Negative Gearing has been touted around for many years to entice property investors to buy. Often every day investors are enticed by property spruikers, the general media, or through the vast noise, both online and offline. Yet do you really understand deeply the concept of Negative Gearing and how it fits with sound property investing? In this article we will dispel some myths and give you a deeper understanding of Total Return and classic investing principles.
What is Negative Gearing (NG)?
Stated simply, Negative Gearing (NG) is the ability to use certain expenses associated with your property investment, such as loan interest costs and depreciation, against asset income and other assessable income. It is usually used by a salary or high income earner so they can better manage their tax and the cash flows associated with their investment. The ‘negative’ bit simply refers to the investment making a tax loss for the relevant financial year. And the ‘gearing’ bit simply refers to using loans and loan costs to lever or gear into the investment.
NG therefore is a tax and a cash flow strategy. It is not a concept to be used solely when selecting a property or any investment vehicle. Asset selection will depend on your particular chosen strategy, objectives, risk management and other factors.
In Australia, the concept of NG has been over-sold. It has been used to entice everyday investors to buy property, so they can ‘afford’ to do so, and at the same time manage their tax better. Recently, I attended a meeting with a ‘property expert’ who still tried to sell me the same idea. I immediately stopped him and asked, ‘what is the quality of the asset and what are the relevant factors to growth rates?’ He did not address these at all.
Cash flow and tax considerations come after, not before your due diligence and assessment of the quality of the property. They should not be the main, or only criteria when looking for investment properties.
How Does NG Fit?
How does NG fit? Astute investors will undertake significant due diligence on a property before they consider tax and cash flow issues. It is never the other way around.
For example, if someone is trying to sell you an investment unit close the CBD, and they say, something like ‘you can easily negatively gear it, so it is a good investment for you’, alarm bells should ring. Seasoned investors will pay little attention to such things. Instead they have a written plan or set of criteria, and they will assess the property accordingly. In this example, looking at the intrinsic value of the unit, assessing past and potential capital gains, and determining gross and net yields, are all things you should before considering tax and cash flow issues.
Only when your investment criteria have been met, can you then address tax and cash flow issues. At this time, it is always good to consult your Property Team, such as your financial or legal advisors.
When you understand NG in this way, you will see it is quite a secondary thing to the due diligence and criteria an experienced investor will use when assessing real estate. Experienced investors want to have an idea of the Total Return of their investment. This will include understanding and assessing in detail (and in writing) the key criteria of: Growth or capital gain (G), and Yield or Income (Y).
A Total Return Formula
A simple formula, you might like to consider for investing in property, stocks or any asset class is a Total Return (TR) formula-
Total Return (TR) = Growth (G) + Yield (Y), ie. TR = G + Y.
To take an example, if we are looking at residential property and if you are using a simple long term buy and hold strategy, then you will be most interested in maximising G or capital gain. Factors such as infrastructure, population growth, long term demand in a region or suburb, and macroeconomic issues will all be relevant to you. Such an investor will be less interested in maximising Y or yield. So, if someone tries to sell you a property and they just talk cash flow and negative gearing, and they say little or nothing about past and future capital gain, then you need either to walk away or undertake strenuous due diligence yourself. Fortunately a lot of this can now be done through online information, but you will need to do this work.
Professional or Amateur?
As you embark on your investing journey, you will need to decide if you want to do things like a professional or like an amateur. In property the entry cost is high and mistakes can cost you dearly, so education and having a professional or business-like approach are imperative. There are no short-cuts. You should work towards having a detailed written checklist of items and accompanying spreadsheet, so you can make sound decisions based on reason and evidence. When you do this, you can then determine the potential Total Return of an investment, and then consider cash flow and tax issues. Remember, we want quality assets bought at the right price, so they can grow, yield and return to us for many years in the future. These are the classic principles of sound investing.