Negative Gearing vs Positive Gearing | Which is Better?
Hello, Ben Kingsley here and today I want to talk about Negative Gearing vs Positive Gearing. Now the difference between the two is an income outcome which basically means that with negative gearing properties, we actually have to put some of our surplus cash into supporting the investment as opposed to positive gearing where we actually get some return on that property straight up. It is important to note that there are a lot of technicalities in here but I am going to try to keep it fairly simple. And by fairly simple, I mean over time the majority of negatively geared properties actually turn positive. So the reason why we are investing in a negatively geared property needs to be for another purpose cause ultimately, we want passive income from both outcomes.
Now, let me explain that in more detail. Let’s look at what negative gearing is. It’s basically the rent that we receive less the costs of holding that property. What do those costs normally include? It’s normally the mortgage repayments so the interest on that mortgage. It’s also the holding costs, if we are getting a property manager to manage the property, and if we’ve got body corporate fees, rates and all those types of things. The other clear message there is we need to understand that we might also provision for some maintenance. I mean, the idea is we’ve got to keep the property in a nice livable order so we can keep our tenants happy so that we can keep that rental income flowing through. Once you’ve add all of those up, so you’ve got the income coming in and you’ve got all your costs, you are left with a negative. So that is where our income from other activities needs to support that. Now in addition to that, or what can improve that picture is what we call depreciation. Depreciation is in relation to what a house does. Effectively over time, the house will depreciate in value so we are able to write off some of the components of the house. That is also a positive message from an income point of view. We can write those off which means we can get a tax benefit associated with that depreciation. This means that the shortfall or the negative gearing position that we are in is potentially less than what it is, so we have to put less of our money in there.
If we look at the positively geared side, it is exactly the same story in terms of income coming in and the holding costs that I’ve mentioned before. But at the end of the day, we’ve actually got a positive outcome.
The question’s got to be to anyone who is investing in property is, “Why would I invest in something that is losing money?”.
I say to anyone out there who is serious about investing in property, it’s crazy to invest purely for a negative outcome or for a tax outcome. That’s just naive but you will see a lot of investment advisors talking about all the depreciation that you might be getting and focus on that as an investment strategy. That’s just dumb. We don’t want to do that. Let me give you an example:
Let’s say we go and buy a business and the business worth $500,000. We are attracted by the fact that we are going to save from a tax point of view so we are going to run at a loss for 10 years on the assumption that the business is going to worth a million dollar in 10 years time. Now, the reality is, not every property is suitable for investment, so you see a lot of people talking about attractive off the plan apartments, house and land packages with really large depreciation components but they are just in the wrong location. So they run this business for 10 years and it doesn’t grow in value and they have been getting all these accumulated losses but they have yet to see any capital growth. So you should always invest for growth as opposed to negative gearing or tax benefits. Tax benefits are purely a fringe benefit associated with that and there are some properties that have excellent growth. The reason why they are negatively geared is because the growth in the value of the property and the area expansion in terms of the need and desire for people to get in there is what pushes the value higher. So rents are lagging. They actually have to catch up to try to get that type of outcome. So when we’re talking to our clients and advising them, we’re actually talking about a growth strategy and looking at location, primarily and then looking at the local neighbourhood and then looking at the property whether it stacks up. If it is negatively geared at that point and it has got some depreciation, that’s a bonus as oppose to just going for tax benefits. It’s crazy to think that you’ll get a $10,000 tax benefit but you are going to lose $30,000 – $50,000 over 5-10 years. That’s not really smart. So that’s negative gearing.
From a positively gearing point of view, we are talking about wow, if this property is going to deliver us returns on a month-to-month basis, why don’t we just always go for positively geared if it means it doesn’t affect the family budget or the household budget, why wouldn’t just keep chasing more and more of these positively geared properties. Now, the argument for that is you will need to accumulate quite a lot of them. In reality, positively geared properties have limited growth opportunities. So the growth story is a timing story where if you can pick the right time to get into the market, then you might see a bit of growth. But you got to ask yourself this question: Why is the property positively geared? In other words, why is tenant willing to actually pay more to rent the property than to actually own it? Because in reality, their rents would be the same as their repayments. This is down to the story, well, you need to test the area. People don’t want to live there or is it a low social economic area? When in reality, there are people who are just comfortable in renting and they don’t know any better, we call them the non-aspirers. They are just going to keep going to rent properties. Well, they don’t get good income and they don’t get good income growth. So the area struggles for that growth story. The other areas where you find positively geared property is in regional towns or mining centres which have boom and bust cycles. So you’ve got to be prepared for a low growth and the challenges of turnover in terms of tenants. The capital growth story over here with negatively geared properties is one of more stable, more reliable, more structured properties in great locations as opposed to the cash flow positive story over here which is we’ve got to be ready for some bumps in the road and some timing issues around performance of growth and it’s just going to outperform on a growth story than what the negatively geared property is going to do.
So let’s wrap that up. Couple of key messages. You chase properties for growth or you chase properties for income. The fact they are negatively geared or cash flow positive and the tax story is a supplementary story. If you are just chasing that tax story, you are going to be sold a lemon. That’s my big message here. Don’t be buying these well-tantalised, well-presented, well-marketed properties on the mass. Sit down, do your sums, do your numbers and do your research. It could mean that you are better off buying an existing property over a new property. On a cash flow positive side, it is going to be a story of making sure and be willing to understand that your tenants aren’t necessary going to be great reliable tenants and making sure your property managers are doing a great job looking after it. So the story is, make sure that you understand those things and from an investment point of view, look at your own household and cash flows. If you’ve got strong cash flows, then we would talk about a growth story. If you’ve got less in the bank in terms of surplus cash flow, then we might talk about a yield story or an income story and it’s a combination of those two as you build your own property portfolio that is going to give you a passive income for life.