The positive gearing vs negative gearing debate

We didn’t give a definitive answer to this question. Why not?

Because once again the answer is really defined by  the investor’s personal circumstances. And yes It’s also true that those circumstances may exclude them from some solutions that are available to others & therefore push them toward investments that may not really be in their best interests; some people have more choices than others, a fact of life that applies to things other than property.

Leaving that aside for a moment the circumstances that will vary from one investor to the next are many & will include such things as income, family dependants & commitments, job stability, borrowing capability, holding capacity, other investments, emotional strength & age, just to name a few. (You can start to see why it’s a good idea to seek professional advice and the opinions of people experienced in these matters to help guide you through the maze.)

In my view one should always keep capital growth at the forefront of your mind when investing and expect to be in the investment for the medium to long term. After that it’s substantially the choices you make that determine if the property is positive or negative.

The pros & cons of positive cash / gearing strategy

The Pros / Advantages of Positive Gearing
•    Receipt of a larger monthly income stream after paying expenses.
•    Positive Cashflow properties can balance your portfolio - the with extra cash being used to pay the shortfall associated with holding negatively geared properties.
•    By increasing your serviceability Positive cash flow properties and can make you a more attractive to proposition to lenders.
•    If your circumstances change, eg. You lose your job, the property is not a drag on your reduced income that potentially could force you to have to sell at a bad time.

The Cons / Disadvantages of positive gearing
•    Cash flow positive properties are sometimes associated with lower levels of capital growth over the longer term. This is not always the case but has been more often than not and will vary from property to property. See our example blow how this pans out over time
•    The positive income generated is taxable adding to your own income tax liability. Without growth it can be difficult to build real wealth off income alone especially if it’s being taxed.

Let’s take two examples

Property one: Cost = $400,000 located in a high growth, stable near capital city area. Gross rental return is 5.2%pa, viz: $400pw.

Property two: Cost = $400,000 located in a regional area where above average rents are being realised and availability of rental property is scarce. Gross rental return is $600pw, viz: 7.8%pa. So property 2 is bringing in $200 per week more cash flow than property 1. Let’s see how having this greater cash flow pans out over the period.

We have assumed 100% occupancy for the sake of this exercise, however in the longer term one could safely say that there was a greater chance of there being vacancies in the regional area, particularly if economic drivers in that area changed markedly, eg. A coal was closed or large numbers of new dwellings were built there.

Obviously property two has the stronger cash flow and is more likely to be cash flow positive.

Let’s look at the capital growth prospects for each

Property one is in a location where historically value’s have doubled every 7.2 years (not always easy to achieve in recent times), roughly equivalent to a 10% pa growth rate whereas property two is in an area where growth is a bit sketchy and untested but is predicted at 7%pa leading to a doubling every ten to 11 years.

Let’s see the situation after 8 years:

Property one: Value = $857,400 – an increase in value of $1,100 per week approximately for each week over those 8 years.

Property two: Value = $687,300 – an increase of $690 per week.

Difference: = $170,100 or $410 per week capital gain, only 50% of which is taxable if sold. That is, property one has increased $170,100 more than property two.

Difference in rent received over the period = $200pw = $72,800 in total in pre-tax dollars favouring property 2, 100% of which is taxable regardless of whether the property is sold or not. So you can immediately see that property 1 far outperforms property 2, even more so when you consider the income tax implications.

For the purposes of this exercise we have assumed no rental growth or expenses against either property which of course there would be, changing the result, but never the less it’s unlikely that the overall result will favour the higher cash flow ‘property two’. The after tax result will change further depending on the investor’s taxable position, but it’s likely that at the end of the day, property one is going to be the better bet as an investment for almost every investor, especially given the parameters that we have used.

And it is those parameters that really determine the result of an exercise like this, just as certain parameters are used when promoting a variety of investment offerings. Careful study of their veracity needs to be undertaken by the savvy investor.

I’m sure that many readers have heard the term "Lies, damned lies, and statistics" which is a phrase describing the persuasive power of numbers, particularly the use of statistics which are often used to bolster weak arguments. The term was popularised in the United States by Mark Twain. So as always one must consider their own particular circumstances when interpreting these ‘numbers’. If that’s too hard then get some help.

So, which is best? For my money, I’d prefer to take the near city certainty of property one any time as opposed to the far flung uncertainties of property two, given the choice. As I said earlier however, not everyone has an equal choice because of their own personal circumstances, sometimes leading them to make a poor choice.

An Alternative Solution

Given the opportunity to make a ‘simply smarter’ choice of locking in some capital gain ‘upfront’ is an even better bet than either of the two examples given above. Those two examples reflect  investing in property in the traditional way. Using the techniques offered by our property ladder shortcut when applied to either property one or two would certainly supercharge any investor’s portfolio.

Go back and run the figures on property one as if you only had to pay $340,000 instead of $400.000 for property one, yet still achieved the same rentals & gains as if you’d paid $400,000. This would allow you to have your cake & eat it too – so to speak; positive return, if that’s your desire, and higher capital growth from a good quality residential asset, or negatively gear, get your capital back in your pocket ready to go again straight away. Which will it be?

This time you have a choice.

About Adrian Stagg
Adrian Stagg is a director of Embark Intelligent Property Investment &  has been actively involved in the property industry since the 1970’s. His first foray at an unusually young age was as an investor.

Since then he has worn the hats of Real Estate Agent, Renovator, Builder, and Property Developer and of course, home owner. Through all these years, he has witnessed several cycles in property markets and now guides clients looking for ‘an edge’ in their journey through  property investment strategies and runs property investment seminars. Check out his blog where he shares his insights on smart property investment and how to get through the property maze.