Gearing

- Caglan Bagci | NZIJ MORTGAGES


The word gearing is often used by lenders to refer to the level of debt in relation to a particular investment or portfolio.  A highly geared portfolio is one that has a high level of debt (perhaps as much as 100%) as a ratio while a lowly geared portfolio is one that has a low level of debt (perhaps 50%). 

Investors normally think of gearing in relation to the cash flow of a particular investment or portfolio.  A positively geared investment is one that makes a profit while a negatively geared investment is one that makes a loss.  A negatively geared strategy can be successful if the (tax free) capital gain is greater than the cash flow loss.

Calculating yield is the first step. This is almost always thought of in terms of a percentage of the value of the property.  The gross yield for any investment property is 12 months rental income divided by the value of a property.  Therefore a residential investment property that is tenanted at $500 per week with a market value of $300,000 would have a gross yield of 8.67% ($26,000 per annum rental divided by $300,000 market value). 
The net yield takes in to account the likely cash outgoings of rates, insurance, body corporate (if applicable), repairs and maintenance and loss of rent due to an untenanted period. With the above example, allowing for rates of $1500pa, insurance of $300 per annum, repairs & maintenance of $300 per annum and allowance for an untenanted period of two weeks costing $1,000 the total of all of these costs is $3,100.  The net yield is (12 months rental income less cash outgoings of $3,100) divided by market value = $300,000 = 7.63%.

An easy rule of thumb is that net yield is approximately 1% less than gross yield. 
If a property manager is involved there will be an additional cost of 7 to 10% of rental income.  This will need to be factored in to the net yield calculation.  In the above example the cash outgoings would increase by $2600 at a rate of 10%.  This would reduce the net yield to 6.77%

It is traditional for property investors to use “other people’s money” to invest with.  An investor needs to know what the difference is between the net cash flow of a property and the cost of borrowing.  In the example above if the net yield is 6.77% with the use of a property manager and the interest rate on borrowings is 7.5%, then there will be a shortfall of 0.73 ($2,190 if the property was 100% financed) to be met from alternative income sources.  This example would be said to be negatively geared (making a loss).  If the net yield is greater than the costs associated with the investment then we would have a positively geared investment (I am deliberately ignoring depreciation).

Critical to calculating net yields is obtaining accurate rental data. The best source of this information is on the Tenancy Services web site.  To go straight to the relevant page use the following address and add it to your list of favourites;
http://www.dbh.govt.nz/housing/tenancy/Market-Rent/market%20rent%20region.asp

Now that you have the formulas, put them to the test.  Look through the local real estate magazines and on Trademe to search for positively geared investment properties (where the net yield will be greater than the costs of the investment property). Our focus is to compare net yield with a borrowing cost of 7.5% (on the expectation of longer term fixed rates).  Yes, we can get lower interest rates than that but the market is always changing and we need to allow for rates going up between now and when you might purchase an investment property. You can decide for yourself if you want to allow for property management costs. Once again ignore depreciation for the time being.

I will also search for positively geared investment properties and report back in the next issue.
As usual I am happy to respond to any questions on this article or anything in previous issues.  Send your questions to mortgages@nzij.co.nz