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When interest rates are low and rental yields are high, some property owners can set up a structure where the rent from the investment property completely covers the interest payments on the loan – commonly known as positive gearing.

Indeed, some say that in this environment, investors are better off being positively geared than the usual scenario of negative gearing.

According to Leanne Wilson wealth education consultant with Suncorp, investors are currently better off buying residential property offering positive cash-flow returns, (and capital gains upside), over negatively geared property purposefully designed to lose money.

Although the strategy behind negative gearing – such as immediate tax benefits and longer-term gains via capital appreciation – can look compelling, Wilson says now isn’t the time for it. That’s because house prices are expected to tread water for some time to come.

So assuming investors can get a discount variable rate under 6 percent, it’s possible that rent can cover the interest payments on the mortgage, and possibly even principle. 

BRW recently named WA’s South Headland – where rental yields go for as much as 12 per cent – as the best place in Australia for positive gearing. However, there are many other markets in Australia where ongoing rental demand is expected to nudge rental yields higher over the long-haul.

Brisbane tenants experienced Australia’s highest house rent rise during the first three months of 2009 at 2.9 per cent; Perth was a close second at 2.8 per cent. According to property research firm RP Data, suburbs likely to have positive gearing opportunities include: Highland Park and Molendinar of the Gold and Sunshine Coasts, Broken Hill and Werris Creek in regional NSW, the Sydney areas of Lakemba, Punchbowl, Chipping Norton and Warwick Farm, and Bowen Basin in Queensland.

Here’s an actual comparison between properties for sale in Brisbane (in March 2009) under $450,000 and those being rented.

  Asking Rent P&I repayments* Int Only Repayments*
 1      $21,840pa $25,968pa $20,160pa
 2 $20,280pa $27,528pa $21,360pa
 3 $17,160pa $22,200pa  $16,080pa

*Source: Suncorp, based on 20 percent deposit, 6 percent interest and 25 year loan.

 

But while positive gearing can be an effective way to fund an investment, Collin Lewis of IPAC Securities reminds investors it typically complements higher income earners with long-term investment horizons who can ride out the ups and downs in market cycles.

Futhermore, with a bigger deposit, these investors can avoid buying investment properties in the less affluent suburbs where there are fewer opportunities for making a decent capital gain.

Lewis notes that investors could think about splitting between fixed and floating mortgage rates so they can also repay principle along the way – thereby enhancing their positive cash-flow position.

So how should investors formulate a positive gearing strategy? Firstly, Lewis recommends working out whether the rental yield will cover both principal and interest.

As the following example illustrates, working out whether investors can positively gear both principle and interest loan depends on the size of the deposit (relative to borrowings), and the annual rent. 

Purchase price: $360,000

Annual rent: $17,000pa ($327/week or yield of 4.72 percent)

Repayments: Working backwards, an investor’s borrowing would be $236,000 at 6 per cent interest for 30 years = monthly repayments of $1415 or $16,980 annually.
 
Deposit: Based on this scenario, an investor would need a deposit of $124,000, plus additional funds for stamp duty, legal fees and other costs.

If the numbers don’t deliver a cash flow-positive outcome, Lewis says investors must be able to readily access cash from other sources such as a salary or super to cover unexpected vacancies, non-paying tenants, unemployment or times when this investment drifts into negative gearing territory.

Ideally, he says the less wealthy should try and stay as close to neutrally geared as possible. This means they’ll neither have to put their hand in their pocket to maintain the property nor worry about off-setting gains against income on assets (they’re less likely to have). “But investors can offset the tax considerations on any gains through either legitimate running repairs or by putting money into super (pre-60).”

While the current environment may better complement positive gearing, Bill Bovingdon CEO and Head of Australian Fixed Income with Aberdeen Asset Management warns that this strategy may be decidedly short-term once interest rates rise. As the RBA edges closer to the bottom of its cash rate range (at 2.5 per cent), Bovingdon expects the low interest rate environment to start disappearing beyond the next 12 months.

And while demographics suggest the shortage of properties will continue, he says investors need the market to be well clear of the ‘distortion bubble’ created by the First Home Buyers grant (FHB) before diving into property. Bovingdon says the significance of an early lift in rates by some banks shouldn’t be lost on those contemplating a long-term positive gearing strategy. “Investors need to be wary of treacherous currents around residential property markets,” he says.

Far from existing in a vacuum, Wilson says investors need to remember that due to changing interest rates, and property valuations – plus the constantly evolving personal circumstance of investors, (notably around cash flow, and tax liabilities) – any gearing strategy on residential property will always be a moving beast.

She says recent history shows what happens when investors don’t allow for interest rate rises. As a case in point, having peaked at 7.25 per cent in 2008, the RBA cash rate in April 2009 was 3.00 per cent. And considering investors could potentially have a debt for 25-30 years, she says they need to remember that interest rates will change greatly over this time. “Looking at the past 30 years, the 90-day bank bill interest rate has ranged from a high of 21.39 per cent in April 1982 to 3.16 percent in March 2009,” advises Wilson.  

Cameron Paul director of Momentum Planning says investors also need to look beyond headline returns (gross yield) and identify the net yield by factoring-in entry and property maintenance costs. Based on his estimates, the cost of managing and maintaining a property equates to between 0.5-1.0 per cent of property value (which on a $500,000 property could be round $5,000 annually).

And while income yield (on residential property) has improved, Cameron says over-valuation across the Australian property market means opportunity for capital growth is limited, especially in the sub-$500,000 bracket. “So if you’re planning to positively gear, choose your residential property/suburb carefully and try to lock-in the lowest rates over three to five years.”

Negative versus Positive Gearing

Lewis reminds investors that the higher their level of gearing, the more likely they are to experience a negative net cash flow and higher investment risk. The following table illustrates how a 40 percent gearing level into a $400,000 property would be positively geared from year one, hence netting $323,713 upon disposal of the property after five years.

Negative Versus Positive Gearing – $400,000 residential property

Source: IPAC Securities. Assumption: Net rental income 3%, growth 5%, interest rate 6.5%, marginal tax rate 45%

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