Hi Steve,
I think I may have had an ah ha moment in relation to negative gearing as a result of yesterday's workshop.
Until now, I've hear that negative gearing is a bad thing, but I haven't been able to connect the dots as to why. Can you let me know if my below understanding is on the right track.
Ok, so with negative gearing we have a property where the properties expenses exceed the income.
To purchase the property we generally need to place a deposit and then, if the property is negatively geared we also need to make contributions from our own pocket to service the loan on a monthly basis.
So for example (in simplistic terms):
Purchase price is $350k (including costs). Assuming 20% deposit, deposit is $70k.
If positively geared, at say $20 per week, we are effectively reducing our deposit down by around $1000 per year, so the amount we have contributed to the loan actually reduces on a monthly basis.
Therefore, when calculating the profit on this purchase
gain = $430k - $350k = $80k
ROI = (gain from investment - cost of investment)/cost of investment
So if property held for 5 years cost is $70k - $5k = $65k
Therefore ROI = ($80k - $65k)/$65k
= 23%
However if negative geared at say $20 per week
$430k - $350k = $80k
ROI = profit/investment
So if property held for 5 years $70k + $5k = $75k
Therefore ROI = ($80k - $75k)/$75k
= 6.7%
or, if like many negative geared properties, the property is negative geared at $100 per week,
$430k - $350k = $80k
ROI = profit/investment
So if property held for 5 years $70k + $25k = $95k
Therefore ROI = ($80k - $95k)/$95k
= -15%
So if my understanding is correct, there has to be a much greater movement in a favourable direction to be able to make a profit from a negatively geared property (out of our control = speculating as we are waiting for price movements and assuming they will actually occur). Negative gearing substantially increases the amount of risk in an individual investment and it is likely to be masking loss making ventures. Even though we receive a return from the tax man for this 'loss' it is unlikely to compensate for the loss we have actually incurred along the way.
Is this a reasonable illustration of the crux of the issue?
Barb
:-)
We have had 6 properties that were all negatively geared. We have sold two in the last three years and have accepted a contract on the third just this week. It is an interesting mind set to think we will miss the income from the property $750 per week .... but the expenses and the fact that it was not covering costs will only leave us with more money in our pocket. There are two more properties with development opportunity, but covering the costs is still a demand that brings a great amount of pressure.
If only the simplicity of these explanations that Steve provided and your concise summary above were available to my partners accountant about 8 years ago when there was the huge move to have negatively geared properties....
live and learn
Wow Barb!!!!
you really do GET IT!!!! :-)
I thought I understood it but after seeing your analysis I am in awe :-)
I understand why it doesn't make sense from personal experience, a few years ago we had a negative geared 1 br unit (wont be buying one of those again either) that we are still paying for now. It sold for less than we owed the bank and the developers un-registered mortgage (lesson, if the developer needs to lend you $50K for it to value up, walk away and lose the deposit !!)
That property sold for $100k less than we paid for it and was losing about $800 per month plus depreciation, we had it for about 4 years so another $40k gone there, oh I forgot the taxman paid it, Ha ha.
The other thing they don't tell you is, if you are on a single income and have children they addback the neg gearing and reduce your family allowance, further reducing cashflow.
Lots of lessons learned, how to negotiate a "short sale" the bank needs to release the property to sell, if they don't have their money they can say no.
Funnily enough after the property was sold the mortgage manger called and thanked me for the work I did in making it all go smoothly. apparently most people don't ask how they can do this, they just stop paying and get foreclosed on and lose their credit. I negotiated an interest free very low repayment for as long as it takes :-), also got the developer to reduce the amount we owed him by the amount we had paid in interest and on the same no interest terms.
Thanks Barb your calculations make it very clear :-)
how come the accountants and financial planners don't get it?
To Your Prosperity
Michelle
blog: www.michellethemoneycoach.com
eBook: http://financialfreedomonyourcurrentincome.com