they are in high demand with renters, the amount of rent paid each week doesn’t usually cover the cost of owning the property.
Regional properties have historically achieved lower capital growth rates, although they do tend to generate a higher rental yield.
Of course, during some time frames capital growth might be solid in certain regional locations, but over the long term, capital growth rates are highest where the demand is strongest and supply constrained.
It’s also important to note that not all property markets are created equal.
There are some capital city markets that don’t perform as strongly as others, and some regional markets that deliver returns and capital growth that are extremely strong.
For this reason, it is important to do deep research before you buy a positive cashflow property.
Some investors have had the unfortunate experience of buying a positive cashflow property and reaping the small cash flow rewards of that purchase every year.
However over the long-term, they realise that the property has barely gone up in value (if at all), and they would have been far better off investing those funds in a different property or alternative asset class.
The other big problem with many cash flow positive properties is…
In general, cash flow positive properties are in cheaper areas, lower socio-economic areas or regional locations.
Not only do these locations offer lower capital growth, but they also offer the prospect of lower rental growth.
So while in the early years of the investment yield, (the rental return as a percentage of the value of your property) may be high, it will be hard to increase the rent in the location where many of these properties are located.
You see… there are two types of tenants:
- Tenants who can’t afford to buy their own home.
- Lifestyle tenants.
The first group of tenants are more likely to be looking for accommodation in cheaper areas – the types of locations where you will find cash flow positive properties, but the financial challenges that the world has brought upon us recently has reminded us that many Australians are only 1 to 2 weeks away from being broke.
In fact many of these tenants end up spending 30% to 50% of the take home pay on rent and I’m more likely to work in occupations where there will be minimal wages growth over the next couple of years.
On the other hand lifestyle tenants usually have better incomes, rent in areas where there will be strong capital growth, and over the years will be able to afford to and be prepared to pay higher rent to live in lifestyle locations.
This can be achieved by renovating or developing the property to add value.
Now that you have a fairly clear and full understanding of what is involved with positively geared property investments, let’s move on to negative gearing.
Negative gearing – what does it mean?
Negative gearing is a tax strategy that Australians have been using for many years (if not decades) to make the prospect of owning investment properties more manageable and more profitable.
In simple terms, negative gearing takes place when you own an asset, in this case property, that costs you more than you are earning from it.
For example, the interest you are paying on your mortgage and all other associated costs with the property, equal more than the income or rent you earn from that property.
As a result, you are making a financial loss.
What makes negative gearing particularly useful when it comes to personal tax is that any net loss from an investment property you own can be offset against other income that would otherwise be included in your assessable income.
What this means in layman’s terms is that your taxable income bracket, and ultimately the amount of tax that you need to pay, is reduced.
By way of a very simplistic example: if you own an investment property and every year, that property costs leaves you $10,000 out of pocket after all expenses and rental income is accounted for, then you can claim that $10,000 against your income tax.
If you pay tax at the higher end of the scale, of around 45 cents in the dollar, then you stand to get $4,500 back at tax time.
Meanwhile, if the investment property goes up in value (but you don’t sell it), no capital gains tax (CGT) will be payable.
It’s important to know too that negative gearing is available for other investments as well, such as shares or businesses.
To explain how negative gearing works in more detail, let’s share an example.
This may be a typical negatively geared property as things stand today.
But before I do, let me remind you of what I said earlier in the piece – negative gearing is the result of how you finance your property and should not be your preferred property strategy.
Never buy a property for tax reasons, saving tax if your property doesn’t increase in value doesn’t get you anywhere.
Your strategic plan should be to obtain capital growth so you can buy more properties, but your cash flow position in the early years will mean you are negatively geared.
Back to the case study…
In this example, a higher rate taxpayer has bought a $750,000, two-bedroom capital city unit, which generates a 3% yield.
They have used a 10% deposit and the mortgage is once again interest only at 3%.
Rental income – 3% yield $19,500
Mortgage – interest only @ 3% = $20,250
Repairs, management, strata fees, council rates etc – $8,000
Net cash flow per annum – a loss of $8,750
That financial loss of $8,750 can be claimed against their income tax, meaning they’ll receive a percentage of that loss back at tax time.
As a higher tax-paying citizen, you could receive up to 45 percent of this loss back.
Again, these sums don’t include depreciation, which is another tax tool afforded to property investors that can help you secure a hefty tax refund.
Even so, negatively geared investments may help to generate a decent investment return.
But the fact remains, they still represent a loss-making investment.
With such a big financial loss on the table, why would investors choose to negatively gear, when they could invest in a positively geared property instead? Why would anyone willingly buy an asset that loses money?
It’s because along the way you’ll be able to buy a property that delivers stong capital growth.
If you have any doubt about the importance of capital growth, the calculations in the table we are about to discuss may change your mind.
Over the long term, “average” property investments in our four big capital cities tend to return around 8% capital growth (averaged over the last 40 years) and 4% rental yield.
The table would be turned the other way in many regional areas that may only achieve 5% capital growth, but a higher rental yield of say 7%.
The argument then continues – if you’re going to achieve 11 or 12% per cent per annum from your property why not go for the high rental returns?
I guess that’s why many Beginner Investors make the mistake of viewing their property investments as income-driven rather than striving for capital growth.
The problem with this argument is that while the first part is generally correct – properties with high growth will give a low return and vice versa – the second part is clearly wrong.
The two types of investments do NOT give similar results over time.
This is easy to explain with the following example.
Imagine you bought a property worth $500,000 in a poor growth area delivering 5% capital growth and 7% rental return.
The calculations in the table below illustrate that in 20 years your property would be worth around $1.3 million.
If you bought a different property for $500,000 in a higher capital growth area, showing 7% per annum capital growth and 4% rental return, this property would be worth over $2.3 million at the end of the same period.
That is a massive difference in the final value of your investment property – over $1 million more.
In the meantime the rentals on this property would also grow substantially, in line with its capital growth, and they’d slowly catch up to the rentals you’d achieve on the first (high return) property.
|Capital growth vs rental income on a $500,000 purchase|
|7 per cent capital growth||4 per cent rental return on property value||5 per cent capital growth||7 per cent rental return on property value|
Let’s look at the same information graphically – using the concept of compounding you can see how different levels of capital growth affect the value of your asset base over time.
I’m trying to show you that if you could outperform the averages – which you will after learning the lessons in this book – and find a property that goes up by say 10% annum (averaged out over a property cycle), over the next 20 years you would make a further $1.5 million in equity.
The real bonus for the investor who bought the high-growth property is that they would be able to access the extra equity and borrow against it to invest in more assets.
It’s very hard to do this with properties that have high rental returns but poorer capital growth.
The few dollars a week you get in positive cash flow is not really going to make much difference to your lifestyle or your ability to service other more desirable properties.
Wealth from real estate is not derived from income, because residential properties are not high-yielding investments.
Real wealth is achieved through long-term capital appreciation and the ability to refinance to buy further properties.
A bit more about how negative gearing works in Australia
The deduction of negative gearing losses on property against income from other sources is permitted in several countries, including Australia and New Zealand.
The way it works is like this: the Australian Tax Office (ATO) allows the landlord to deduct a number of property-related expenses against your regular income tax.
In the above example, every year, the landlord would have the following expenses:
|Repairs and expenses
The difference between the landlord’s on paper costs and income is therefore $17,250, which can be deducted against the property owner’s income tax at end of financial year.
Negative gearing tax legislation has therefore turned what might otherwise be a fairly significant loss in the early years of investment property ownership, into a less substantial loss, and a less financially painful scenario for the taxpayer.
The landlord also feels pretty good that they have ‘saved’ paying some income tax due to the on-paper allowances and negative gearing rules.
*Note: Depreciation is an allowance from the government, which acknowledges that the property asset you own will decline in quality over time, and will require you to spend money to repair or replace the items that wear out over time. It is not a physical cost to you, but an allowance that is estimated by quantity surveyors. You generally need to pay a quantity surveyor for a deprecation schedule when you buy a property, and this outlines how much you can claim in depreciation each year.
This strategy is not without risks
The four main risks of negative gearing are:
- Poor capital growth – that’s why correct asset selection is so important.
- Interest rate increases – which is unlikely in the foreseeable future, but can be addressed by fixing interest rates on some or all of your debt.
- Poor rental growth – which highlights the importance of owning properties that will be in continuous strong demand by a wide tenant demographic.
- Lack of financial discipline – never use your financial buffers for anything other than covering your property-related expenses.
How the Tax Office will help you fund the ongoing cash shortfall
Paying the cash shortfall on a negatively geared property through the year could be a burden, even though you expect a large tax refund at the end of the year, but there is even a way the taxman will help you to do this.
There is a variation provision in the Tax Act, whereby as soon as you purchase your property you can arrange to reduce the tax being deducted from your salary.
Either you or your accountant can complete an “Income Tax Withholding Variation Form” (Section 15/15 form), which is a short questionnaire asking details of your salary income, the rent that you expect to receive, the expenses that you expect to pay (including the non-cash deductions) and the net loss expected on the investment.
You can simply download one from the ATO website.
You then mail this completed form to the Tax Office and usually within 14 days you will receive a letter, authorising the amount of tax deducted from your PAYG income to be reduced by the amount of annual cash shortfall you expect to have from your investment property, divided by the number of pay periods in a year.
All you do is hand this letter to your employer or, if you are self-employed, to your book-keeper, and he or she will immediately reduce the tax deducted from your pay by the appropriate amount.
Of course, should your estimates be inaccurate you will have to pay or be refunded the difference when you submit your annual tax return.
At the time of writing this edition of my book, the Labor Opposition party is proposing to remove negative gearing and change the level of exemptions for CGT.
Big benefits of negative gearing property
There are a number of benefits of negatively geared property investing, particularly for those property owners who invest over the long term.
These include the personal tax benefits outlined above, but there are also a number of benefits for the broader community.
These include the following:
- Providing accommodation for the wider community
Negatively geared investors support the private residential tenancy market, assisting those who can’t afford to buy and reducing demand on government public housing. Without private landlords providing accommodation to the almost 30 per cent of Australians who rent, there would be a national housing crisis.
- Drive demand for construction
Investor demand for property supports the building industry, particularly since negative gearing rules were changed to favour new properties.
This helps to create and sustain employment.
It’s estimated that more than one million Australians are employed in property or property-related industries.
- Personal financial responsibility
The tax benefits associated with negative gearing encourage individuals to invest and save, especially to help them become self-sufficient in retirement.
This reduces the financial burden on the government over the long-term.
At a personal level for the investor, a negatively geared investment property will usually remain negatively geared for a number of years, but will not generally stay that way over the long-term due to increasing rent returns.
As the rents increase, this means that your negatively geared investment will eventually become positive.
Negative gearing vs positive gearing – which is better?
As frustrating as this might be to read, the truth about positive versus negative gearing is: there is no “better” strategy.
Whether a negative or positive investment strategy will work for you depends on your unique and personal situation.
Ultimately, different investment plans require different strategies based on any one person’s income, tax position and goals.
We could find a very good quality property investment opportunity priced at $700,000 with a rental return of $500.
This might suit Investor A extremely well, based on his personal income tax rate, savings, risk profile and goals.
However Investor B – who has a different budget, different investment timeline and different risk profile – might find this particular property to be completely unsuitable.
Does this mean that our $700,000 property is a “bad” investment? Absolutely not!
What it means is that every individual property investor in Australia needs to make their investing decisions based on their own unique circumstances and goals.
Taking our above example, this $700,000 property may be sitting on a large corner block that is ripe for development.
Investor A wishes to own it for a few years whilst they aggressively pay down the mortgage, at which point they plan to split and subdivide the block, selling the land component off.
At this stage, they will use the proceeds of the land sale to pay off the existing home.
They now own an investment property free and clear with no debt against it.
This is going to help to fund their retirement from the workforce in five years’ time.
This is a great strategy and would be very suitable for a number of people.
It could also be the completely wrong approach for a different type of investor.
This is why we always suggest that rather than trying to decide whether to look for a positive or negative investment property, a much better strategy for property investors to employ is to understand what their end game is (as well as their risk profile).
From that point, they can then develop an investment strategy that reflects their financial goals, their budget, as well as their personal cash flow – which can be used to fund any shortfalls until their portfolio matures over the long-term.
In the meantime, the ability to claim negative gearing benefits should be viewed for what it is: a legitimate taxation deduction in the same league as claiming for a home office or work-related car expenses, or indeed the initial losses when setting up a new business.
Now, anyone who has invested in property before knows that the rules of the game can and will change.
Many politicians have tweaked the rules of negative gearing in the past, and others have proposed or made plans for large-scale overhauls to the negative gearing rules (although these have always failed to go through).
The point being: the availability of negative gearing in the future is not guaranteed, so you should never invest in a property simply because it offers tax advantages.
If those tax breaks are suddenly whisked off the table, what are you left with? It could be a low quality property with poor rental demand, which costs you a small fortune to maintain.
This is the last place you want to end up as a landlord, so it’s essential that you do your research, engage with experts, and create a clear picture of what you wish to achieve as a property investor.
Once you have this, you can then start working backwards and create a plan to help you get from A (where you are now) to B (where you wish to be).
One thing that remains true regardless of which strategy you use is that the earlier you start acquiring assets, the better.
There’s a saying: “The best time to buy a property was 20 years ago. The next best time is today.”
If you’ve been considering becoming a landlord, what is stopping you from taking the next step?
Now is the time to take action and set yourself for the opportunities that will present themselves as the market moves on
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