Which side of zero to gear?

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A couple of weeks ago I wrote a pair of articles about real-estate: the ‘$7million Real Estate’ Question and Rule.

The first part of the shared title was an obvious reference to how I made my first $7 mill. of which the majority was made in real-estate … not directly in business, as many assume – but, certainly ‘fueled’ by an income generated by two (then mediocre) small businesses diverted towards RE purchases and mortgage payments rather than to my spending ‘wants’.

These articles seemed to ‘flush out’ of hiding the RE enthusiasts from the 7m7y Community!

One of those was Luis who is a 7 Millionaires … In Training! Final 15 applicant and he asked (as a comment to the first of the two articles):

How close to positive is close enough? How do you calculate against vacancies?

Should we expect 2 months out of the year which we would have to pay the entire mortgage?

Lastly, would you stay away from areas that are under rent control laws?

I should warn you in advance: I don’t always answer questions left by readers left as comments or sent in as e-mails; sometimes I let them know that I feel the question deserves a follow-up post, as I told Luis in this case, and sometimes I am simply not expert enough to proffer specific advice.

If so, simply diarize for 45 to 60 days (as I told Luis) and contact me if you don’t see a response within that period …

… I NEVER use “I’ll get back to you” as a tactic to get out of answering … if I don’t have direct experience in the specific area of a question, I will say so.

Back to Luis

The first part of his question relates to the whole concept of positive gearing and negative gearing … in my opinion, one of the worst-handled subjects in real-estate …

… in fact, I have never seen as much rubbish written about any investing subject (except maybe diversification and 401k’s) as I have about negative gearing!

Generally, the RE [Real-Estate] Guru’s fall into two camps:

The Argument For Negative Gearing

Those promoting negative gearing say this allows you to buy more real-estate for greater capital appreciation. The more property appreciates and the less that you put in, the greater your cash-on-cash return.

Here’s why:

Negative gearing implies that your expenses on the real-estate (your mortgage payments; repairs and maintenance; insurance payments; and the like) are greater than your income (rent received).

To a great extent, you can ‘control’ the amount of the ‘negatively geared’ short-fall simply by ‘dialling’ up/down the amount of capital that you put into the property (usually more quickly by way of a deposit, or more slowly through making larger Principle & Interest payments)

Lower deposits generally mean higher mortgage payments, therefore you are ‘controlling’ more real-estate with less of your own money.

This may mean that your cash-on-cash returns get higher and higher as property appreciates with less of your own cash (and, more of the bank’s committed). You can use that cash to buy more and more of these appreciating properties.

But, there’s a downside: as you borrow more and more from the bank against any specific property (by putting in a lower deposit yourself) your interest bill goes up … your rent stays the same (your tenants won’t pay higher than market rates just because you get a big interest bill from the bank!) … you may make a loss on the property.

But, you get it all back – and more – on the capital appreciation on the property. Don’t you?

Amazing how the proponents of negative gearing are suddenly quiet when the ‘RE bubble pops’ … not, to mention your ability to grow your portfolio will depend upon how much monthly loss you can fund.

The Argument For Positive Gearing

Those promoting positive gearing say “buying a property is an investment … investments should make you money, not lose you money”.

So they suggest looking in areas where rents are relatively high, stable and growing.

They recommend buying fewer properties, putting in a bigger deposit, and letting your rents cover the costs and pay down the property.

Not only do you have a buffer (and build an even bigger one over time) against market crashes, vacancies, interest rate hikes, and unexpected repair bills, but you build up a nice little pot of equity if these properties also rise in value (as they surely will, given a long enough holding period?).

The problem is that these types of properties (i.e. the ones that generate a decent rental return) don’t tend to be in high appreciation areas, whereas properties that appreciate nicely tend not to produce a great rental return.

So, it seems that real-estate investing is a trade-off: do you want faster appreciation or do you want a greater income?

If you are young and are investing to build great wealth – and, are prepared to take greater risk – then you may be chasing higher appreciation and may have the income to carry some short-term (you hope!) losses.

On the other hand, if you are approaching retirement, you may want to be selling some of your portfolio, using the proceeds to jack up the equity (by paying off some of the mortgage, hence lowering your largest monthly expense) – keeping some as a cash reserve against vacancies and expenses – of each remaining property so that you can live off the proceeds. An income that should rise roughly in accordance with inflation … nice.

Here’s how I look at it:

I am neither for nor against negative gearing … ideally, I see absolutely no reason to take a loss. But, this can come in two ways:

1. By buying a property that doesn’t produce enough income, when (if I just looked a little harder, negotiated a little better, added a little more post-purchase value, chose a different class of RE or a different location) I could have bought something with similar appreciation that didn’t produce a monthly loss, or

2. By passing on a property that had great potential because I didn’t want to suffer a little short-term loss.

Both are dumb reasons to buy (or pass) on an opportunity …

… to me, the monthly short-fall or excess (if i don’t actually need the money to live off NOW) is just a part of the investment in my future.

If negative, then I am just increasing the capital that I am allocating to that property … if positive, then I am calculating whether that return could be used better elsewhere by pulling some capital (by refinancing) out of the property.

In other words, to me, a monthly excess/shortfall is just ONE part of the overall investment equation and there’s absolutely no reason to be bloody-minded one way or the other.

Let me leave you with a couple of final thoughts:

i) For those proponents of negative gearing who justify their methods on the basis that “you get a tax deduction on the loss, so Uncle Sam is helping to pay for your future” … get a life. Let the tax deduction be an effect of a business decision taken for other reasons, not the cause! Why lose 70% just so that Uncle Same can ‘donate’ 30%?

ii) Sometimes a negatively geared property can become positively geared just through tax benefits: depreciation is a great one to have available as it is tied to this property (so, if one works; maybe 100 will work for you just as well?) whereas the deduction on negative gearing only works when you have enough outside income to make use of it, so it may only work on one or two properties at a time.

So, in which camp do you sit, and why?

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4 thoughts on “Which side of zero to gear?

  1. Sorry to say that I don’t quite understand what you’re talking about yet, AJ, but do agree about the cost of 70% just so US can pay 30% is not a good reason to go for something. Only if you were paying 100% anyway would that make sense (e.g., turning driving costs into a tax-deductible expense if you’re already doing the driving and can work it into a different scenario like sales, speeches, etc.). I’ll re-read. I’ve not heard the terms negative gearing and positive gearing and that don’t appear to be intuitive terms to me (where does “gear” come in?) Thanks for posting about this.
    @Luis – thanks for asking about it, too!

  2. @ Diane – Here’s the definition of ‘negatively gearing’ (which, just means that you lose each month on the investment because you borrowed too much): http://en.wikipedia.org/wiki/Negative_gearing

    Positive gearing (a.k.a. just plain ol’ ‘gearing’) means the opposite: you have borrowed money to help purchase the investment (be it real-estate, stocks, of whatever) but you are making a monthly (or yearly) profit from rents/dividends.

    This article merely states that neither is intrinsically ‘good’ or ‘bad’ as their proponents or detractors, respectively, would like to have you believe.

  3. AJC,
    Has it been 45 days? How time flies…I guess I’m hovering right around both IF the negative amount is small and I can rent/lease it continously then I would carry it. On the other hand, I want positive money streams from the beginning…

    My max negative would be about 1/5 of total incoming income…(Not sure if this is a sound number)

    One Ideal scenario would be, if I can p/u something with multiple units, say 3 on a lot, and I can live in one and rent out the other two units and have the rentals pay for the total PITI or have a low negative to cover. Thus freeing up my money for more investing.

    Your statement: “2. By passing on a property that had great potential because I didn’t want to suffer a little short-term loss.” Just keeps nagging me all day…

    Here’s why: I am looking at several SF units in El Paso, TX that are about 100 bucks positive each (200 total), though not great at least nothing out of my pocket. One thing keeping me from pulling the trigger is the fact that TX RE does not appreciate much. SO I’m holding on to my downpayment money and looking for deals around San Diego which was hit hard during this RE bubble. I’m hesitate because the short-term loss of my down payment might cause me to lose out on something better…

    @ Diane – you might want to substitute “gearing” with “cashflow”
    e.g. negative gearing = negative cashflow and positive gearing = positive cash flow. Not an exact substitute, you might be able to find ways to apply it to your situation. Hope this helps.

    thanks AJC!


  4. @ Luis – In the current market it is hard to expect/anticipate capital growth (a.k.a. appreciation) so positive gearing/cashflow is something to look for. Of course, if both cashflow AND appreciation look weak, you need to question if the investment ‘stacks up’ and perhaps, as you suggest, reserve your capital (‘deposit’) for something else.

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