There – I said it! Negative gearing is all about losing money – it involves debt and high risk yet I’m almost certain that many readers will have never heard it described so bluntly.

 When was the last time you heard anyone point this out?  The promoters of negatively geared investment strategies (into property and/or shares for example) have much to gain from encouraging people to negatively gear so you won’t always receive the full story from parties who have a vested interest. So let’s look in detail at negative gearing: What is it? When is appropriate and what type of investors is it suitable for?

Gearing?

Gearing is a proxy term for ‘borrowing’ – it’s as simple as that.  You might sometimes see the term ‘leveraged investing’ wherein ‘leveraged’ also simply means borrowing.

Gearing, like how gears on a bicycle enable the rider to get over very steep hills, enables an investor to buy a larger investment(s) than their financial position would otherwise allow.  Similarly, like a ‘lever’ can enable the movement of large objects with much less human effort, so too does leveraged investing permit a larger investment(s) to be purchased than might otherwise be possible.

Gearing – leveraging – call it what you like but the bottom line is that involves borrowing money.

Negative?

This is where money is lost.  The negative in ‘negative gearing’ applies wherever the costs of servicing the investment such as loan interest, professional fees, investment maintenance (repairs etc.) exceed the income being generated by the investment(s).  In other words, the investor has to spend more to hold the investment than what the income received from it amounts to.

“Yes – but at least I can get a tax deduction!”

True, but as I once heard it stated quite simply: “That’s like spending a dollar to save 50 cents.”  And note that, under current Australian tax law, a deduction is permissible wherever the asset is Australian based and produces taxable income.  The deduction applies only to the amount of costs (interest etc.) which exceeds the income received from the investment.

So why would anyone ever negatively gear an investment(s)?

This is the key point – such an investment strategy only makes financial sense if there is a likelihood that the value of the investment(s) will increase over time.  And it is time which is a key determinant in whether or not a profit can actually be made from the strategy.

While waiting for the value of the investment(s) to increase, under a negatively geared investment strategy, an investor is losing money on the cash flow – i.e. the costs exceed the income less any tax deduction which might be available.  As such, the longer it takes for an investment to increase in value the higher the accumulating cash flow losses (negative).

So if asset values are being pushed higher quickly during say high economic growth or high inflation periods, the more quickly a negatively geared investment strategy becomes profitable – capital growth exceeds the losses being made on the cash flow.

Who does it suit and when is it best to do it?

Primarily negative gearing is most suitable for investors in the highest income tax bracket. This is because the tax deduction they can receive is at a higher level than someone on the lowest tax bracket, for example.  This just means they have less out of pocket costs in meeting the expenses of the strategy.

Periods of high economic growth and/or high inflation are generally more beneficial for negatively geared strategies simply because asset values increase more quickly at such times.

Note however that, for around twenty years, Australia has had quite low inflation and economic growth, despite the resources boom of recent years, is currently modest.

What’s the risk?

There’s more than one risk but suffice to say the list of risks includes: loan interest rate rises – loss of employment income required to cover the ‘out of pocket’ costs (investment costs – investment income + tax deduction = out of pocket costs) – prolonged injury or sickness of the investor (out of pocket costs) – slow investment value growth – declines in investment values – slow economic growth – low inflation – a future government might cancel the tax benefits …

Neutral? Positive?

Investors don’t have to gear negatively – it is possible in some situations to have a neutral gearing position or even a positively geared investment(s) and I’ll explain these strategies in my next blog.

Ray

 

       IMPORTANT – THIS IS NOT INVESTMENT ADVICE

This discussion is not a recommendation for readers to invest in any or all of the specific investments, or types of investments, discussed in this blog. Please do not act to make investments based in this commentary.  This is a general discussion about some aspects of investing and cannot account for all circumstances.

 

 

Bond, Skase and Connell are names of just three of the list of high profile entrepreneurial Australians who have failed at some point in their business careers.  In Australia, the latest high-profile entrepreneur to run into financial trouble is Inverell born Nathan Tinkler who, through the good fortune of a ‘tailwind’ of inflated commodity prices and friendly lenders, in April 2012 had an estimated wealth of $1.1 billion.

nathan

Photo: Louie Douvis (Sydney Morning Herald, Business Spectator)

However, with the Australian Taxation Office being the latest creditor to seek payment of the comparatively small amount of $2.7 million in back taxes, Mr Tinkler’s wealth might have fallen to the point of him being in net debt. With his holding in Whitehaven Coal now valued at around $625 million but with estimated debts of $700 million, things are certainly tight for him.

Over the last month he has embarked on selling down much of his thoroughbred horse racing interests and has had his private jet and helicopter repossessed by financiers.  From the outset, the Achilles Heel of Tinkler’s operations was the very high levels of gearing (borrowings) and he is now in substantial financial difficulty.  There are lessons in this for every business owner; for every individual.

Firstly, much of his wealth was based on borrowed money and while, in and of itself, borrowing is not a bad thing, like many things in life too much of it is far from good.  Nathan Tinkler’s ability to borrow very large amounts has to this point been underpinned by two key planks.  Firstly, borrowings were secured by a lien (a mortgage) over his shares in Whitehaven Coal (and predecessor companies) and secondly, lenders lent against the shares on an expectation that the resources boom would continue unabated for a much longer period into the future.

With the decline in global commodity prices over the last calendar year or so, in part a response to slowing demand from China, shares in resource companies like Whitehaven Coal have been bearing considerable downward price pressure.  For all resources companies this has brought on a need to cut costs wherever possible in the face of reduced revenue from sales of commodities – witness redundancies afflicting thousands of mining workers across the nation over the last six months.

From the outside at least, the Tinkler situation appears to be a case of too much (debt) too soon.  Cash flow is ultimately the lifeblood of every business (substitute ‘salary’ for cash flow, for employees) and if it’s impeded (e.g. reduced commodity prices) then things can get grim very quickly.  With an inability to meet debt obligations because of falling revenue, it’s only a matter of time before smiling lenders start to deliver other facial expressions.

The same risks are at play for individuals. Too much debt is never a good thing and myriad risks abound to curtail loan repayment ability. Consider sickness, accident and unemployment as just three of the things that could jeopardise an individual’s capacity to meet loan repayments. Then there are issues like rising interest rate cycles which eventually send some borrowers into default on loans.

Whether or not Nathan Tinkler will be able to resurrect his business’ ascendency remains to be seen. The headwinds that confront him now seem unlikely to dissipate any time soon.

While the very essence of a successful economy is that at points along the way, people have been brave enough to be entrepreneurial and start a business, there can be failures at any time in every business cycle – in good times and bad.  Yet, thanks to sound business management, plenty do succeed.  As in nature, business evolution initially sees the strong (balance sheets) survive along with those that can adapt to a changing environment.

As you read this it’s worth remembering that the very reason you can read this online, right now, is in very large part due to the entrepreneurship of people with names like Gates and Jobs!