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Way back in 1996 I bought my first home. It was a two bedroom flat in a very ugly brown brick building, probably built in the 70’s with nothing done since. It wasn’t flash but it was within my budget and in a good location close to town – Kew for the Melbournites. I paid $107,000.
Now I know that for those looking to buy their first home, $107,000 is probably pretty sickening right now, but 20 odd years ago that was the going rate.
4 years later and I’d meet my now wife, and it was time to move from a flat to a house. We were starting to think about having a family. So I sold the flat for $189,000.
Now those straight numbers – $107,000 purchase price, $189,000 sale price, look pretty good right? And they were. It equates to 15% per year growth. I wish I could say that I got that return due to a whole lot of research and planning, but the truth is it was pure luck. I bought when I could afford to buy, and I sold when I needed to sell.
But that 15% does not tell the true picture, and that’s what I want to explore in today’s episode. My actual return was just over 68% per annum. Yep you heard that right – 68%!
Gearing. Borrowing to invest. It’s about magnifying outcomes. Gears are used in engines and other mechanical devices so that one small turn over here can lead to a really big or fast turn somewhere else.
This magnification of outcomes may be the key to you reaching your financial autonomy goals in the time frame you want. It’s an accelerant. But as with all accelerants, gearing also has risks. It’s a tool you can definitely use to gain the choice you desire. But it’s one to use as part of a well thought out strategy, with the potential downsides considered and mitigated against where possible.
Property investment is the most common area where we see gearing, but it can just as easily be done with shares, exchange traded funds, or managed funds. Given the interest costs associated with borrowing, gearing only makes sense into investments that are likely to grow, and where the expected return after tax is greater than the interest cost. So for instance it wouldn’t make sense to gear into a term deposit investment – the return on the term deposit would be less than the interest expense.
So let’s get back to my 68% per annum return. I’d be disappointed if you weren’t a bit sceptical. The Financial Autonomy community is a savvy bunch and you know the old saying, if it sounds too good to be true, it probably is. But stick with me, in this instance it really did happen.
When I bought my first home, I put down a 10% deposit. So that meant I put in $10,700 and the bank funded the rest. Of course there was some stamp duty but it wasn’t a lot at that price point, and I had a friend help me with the conveyancing so that cost me next to nothing.
Over the 4 years that I owned it, for much of the time I had a flat mate in the spare room, and her rent helped with the loan repayments. I didn’t really make much of a dent on the loan during that 4 years, but it went down a little, and I had a roof over my head.
So I sold for $189,000. The first thing to happen was that the associated loan needed to be repaid. With that done I had around $93,000 in my bank account. Now of course I had to pay a real estate agent for the sale, and some legal costs. I can’t recall exactly how much they were, but being conservative, let’s say I was left with $87,000.
I bought my flat for $107,000, and sold it 4 years latter for $189,000, a gain of about 15% per year. But the real story here, the one relevant to me, is that I put down almost $11,000 of my savings, and 4 years later, that had become $87,000 – my savings had multiplied by a factor of 8!
Now as I said at the start, whilst I’d love to say that I got this amazing return because I was some sort of property investment genius, the truth is it was pure luck. But you make your own luck. I wasn’t to know the property value was going to increase that much, but by saving a deposit, finding something in my budget (even though it was a long way from my dream home), and making a start, I enabled that luck to happen.
And the power of gearing significantly magnified my outcome.
So how could you use gearing to magnify your investment outcomes and get to your Financial Autonomy goals quicker?
A popular strategy that we use with clients a lot is regular gearing. You might put $1,000 per month into an investment, and we arrange a lender to lend a matching $1,000 so that each month you are buying $2,000. Your investment exposure is therefore doubled, and by doing this monthly, you are averaging out your entry price – dollar cost averaging is the jargon, which serves to reduce risk.
There are also products that will allow you to buy a parcel of shares or funds, and put down a deposit in the same way you would buy a property. You then make monthly repayments on the loan in the usual way. This enables you to have a potentially large exposure to the market right from day 1.
There are also some offerings that have protection built into them, typically created via options contracts. With these, there will be a set term, say 5 years, and at the end of that term, if any of the shares are worth less than what you bought them for, you are not up for the loss. Now of course you have to pay for the protection, but some people appreciate the peace of mind.
And then of course there is the traditional investment gearing avenue – property. Banks have always been very comfortable lending against property, so your ability to magnify outcomes is quite high – in my example I only put down 10% and the bank provided the other 90%. The less you put in, and the more that is financed, the stronger is the gearing impact.
Now it’s appropriate at this point to talk about risk. All through this piece I’ve talked about magnifying outcomes. Outcomes can be good and bad. If the numbers in my flat example had gone the other way, and I had turned $87,000 of savings into less than $11,000 in 4 years, I’d have been a very unhappy person.
So gearing magnifies outcomes – both good, and bad. So what can you do to reduce the risk of a bad outcome?
The primary tool is time. The longer you hold the investment, the greater the chance of a positive outcome. Buy some shares or a property and sell it a year or two later, and the chances of a negative outcome are quite high. But hold those investments for 10 years, and the likelihood that the value of the asset will have declined since purchase, is fairly low.
As a rough rule of thumb I would suggest not going into a geared investment strategy unless you felt it was likely to be able to remain undisturbed for at least 5 years.
Of course in contemplating commencing a gearing strategy you need to have a good handle on your cash flow – can you afford the loan repayments? Should you fix the interest rate to provide greater certainty? If you’re investing in property, how would you go if there was no tenant for a few weeks or months?
It would also be wise to check that your Income Protection cover is adequate. Given the importance of investment time frame to your gearing strategy, you don’t want a period where you are off work due to illness or injury to force you to sell your investment at an unfavourable time.
If you are investing into property, things like landlords insurance may also be of value to reduce your risk.
Before I wrap this post up, I thought it was worth touching on a question I get quite a bit – what is negative gearing?
With any gearing strategy you have money going out – primarily the interest expense on the loan, but in the case of a property, also expenses like council rates and insurance. You also have money coming in – rent or dividends.
Negative gearing refers to a scenario where the money going out, is more than the money coming back in. So for instance an investment where there was $20,000 going out each year, and $15,000 coming in. There is a loss here each year of $5,000. This investment would be term negatively geared.
Were the scenario reversed and there $5,000 more coming in than going it, it would be called positively geared.
So a negatively geared investment is losing money each year in a cash flow sense. Yet negative gearing is usually described in the media as some sort of investment secret of the wealthy or well informed. What’s going on?
There’s two elements. One is that in the case of shares and property, the return isn’t just the income they produce. There is also the expected growth in the value of the investment over time.
The second element is that the loss amount in a negatively geared scenario can be tax deductable.
So an investor entering into a negatively geared strategy will be hoping that over time, the value of the tax deductions, plus the growth in the value of the investment, will make the whole exercise worthwhile.
It’s worth highlighting here that whilst the tax deductions are helpful, in isolation they aren’t enough to make a negative gearing strategy sensible. Growth in the value of the underlying investment is a must if this strategy to produce a successful outcome for you.
Well thanks very much for using some of your precious time to consume this post. I hope you got something useful from it. As always, we have a toolkit made up to help you take action. I’ve summarised the key ways to manage risk when embarking on a gearing strategy, which I hope will empower you to take action. I’ve got some other bonus items in their too so check it out.
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