Chapter 8 - Positive gearing
Positive gearing is where the income from a debt-financed asset exceeds the interest cost. This is actually quite rare in property investment, but no so rare in share investing.
For example, in December 2012 ASX Investor Update newsletter Paul Zwi from Clime Investment Management observed that National Australia Bank shares offered a high dividend rate of 7.5% or 10.7% grossed up for franking credits.
Clients who borrowed to buy NAB shares would have experienced positive gearing: the dividend return was greater than the interest cost. The shares would have paid for themselves, and a bit more, even before capital gains were considered.
Positive gearing may reduce risk. By improving cash flow, it improves the client’s ability to reduce debt or make fresh investments – or both. Common sense is needed: the critical question is ‘will the expected income in fact occur?’ Advisers should always complete their due diligence – but to be frank if you stick with blue chip investments like NAB shares it’s hard to see what can go wrong.
We have seen structured positive gearing products blow up in client’s faces. In 2007 one well-known institution marketed a positive gearing arrangement where clients borrowed from one arm of the institution at 9% per annum, to invest in another arm of the institution at a “guaranteed” 12% per annum. What could go wrong? Well, what went wrong was there in the fine print all along. The ‘guarantee’ was not a very good guarantee and was in fact discretionary. Not surprisingly, after about 6 months the institution invoked its discretion and stopped the 12% income payments to clients, but continued to enforce the 9% interest charge on clients.
From the institution’s point of view the fine print was very fine: there was nothing the clients could do but pay up and wait for five years to get their money back, less interest. The institution made a fortune from it.
So, while the logic of positive cash flow investments is strong, caution needs to be applied. Positive cash flow might also mean that relatively few people want to own the asset – which may make future capital returns problematic.