NEGATIVE GEARING

Chapter 5 - Debt and the prudent investor

Tax deductible debt

Borrowing to invest

Handy hints for getting the money

We have never seen a self-made millionaire become wealthy without using debt. We have also never seen a self-made bankrupt go broke without using debt. Debt is a two edged sword: it can create wealth or it can destroy wealth. Most people use debt intelligently and enjoy the wealth it creates.

 

Whether it is increasing equity in the family home or a rental property or a geared investment in shares, unit trusts or other securities, most prudent investors (‘PI’s’) over the last ten or so years have enjoyed an increase in their wealth. Much of this has sprung from the judicious and sensible application of debt.

The high cost of living and high tax rates make it hard to accumulate wealth from personal income alone. Superannuation, mandatory and voluntary, helps. But even double-digit contribution rates are insufficient to accumulate wealth, except over a very long time. Most people are not prepared to wait that long, i.e. until retirement, to enjoy the benefits of wealth.

Borrowing to acquire appreciating and income-producing assets is the solution.

Tax deductible debt

Debt is the prudent investor’s friend. Most prudent investors who have historically borrowed money to acquire investment assets have ended up much better off as a result. This is because – again historically – each of the major asset classes has produced average annual returns significantly greater than the cost of borrowing to acquire and hold them, i.e. the interest rate. Most PIs who borrowed money over the last twenty years to buy good quality diversified assets have done well. This is even before the tax benefits are factored into the equation.

In the long term, which we define as being twenty years or more, it is very probable that the rate of return on each of the major asset classes will exceed the interest rate. And this means PI’s who have borrowed prudently to invest will become wealthier.

The basic benefit of a geared investment, that is, that the return on investment is greater than the cost of investing, is enhanced by a number of features. These include:

  1. most geared investments have some owner’s equity in them. Therefore, not only is the rate of return greater than the cost of funds, but that greater rate of return is earned on a larger capital base;

  2. most geared investments produce at least some un-realized capital gains. Un-realized gains are not taxed until they are realized. And when they are finally realized are only 50% taxed provided they are held for more than one year. Warren Buffett calls this tax deferral an ‘interest free government loan;’

  3. tax benefits will exist if the assessable income (which does not include un-realized capital gains or half of any realized capital gains on assets held for more than a year) is less than the allowable deductions, i.e. if the investment is negatively geared; and

  4. sometimes, tax benefits can be enhanced by the intelligent use of depreciation, repairs and pre-paid interest arrangements.

Investing in a diverse range of assets is a good idea when gearing. Diversification reduces risk. Do not have all your eggs in one basket. By investing in a number of different assets and a number of different asset classes one can reduce the risk of specific asset values falling, and, in particular, reduce the risk of them falling below the debt, so that owner’s equity is wiped out. How much, or how little, diversification there is depends on the investor’s own expectations of performance and attitude to risk.

Despite the need for these cautions and comments, it is clear that those who borrowed money to gear sound investments over the last ten years or more have by now mostly done very well. Many wish they had geared more investments. Those who lost money on geared investments tended either to sell too quickly or they speculated on unrepresentative shares. They did not fully appreciate that property and shares investments are long term, (i.e. at least ten years,) and a year or two of poor performance does not mean that they should be sold. Others just made poor investment decisions. Thankfully, these tend to be the minority, and it is rare for all investments to perform poorly. Normally it is just one or two. Diversification is the key here, reducing the prospects of being left with just one or two poor performing assets.

It is hard for anyone, PI’s included, to accumulate significant wealth without taking on at least some debt for some time. The amount of debt is a matter of choice, and reflects an underlying attitude towards risk. But as a general proposition, over the last ten years, PIs who borrowed to acquire sound investments did a lot better than those who did not

Looking to the future, then, it is likely, therefore, that PIs who take on debt to acquire more investments will accumulate more wealth than those who do not. Sadly there are no guarantees that this will be the case, and each person has to make their own decisions. What is good for one person may not be good for another. But as a general proposition, investors who borrow to invest prudently will probably do quite well.

Borrowing to Invest

If you need more encouragement, or perhaps convincing, that IPs should be borrowing more, shout yourself a copy of Noel Whittaker and Paul Resnik’s book “Borrowing to invest: the fast way to wealth: a user’s guide for borrowers”. No one could ever accuse either of the two authors of lacking conservatism, and they each have ‘elder statesman’ standing in the financial advising community.

Published by Simon and Schuster in July 2002, paragraph 1 of chapter 1 reads:

“Are you prepared to use other people’s money to build a better life for yourself? Have you stopped to think about what will happen if you don’t? Chances are you would never own your own home. Every mortgage is, after all, built on someone else’s money. And, unless you are heir to a fortune, it’s just as likely that your years in retirement will be years of watching the dollars.”

This paragraph, and the title of the book “Borrowing to invest: the fast way to wealth”, gives you a good idea of their basic thesis. But we recommend you read the rest of the book to find out what else they have to say.

In her excellent book “Personal Finance for Australians for Dummies” Barbara Drury writes:

“Many people still feel uncomfortable about borrowing money to invest, a practice referred to as gearing. Yet the same people cheerfully borrow to the gills to buy their own home because they understand that the only way to own such an expensive asset is to use other people’s money.

Borrowing to buy growth assets, such as shares or property, and using your own cash or equity in your home as a down payment, helps you increase your returns. You make a profit as long as the investment returns (income plus capital gains) are greater than your interest payments. Say you have $10,000 and borrow another $10,000 at 8% interest to buy shares with a dividend yield of 4%. The dividends of $400 cover your interest payments but you stand to make double the profit when you sell the shares because you bought twice as many shares as you could have done with your own money.

Gearing can substantially increase long-term investment returns, but it magnifies the potential risks as well as the potential rewards. If you choose to gear into shares or investment property, invest in a diversified portfolio of high quality assets that have the best chance of producing solid capital growth over the long term. Never gear to invest in speculative investments, or to avoid tax.”

An investment is “negatively geared” if its income is less than the interest incurred on any amounts borrowed to acquire it. An investment is neutrally geared if the income derived from it is (roughly) equal to the interest incurred on any amounts borrowed to acquire it. And, similarly, an investment is positively geared if the income derived from it is greater than the interest incurred on any amounts borrowed to acquire it.

The investment may be property, whether residential, retail, commercial or industrial, shares or similar securities in listed or unlisted companies, or managed funds or indexed funds. Each of the major asset classes is suited to geared investment strategies.

The word “geared” is chosen because of its engineering connotations: the idea is that with correct gearing or leverage a result can be obtained that is better than that obtained without gearing. This is usually achieved by expanding the practitioner’s asset base and allowing time to run, and capital gains to accrue, which more than compensate for the deficiency in cash flow caused by the interest being greater than the income.

This technique usually works. But there is no guarantee that it will. It depends on the quality of the underlying investment. A word of caution is appropriate: gearing works in reverse to. The effect of any drop in value will be greater too, and it is possible that the practitioner’s equity in an investment can be wiped out as a result of this phenomena.

A rational investor will be prepared to negatively gear an investment if the expected after tax return, including capital gains, is greater than the expected after tax cost of holding the investment. The after tax return will usually be made up of two things; one, the income from the investment (i.e. rents, dividends, or distributions, depending on the investment), and two, the increase in value, or capital gain, over time. The income can usually be predicted with reasonable certainty. The capital gain is the wild card. No one knows the future, so the best one can do is expect a capital gain. This is where investing becomes an art rather than a science; expectations will be the critical issue.

We have never seen a wealthy person who at some stage has not taken on at least some debt for business or investment purposes. We have also never seen a bankrupt person who has not taken on at least some debt as well. It is clear that debt is a two-edged sword: it can increase investment returns and it can reduce investment returns.

It is best to keep to sensible debt levels, manage interest costs and to favour higher income yielding investments if the downside of debt is to be avoided.

The Australian Master Financial Planning Guide says that:

“An investor should only make a negatively geared investment if:

  • the investor has secure and permanent income from other sources sufficient to cover living expenses and all other requirements as well as the shortfall under the negative gearing;

  • where the gearing arrangement or borrowing includes a liability to make margin calls in certain circumstances, the investor can satisfy the margin calls by supplying further security or by payment from other sources to avoid the possibility of a forced sale (keep in mind that the economic conditions that lead to the need for a margin call will, almost certainly, mean that any forced sale will be at depressed prices and will lead to a significant loss to the investor;

  • the investment is made on the understanding that it will be retained for at least five, preferably, ten years or longer;

  • the investment and borrowing have sufficient flexibility to cover events such as death, disablement; major illness or redundancy. The first three of these would normally be covered by insurance or superannuation benefits and redundancy could be covered by an employer pay out. However, even in these circumstances the negative gearing arrangement … may need to be terminated. Check whether this can be done without incurring penalties and with the flexibility to avoid suffering loss through a forced sale of the asset;

  • there is flexibility to cover changes in circumstances, such as a transfer overseas (where the tax advantages may not apply) or divorce; and

  • the taxpayer can take full advantage of the tax deduction. Negative gearing normally works best for investors on the highest marginal tax rate but may be of less value to low tax rate or non-tax-paying investors.”

The author then warns of the danger of negatively gearing into an already geared investment, such as a listed company or a property trust. This increases both the up-side risk and the downside risk even further.

Handy hints for getting the money

If you are a prudent investor with a good credit rating, and you are buying an asset that would be regarded as representative (for example, an investment property in a well-regarded suburb), then you should be able to obtain loan finance reasonably easily. That said, there are some things you can do to make it more likely that someone will lend you money for your investment.

Research costs before you sign the contract. Make sure you know the interest rate, the principal repayment rate, the administration costs and the early repayment penalties.

Shop around. The first offer is unlikely to be the best offer. Some finance brokers specialize in investors. We generally find them quite good. Their rates are as competitive as the banks will give directly and their service is usually exemplary: perhaps they are more aware of their exposure to bad word of mouth advertising – especially in the age of Facebook and Twitter!

Make sure that your finance application is clear and to the point. Support it with recent accounts, company searches, business plans and similar documents where necessary. These materials are best included as appendices to the main application as they may cloud the message you are trying to deliver. If the loan is for business or investment purposes, stress this, as it may be relevant if the ATO questions the deductibility of any interest claimed on the loans down the track.

Ensure that your application shows all repayments can be met out of existing and expected business cash flows. If asset sales are contemplated in the short or medium term then say so, as this is very relevant to your capacity to service the debt. Financiers may not be impressed if the repayment of principal depends solely on the sale of the object investment.

Do not borrow too much. Most banks work on a debt to equity ratio of about 70:30. But in working out the value of your equity, they discount historical cost by factors representing their expected resale experiences. Take account of these discount factors before you commit yourself to a transaction. Ensure that your finance application includes all relevant materials. This should include all financial information that does not favour your application. If something goes wrong later on and the bank finds out that you withheld certain information then, to say the least, tempers could rise.

Keep the communication channels clear. If something does go wrong, tell the bank straight away. This is important because banks base their recovery actions on how they perceive the borrower to have behaved. Trust is very important with banks. If your word is your bond then you will get much better treatment if an unexpected situation arises. For example, time and time again we have seen banks extend an existing facility over the ‘phone without any extra security when a PI has asked for it, whether it be to use as a deposit for a new property or whatever. Because trust has been established the banks will come to the party and help you out where needed. Open and honest communication is the key to building this sort of a relationship, and once it is created, don’t waste it!

The banks will be extremely reasonable if you are reasonable with them. It is therefore important to play with a straight bat at all times.

4. Example of negative gearing - Share portfolio
6. Don't mix your debts

 ©2016 WHOLE WEALTH

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