Negative Gearing vs Positive Gearing in Property Investment

Is it better to have a positively geared property versus a negatively geared property when we're trying to retire with real estate?

‍

In this article, I'm going to talk to you about the strategy around:

‍

• When it's better to have a positive portfolio; and 
• When it's better to have a negative portfolio.

‍

With the rising interest rates, right now, it is almost impossible to get a positively geared property if you're financing at 90% LVR.

‍

If you go out there and say, you have a 30 or 40% deposit, then you might find yourself in a position where you might be positively geared.

‍

However, you might also be someone who's purchased a property 5 or 10 years ago and now your rents have continued to climb up, but your debt is not that large, and you may have even fixed it at rates that were really low before. So then you might be in a position where you're positively geared.

‍

Now let's figure out what the two are because you might get to this point of the article and be like: Okay, I don't think I really understand positive gearing, negative gearing, and then high rental yield.

‍

So let's just break it down in the simplest way possible.

‍

Positive and Negative Gearing Explained

‍

Positive gearing essentially means that when you've purchased a property, the cost of holding this property is taken care of by the property's rental income.

‍

So if your investment property is renting for $500 a week, but your costs work out to be $450 a week, then you're in a position where it's $50 positive.

‍

Now that you understand what positive is, negative is the opposite.

‍

When I was in Year 11 in Economics class, we spent 9 out of the 10 weeks in that term learning about demand. So economics is demand and supply.

‍

I was thinking: Well it would make sense to spend 5 weeks on demand, and then 5 weeks on supply, right?

‍

However, this economics teacher was like: No, just trust me, we're just going to learn demand.

‍

So we got to week 7, week 8, week 9, and I had to ask him. I was like: “Look, the exams are in 2 weeks. I have no idea what supply is and all you've been talking about for 9 weeks is demand. So when are we going to learn supply?”

‍

In response, he said: “Well, it's your lucky day because today is the actual day we're going to learn about supply.”

‍

I said: “Alright, cool.” 

‍

So I got out there and I was like: Okay, I expect this is going to be a complete cram session because we have to do 9 weeks' worth of work in like 5 days.

‍

Then, he turned around and he said: “Supply is simply the opposite of demand. Everything that you've learned about demand—just think the opposite.”

‍

After that, I realised this guy was actually a genius. While some in the class thought he was an idiot, I believed he was brilliant, and it worked out. Every time I thought it was one thing, it turned out to be the other. But I digress.

‍

Now in this case, what we have is negatively geared properties are the opposite. So if we have our property renting for $500 a week but our expenses to hold that property are $550 a week, then it would be negatively geared.

‍

Negative Gearing Vs. Positive Gearing

‍

Now when is one better than the other?

‍

Is one going to help us retire earlier?

‍

Well on the surface you might say: Well I just want to replace my income. In order for me to do that all I need to do is get $80,000 worth of income from my properties.

‍

This is 100% true.

‍

Why? Because if you said: I have one property that generates 20K a year after all my expenses, I just need four of those, and I retired.

‍

However, it goes deeper than that. When you're starting to build out a portfolio, people often chase yield and they say: Okay, well as long as the yield is high, I can go and retire as quickly as possible.

‍

I know some people have been following me for 4 years on my YouTube channel and have said: “Well you only focus on cash flow. You don't focus on capital growth.”

‍

Then I said in response: “No I don't. The yield or the cash flow is actually just a bonus. What you really want is capital growth and then the yield or the cash flow allows you to stay in the game.”

‍

I often say that the cash flow keeps you in the game, and capital growth gets you out of the game…what game I'm talking about is the game of life. (It's getting real philosophical here today. Haha!)

‍

However, what I'm actually referring to is being able to retire and what you need is a combination of both. It doesn't matter who you talk to. It really comes down to:

‍

• What your goals are; and
• How you're going to execute them.

‍

You might go: “Well look, I don't care about capital growth all I want is the rental income, so I can retire.” So if we use the example of replacing an $80,000 income, we need four properties, giving us $20,000 each—okay seems fair.

‍

However, when you go to buy these four properties, you're going to need:

‍

• A deposit; and
• Borrowing capacity.

‍

This is where cash flow and capital growth play a part.

‍

Why? Let's say for instance: You need a deposit for your second, third, and fourth properties. You might have enough for the first property. But where are you going to get the second one?

‍

If you have to save another $60,000 to $80,000, it might take you a couple of years to get there and that means this idea of getting to the $80,000 number is actually moving further, and further away because we all know that if property prices continue to rise, you might not be able to retire when you want to.

‍

In this case, you're out of the market for 3 years because you're trying to save your money, and you bought in say a rural town or mining town in the hope that the yield is going to allow you to retire early.

‍

Now let's just flip this conversation around.

‍

If you happen to go for a property that was neutral or slightly negative, yet had capital growth of 5%, 6%, or 7%, then you'd be in a position where you could get your next deposit for your second property a lot sooner. Because the property is growing in wealth, you've got the equity there and that equity then acts as a deposit for your second property.

‍

This is where capital growth really plays a part because if I can buy one property and that one property keeps going higher, I can use the equity on that one to purchase the second property, third property, and fourth property.

‍

‍

Now if I've taken a balanced approach, I might find that I've purchased all four properties a lot sooner than if I simply focused on the yield.

‍

Now, you might be at this point thinking: Well it sounds like capital growth is the way to go, so why don't I just focus completely on that?

‍

This is where the borrowing capacity argument comes in because if you're in a position where you can actually borrow for one property, that's fantastic.

‍

However, if that one property is negatively geared by a lot, it reduces your borrowing capacity significantly. So what happens is the bank will say: Yeah, you have the deposit, you have the equity, but you just can't access that and you cannot purchase another property because we're not ready to give you out the debt because based on our calculators, you can't afford it.

‍

So, if you had strong cash flow, it may not increase your borrowing capacity, but it doesn't negatively impact it as much if your property is in a position of neutral or slightly negative versus being super negative by $20,000 or $30,000, which is most likely the case for most people who've bought in Sydney with a yield of maybe 2% or 3%.

Recap

‍

To recap, we know that we need both cash flow and capital growth to be able to grow a portfolio.

‍

Some may argue and say: Well you can't get cash flow and you can't get capital growth on the same property.

‍

Although this is an age-old argument because of the information that we got taught back over the last 15 years. If you look at a data-driven approach, that's where the numbers don't lie.

‍

As I've said before, men and women lie, but data does not lie and that is why it's your friend and that's why you need to trust the data that you see and match that up with what's happening on the ground floor.

‍

Now ultimately if you're positively geared, it's important to know that you're generating an income after those expenses. This means you're going to get taxed and this is something that some people don't realise until after the fact and to me, it seems like it's pretty logical.

‍

Let's say you go to your job and you earn a salary.

‍

Well on that salary, you get taxed because it's income.

‍

Now if I go and do that with a property, and I treat property like a business, I go out and say: Okay, I'm going to accumulate more assets, and now I'm making more income.

‍

This income is going to be taxed. We need to all be aware of that.

‍

On the flip side, the accountants are going to love this. They will often say: Just go for a property that is negatively geared. You’re getting your taxes too high. We need to reduce those taxes.

‍

If you're an accountant reading this or you're someone who's had this advice come from their accountant, it is the dumbest advice ever and I'll tell you why.

‍

You don't simply go and acquire property to reduce taxes.

‍

You go to acquire property to increase wealth, and if that means that it's going to help reduce taxes or it's going to increase my taxes afterwards, that's a byproduct of what you're trying to do.

‍

Now, capital growth? You're not going to pay tax on it. If you go out there and make some equity, and it comes out to purchase another property, you're not getting taxed on that.

‍

However, if you are negatively geared, you'll be able to reduce your taxable income for that year, which means effectively you could get some money back in taxes.

‍

To illustrate this point and why I think it is the dumbest advice you're going to get, consider this: You're effectively saying, "I'm going to buy a property. I don't really care if it goes up. Ideally, I would like it to because we all live in a perfect world, but the real reason I bought this is so I can reduce my taxes."

‍

In order to reduce your taxes, you've effectively got to say: "I'm willing to spend a dollar so that I can save 55 cents or 45 cents or 37 cents," depending on what you're actually getting taxed.

‍

Just think about that.

‍

On the flip side, it also makes a lot of sense. You're saying: "I don't want to make an extra dollar. I don't want to be positively geared. I don't want to make that extra dollar because I'm going to have to pay taxes, and that might be 30%, it might be 45%, but I don't want to make that dollar."

‍

Guess what? You still get to keep at least 55 cents on that dollar, and that is how the rich are getting richer because they understand that at some point, if I buy a property today and the rents continue going higher, and my debt pretty much stays the same, it's going to eventually turn positive anyway.

‍

So if you want to go down the path of reducing your taxes, good luck to you as you're probably not going to make it.

‍

However, if you're going out there and picking:

‍

• The right areas;
• The right location; and
• One goal in mind, which is: How do I increase my wealth and increase the value of my assets?

‍

You are going to do really, really well financially over the next 20 years.

‍

If you need any help at all, definitely do reach out to my Search Property team and book a free discovery call.

‍

I'll catch you guys in the next one. Thanks, guys!

‍