Smart Banking Guide

Gearing – Speeding Up the Way to Wealth (Or Ruin!)

Written on May 1, 2009 – 8:09 PM | by dodolovesme

If you have ever used a tyre lever, or played on a seesaw, you will understand the principle of leverage. By the use of leverage the power of a small force can be greatly increased to have an almost unbelievable effect. In investing the correct use of leverage, or “gearing” as it is more often called, enables the rate of return to be increased substantially.

Think about two people with $50 000 each. The first buys a house for $50 000 that is returning $400 per month. The second is more adventurous and buys two houses for $50 000 each. Because he has only $50 000, he has to borrow another $50 000 to complete the purchase, using the rents to pay the loan repayments.

Let’s look at where they will be in five years’ time. If we assume that inflation is running at an average of 14% and that the house values keep up with that, we can calculate that their prices will have doubled. So the first person will have one house worth $100 000 and the second will have two houses worth a total of $200 000 less a bond of $50 000. The first person has doubled his money. By the use of gearingsecond person has done much better and in fact has trebled his original stake. the

The purpose of the above example is to show you the principle of “gearing“. At this stage I have not brought into account such other factors as rental income after tax, interest rates, or what the loan would be after five years. The point is, in inflationary times, borrowing money enables an investor to control more assets. These assets, if carefully chosen, should be growing with inflation.

Think of it as a game of Monopoly. The aim is to control as many properties as possible. Thus a person who is not afraid to borrow will have a larger portfolio of property than a less adventurous person who has not borrowed so much. When prices are rising strongly the heavy borrower will do extremely well.

Negative Gearing?

Negative gearing is a good strategy. (Borrowing for Investment) covers it in detail, but most people I encounter seem confused at the term so I’ll explain it now. “Gearing” is another name for borrowing. If your loan is large enough the repayments and the other outgoings such as rates and insurance will be more than the income from the particular asset. Thus your cash flow is negative (more going out than coming in) and the situation is said to be “negatively geared”.

How Much Gearing?

It is important to understand that, if prices fall, gearing will increase the amount of any loss. Buy a $70 000 house with a $7 000 deposit and you have doubled your money when the price reaches $77 000. If the price falls to $66 500 you have lost 50%. Almost everybody who started with nothing and achieved wealth has done it with gearing, but the art of maximising profits is to achieve the right amount of gearing. Let’s think about two silly examples to illustrate extreme cases. A person with $70 000 may put down a $69 000 deposit on a property and borrow $1 000 — another may buy 35 houses putting $2 000 deposit and borrowing $68 000 on each one. The first is “under geared” the second is “over geared” and almost certainly on the way to insolvency.

It has been said that the amount of gearing depends on three strengths.

• The strength of your income
• The strength of your total assets and
• The strength of your nerves.

As soon as you borrow, you incur obligations to repay money and the weaker your financial position the harder it will be if the economy turns against you. It is far safer to take a very conservative attitude from the start and stay well within your comfort level. Even if the gearing is fairly low so that the rents are greater than the loan repayments, large profits can still be made in carefully selected income-producing property.

My advice to potential investors who are inexperienced in negative gearing is to start with residential property by way of a house or a small block of flats or to acquire an interest in commercial property through top property trusts. Make a goal to pay off the loan as quickly as possible. This will do three things — provide experience, substantially increase the investor’s asset base and provide an extra rental income with which to finance additional investment.

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