“Gearing” is a widely used term in the investment property industry. It only applies when money is borrowed to purchase the property. (A property paid for in full in cash, could not be said to be “geared”.) An investment property where the income earned by the property is higher than the costs incurred by the property is said to be “positively geared”. But a “negatively geared” property is where the costs incurred by the property are greater than the income earned by the property.
Think of a “positively geared” property as a business that makes a profit and “negatively geared” property as a business that makes a loss. The value of a negatively geared property to some investors is that they can claim the “loss” as a tax deduction.
The reason for “gearing” a property is using debt to purchase an investment. This allows an investor to get into the property market earlier than they would have been able to if they had to save up the entire capital to buy the property. This enables them to capture the future growth in the value of the property, while paying the minimum interest only repayments to service the debt.
If the property growth rate is higher than the interest rate, increasing your gearing can be efficient because the value of the property is growing faster than the cost of servicing the debt. If however the property growth rate is below the interest rate, reducing the gearing on the property is more efficient.
Gearing can be a double-edged sword in that you can make a lot of money if the market is on your side, but you can also lose a lot of money if the market goes against you.
For beginning investors who do not have a lot of equity, you usually have no option but to start quite highly geared just to get into the game. So borrowing 95% of the value of your first property is not uncommon, as is borrowing 100% plus costs for subsequent investment properties using the equity from earlier purchased properties is also quite common.
But your debt level increases, it becomes important to try and keep your cash flow neutral or positive, which usually requires you to start reducing your gearing to achieve that. As a general rule I always say the more debt you have, the more you need to “gear down” as interest rate movements can have a much bigger impact on you.
This is where Loan to Value Ratios become important. An LVR is simply the ratio of how much you’ve borrowed versus the value of the property. So a 90% LVR on a million dollar property means you borrowed $900,000 against the $1 million the property is worth or 90% of its value.
On a portfolio worth $1 million a conservative LVR might be 90%. On a $5 million portfolio you might want to gear down to 50% LVR.
If you want to achieve optimum growth and cash flow combination, you can aim at reducing your investment property gearing towards 25% if your investment properties have the profile of 7-9% growth and 4-5% rent, assuming you have no other personal tax benefit to contribute.
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