February 03, 2014
By Alan Heath Mortgage Choice, Mortgage Broker in Brisbane CBD
What is an Asset? There are differing definitions of what makes something an investment but they all focus on two main points
- The ability to generate income
- The ability to increase in value
In my opinion, the one to which the MOST attention should be paid is the ability to generate income because that is the most reliable indicator of something’s inherent financial value. From this perspective something that generates no income is NOT an asset. This rules out many things often “said” to be assets.
The most obvious here is a car. Let’s say the car is purchased with a loan. This car generates only expense for you, its value decreases year by year and the only income it produces is for the lender. The car is a liability to you. The car is an asset to the lender.
Let’s revisit purchasing an “investment” property.
Let’s say this property costs $100,000 and we borrow it all.
Let’s say it rents for $100pw so a 5.2%pa return
(if the property costs $200,000 and rents for $200pw, or costs $500,000 and rents for $500pw then the percentages are the same. Choose a value appropriate to your area – or just ignore the value and use my example)
Let’s say the interest rate is 5.2%pa This would be a neutral return (ignoring inflation)
Let’s say the interest rate is 6.2%pa. This would generate a negative return of 1%pa - this is what people call “negatively geared” – in this example that loss would be $1000
Let’s say the interest rate is 4.8%pa. This would generate a positive return of 0.4%pa – this is what people call “positively geared”
Negative gearing : How many times have you heard someone say that negative gearing is a good thing? Is it? What does it mean? Let’s put one thing to rest absolutely – losing money is a bad thing! Why would you invest to lose money.
There are two important points to understand Any real loss can be deducted from your taxable income reducing the tax you pay. In the example above let’s say you income is $15,000 – your income would reduce to $14,000. You didn’t pay tax before and you don’t pay tax now. The whole $1,000 loss is yours.
Let’s say your income is $60,000 – your income would reduce to $59,000 and given that your tax rate is 30c you get a tax refund of $300 so $700 of the loss is yours.
Let’s say your taxable income is $150,000 – your income would reduce to $149,000 and given your tax rate is 47c you get a tax refund of $470 so $530 of the loss is yours.
What is the financial “lesson”? All negative gearing generates a loss.Don’t take any notice of the refund – a loss is a loss. NO investor tries to LOSE money. A sub lesson is that using negative gearing as a strategy on a low income makes no sense.
So if ALL negative gearing means you have lost money – why do it? An investor is hoping that the other reason for investing – capital growth – outweighs the loss.
Let’s say that property rises by 8% in value this year. Your property is now worth $108,000. The loss can be justified with a very big BUT. The capital growth is a “paper gain”, the negative gearing loss comes out of your wallet each month – it’s real “in the moment”. One thing is clear – a negatively geared property that has no capital growth prospects is not a good investment
Positive gearing : A positively geared property is what all investors should aim for. It generates income in the short term and capital growth in the long term. Sure the profit is added to your income and you pay tax on that profit. Making a profit and having to pay tax is a wonderful “problem” to have.
Now let’s go back to our examples
Let’s say our property that cost $100,000 (and we borrow it all) rents for $300pw which is a 15.6%pa return.
Let’s have an interest rate of 5.2%pa which gives us a profit of 10.4%pa or $10,400. Sure we have to pay tax BUT what a great problem. If you could find a property like that you’d want it!!
How do you find positively geared property – I sometimes have new investors come to me and say they only want to buy positively geared property.
There are two common sources but investors should tread very carefully. Often investment property in regional mining towns can be bought quite cheaply and rented out for very high rent. That would be a good thing, right? Not necessarily. Mining towns are often very narrow in employment scope and hence population. When mining is on the upswing, population swells, capital growth and rents escalate. As they say, all that glitters is not gold. If that mining town loses the mine then population leaves just as quickly and you investment property will drop in rent and have very little prospect of capital growth again. Investing in mining or other single industry towns is a high risk strategy. When a large company is considering closing that mine or industry down the average investor is rarely if ever given warning. The investor is left high and dry. You are probably gaining the impression that I would call investing in single industry towns “speculation” rather than “investment”
There is another way to find a positively geared property. EVERY property is positively geared if it is held for long enough. How? I have clients who purchased property for $100,000 and the loan was $100,000. It initially rented for $100pw but over time the capital value of the property rose – and is now $300,000 and the rent has risen with time too to $300pw. The key point is that the loan is still $100,000. There you have it! A $100,000 loan and $300pw in rent. What is the smartest way to get positively geared property. Buy almost any property and hold it for a considerable time. The key now is simply to seek out a sound property that will be easily maintained over time.
There are other types of “specialty property” that can appear to have good rental returns. Let me give one example – Defence Housing. This is a property where you purchase a property and the Defence Force becomes your tenant. The tenancy period is usually quite long – say 10 years and the rent is often quite attractive. Let’s look at an important part of any investment – the exit strategy. This would commonly involve selling the property. You might need to sell the property because a particular situation has arisen. If you need to sell your property it is wise to be able to sell to the “whole” market, owner occupiers (including First Home Buyers) and investors. If you have chosen a property that can ONLY be sold to investors then you have eliminated the largest part of the buying market. It is wise to consider holding property that can eventually be sold without restriction to all segments of the market. (other types of property in this category – where you should look before you leap into buying – would be retirement style housing, and the govt sponsored NRAS (National Rental Affordability Scheme)
Although there is no right and wrong in this area, this factor in selling a home is often completely overlooked.
Want More? Download my app - Ask Alan - from the App Store and Google Play (click below) Talk to me, ask questions, read up to date information, watch video on topics of interest...
App Store: http://apple.co/1ObU9AI
Google Play: http://bit.ly/1MP04tP
Disclaimer : This email provides basic and generalised information only. It has no regard to a particular person's financial goals and objectives or particular personal situation. The reader should seek advice specific to their situation before making any decision and acting on anything contained within.