Owning property is the investment choice of many Australians. You may have heard of negative gearing - when the income generated from your property is less than its expenses - but this isn’t the only outcome you could have when investing in property.
According to the Australian Taxation Office (ATO), around 30% of Australians own an investment property with 40% of those either neutrally or positively geared. So, what exactly is positive gearing and what are its benefits?
What is positive gearing?
Positive gearing occurs when the rental income you generate from an investment property is greater than its expenses.
Property expenses can include any of the following:
- Interest repayments
- Maintenance costs
- Property management fees
- Body corporate fees
- Council rates
- Insurance premiums
- Gas and electricity
- Legal expenses
Put simply, it's the traditional way of making money from an investment property.
How does positive gearing work?
You may find that your investment property is positively geared if you purchased a home with a large deposit - leaving less of the purchase price to be taken out via your mortgage. Or, it can also occur when rents are high due to strong demand in the rental market.
If the rent you’re receiving for the property is more than you’re spending on it after adding up all your expenses, you’re generating positive cash flow. Here is a simple example of how positive gearing works:
John earns $30,000 a year from rent on his investment property. To work out whether his investment was positively geared, he sat down and worked out all his expenses (listed above) and the associated yearly costs. After adding them together, John’s expenses cost $20,000. Therefore, he has a positive annual cashflow of $10,000 which goes straight into his pockets.
Depending on how much rental income you receive, you may not have a positively geared property straight away. It may take time for your property to generate positive cash flow - like when you’ve paid down more of your mortgage or raised your weekly rental amount - but the alternative is neutrally or negatively gearing the property.
The advantages and disadvantages of positive gearing
Here are the advantages and disadvantages you should be aware of:
Advantages
- Increased income: you’re likely to be making a profit which means you can save money towards another house deposit or pay off existing debt.
- The investment property is paying for itself: the impact of the mortgage on your debt obligations is reduced.
- Less of a risk to cash flow: the property is self-sustainable as the rental income pays for itself. If you were to lose your job, your investment is safe.
- Grow your wealth: a positive cash flow investment provides passive income.
- Portfolio balance: positive cash flow properties can balance a property portfolio for investors who also have negatively geared properties.
Disadvantages
- Tax: as you’re receiving extra taxable income, you will likely need to pay more each year.
- Less potential for capital growth: positively geared properties tend to be located in regional areas so it could experience slower capital growth.
- Rental rates: if rental prices decline, you could end up having your rental income slip below your expenses.
How is positive gearing calculated?
Calculating positive gearing is quite simple: if the income is more than the expenses - the property is positively geared. This can be illustrated with an example.
Let’s say you purchased an investment property worth $400,000 with a 30% deposit ($120,000), leaving you with a $280,000 mortgage. Assuming you take out a 30 year loan term at a 6.24% interest rate, you can expect to pay a monthly principal and interest mortgage repayment of $1,722.19. This would equate to a weekly mortgage repayment of $430.55. But you charge $600 per week to rent out the property.
Additional expenses may include property management fees ($20 per week); council rates ($1,000 per year); and strata fees ($50 per week). Given this example, over one year your rental income is $31,200 and your expenses equal $27,028 ($22,388 mortgage + $1000 rates + $2,600 strata + $1040 property management ). So, your property is positively geared by $4,172 (before tax).
What factors should you consider before investing in a positively geared property?
While it might all sound too good to be true, there are still things that should be considered before investing in a positive cash flow property.
Tax Implications
Firstly, the income generated from the property is taxable. This will raise your taxable income from just your salary/wage to your salary/wage plus rental income. You could find this pushes you into another tax bracket, which could mean you’re getting taxed at a higher rate.
Deposit size
Investing in positive cash flow property likely means you’ve put down a hefty deposit. You should consider whether this is the right investment move for you, or whether you’d rather take on a bigger mortgage and neutrally/negatively gear the property. This decision will be completely up to you.
Purchase price
Another thing to consider is that investing in a positively geared property might mean it’s cheaper to purchase - which is often the case with properties located in areas where the rate of growth is inconsistent. This means that the future value of your investment can be hard to determine.
Location of your rental property
A sound positively geared investment property can be hard to come by in some areas. With the inflated prices of property in city centres in particular, it may not be possible to make a positive return even when any incoming rent is considered. Simply, location plays a big part in the success of a positively geared investment property.
At the end of the day, positive gearing may sound like the go as it makes the property seem profitable straight away. However, many experts argue that the real value of an investment property lies in its capital gains - which both types of property investment are likely to generate.
If you’re looking at purchasing an investment property, talk to one our friendly lending specialists to help you get started.
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