The Pros And Cons Of Negatively Geared Investments

Critically analyse the Risks and Returns associated to Negative Gearing from Investment in Definite Assets, Particularly in the Context of Increasingly Volatile Conditions of the Market.

 

Introduction

Background of the topic

Negative gearing indicates towards purchase of a particular asset without even receiving adequate earnings from the specific investment to cover the interest expends as well as other associated costs involved in maintaining the same. As rightly indicated by Wood and Kemp (2013), negative gearing can be regarded as a certain form of negative leverage in which a particular investor can borrow money in order to invest.

Objective of the report

The objective of the current report is to critically analyse the risks and returns associated to negative gearing from investment in definite assets, particularly in the context of increasingly volatile conditions of the market.

Summary of the findings

Analysis of the findings reveals the fact that in the United Kingdom, negative gearing that leads to loss of earnings of a tax payer, that loss is essentially quarantined. Nevertheless, in cases where the taxpayer owns in excess of one asset, then any kind of loss can essentially be applied against gains of another, that too in the same financial year. However, in case if after the application of the loss, the tax payer remains in a position of net loss for the specific year, then in that case, that particular loss can also be carried forward as well as utilized in the upcoming income years (Grudnoff 2015). Thus, any kind of applied loss can be particularly offset as against the capital gains of the subsequent clearance of the assets.

Analysis of the Risks and Return of negatively geared investments

As advocated by Davidson and Evans (2015), all kinds of investment have an element of risk. However, there is always a cost associated to the factor of lowering of risk. Thus, it is often said that the lower the risk, the lower is the return. As correctly indicated by Mkumbuzi (2016), the risks that can be associated to negative gearing is that the entire value of the property might not sufficiently increase for covering up the losses. Yet another risk that can be associated to the negatively geared property is that the interest expense might rise. There are several individuals whom have suffered due to both of these two reasons. In addition to this, there are also issues of specific time that is taken to attain capital gains taking into account the uncertainty of attaining the same.

As rightly indicated by Fajana and Oduyemi (2016), the bottom line that can be associated with negative gearing is that the investment is incurring a loss, and the ones who are banking on different windfalls can play a very risky game. The very word negative gearing suggests that the income or else the rent cannot essentially cover the costs of interest or in other words expenses of running the particular property. However, the gross earnings generated from the specific investment is lower than the owning cost as well as the cost of management, counting depreciation and the interest charged excluding repayment of capital. As rightly put forward by Wood and Ong (2013), a particular property with positive flow of cash implies that the rental earnings from the specific property can cover all the cost of outgoing cash related to the property. Contrarily, a property with negative flow of cash implies that the rental earnings from the definite property cannot cover up all the cost of the outgoing cash related to the particular property.

Another major risk that can be related to the negative gearing is essentially the legislative risk. Critics are also of the view that negative gearing is a bad thing as this makes it difficult for different first time owners to purchase a property such s home or else investment portfolio. However, this happens mainly because the investors need to compete with diverse offers presented by financiers and there are a few new comers who can compete with particularly seasoned as well as established investors. Furthermore, the things that are not taxed need to be made up by different other earnings, subsequently costing more to all the average (Peel 2016).

As indicated by Baum and Crosby (2014), individuals who go for negative gearing essentially bet on bigger capital gain when they can sell all the acquired properties to make up for all the losses on essentially the income side. However, this can be observed as a dangerous scheme in which the risks can remain masked in a specific environment in which prices of the property can remain at high or else low level. On the other hand, Wood et al.  (2016) argues that the advantages of negative gearing exist primarily for the financiers that deal with different types of property. However, since the losses from the investments decrease from specific taxable income, payment of taxes are comparatively less. Whilst there is net loss for a certain period, this too can assist in offsetting the loss until the overall investment develops and becomes something greater or more than the original. Particularly, the association with the taxes is not in all the nations.

As correctly indicated by Morley and Thomas (2016), negative gearing occurs at the time when the overall rental earning received is lower than the entire cost involved in purchasing the investment property. This is also often regarded as capital growth properties and particularly the negatively geared investments are anticipated to appreciate in terms of value over a specific period of time. However, this increase is anticipated to outweigh all kinds of financial losses that occur during the short term period. In addition to this, the properties are also usually situated in areas that are closer to all the capital cities that typically performs over a specific long term period. Abeywardhana and Krishanthi (2015) debates that despite different disadvantages there are certain advantages of the negatively geared investments. The advantages can be observed in terms of growth in capital. Geurs and Halden (2015) advocates that the returns from capital are said to outweigh the entire levels of borrowings in addition to costs in order to create wealth for all the investors at sale given that the strategies and arrangement of negative gearing are implemented.

Baum and Crosby (2014) suggests that the negatively geared investment schemes also help in affordable investments for tenants owing to the affordability. This can help in securing tenants for a long term period. In addition, negatively geared investments are also less volatile unlike a particular property in a local areas that might depend heavily on specific employment industries to lift up the demand. In this case, the properties heavily depend on varied factors and can be regarded to be less volatile investments. However, critics argue that there are also disadvantages or risks that are attached to the negative gearing. For instance, budgeting is required in order to deliver budget for different ongoing shortfalls at the time when the particular property under consideration is sold against a profit. Furthermore, critics put their view against the negative gearing and advocates that this is not a long term strategy for creation of wealth (Peel 2016). Thus, in case if the circumstances alter and a sale becomes obligatory then the sums might not work out desirably. Again, if in case an individual losses a job, then there is need to maintain the costs associated. Thereafter, it becomes necessary to build a plan that can ensure that the individuals are entirely prepared. For example, protection of income long with insurance policies (Mkumbuzi 2016).

Numerical Example

A numerical example can help in further explaining the negatively geared investment and help in correctly appraising the same. For instance, there is purchase of an investment property and the purchased property is situated in an area of high growth and stable area where essentially properties are rented at an affordable price owing to higher availability of different rental properties in the specific area. Let us consider, the property is rented to tenants against a rental return of around $425 every week. However, the cost of repayments for the specific property that includes repayments of loans, management of property, fees and rates amounts to $440 each week. Thus, after all expends it can be observed that the rental income generated from the property does not cover the entire cost of repayment and there is a shortfall of around -$15 every week. Thus, in this particular situation, it can be said that the property is negatively geared.

Another example of negative gearing, suppose a property is purchased for $300000 and $250000 is borrowed for financing the project at a interest rate of 8% along with weekly rent of $300. Other ongoing costs comprise of fee of then agents that is around 8.5% of all specific rents, rates, repairs, maintenance as well as insurance. This suggests that the net income for the entire year can be $14274 obtained by deducting $1326 from $15600 that is equal to a net yield of rental of 4.75%.

Conclusion

The above mentioned helps in comprehensive understanding regarding the pros and cons of negatively geared investments. The current segment explicates the fact that the negatively geared investments are anticipated to generate higher profits only by means of capital gains. In addition to this, there remains no assurance as regards the value of particular property that can appreciate during the time period of holding that in turn can cover up for the losses. In this regard, it can be said that the gearing policy can increase gains and at the same time can amplify the figure of losses in case if the property price falls that is in volatile market conditions. This in turn can lead to increase in the loan balance in comparison to the value of the property.

References

Abeywardhana, Y. and Krishanthi, D., 2015. Capital Structure and Profitability: An Empirical Analysis of SMEs in the UK. Browser Download This Paper.

Baum, A.E. and Crosby, N., 2014. Property investment appraisal. John Wiley & Sons.

Davidson, P. and Evans, R., 2015. Fuel on the fire: Negative gearing, capital gains tax & housing affordability. ACOSS Papers, p.29.

Fajana, O.S. and Oduyemi, O., 2016. Is Opportunistic Investing Rewarding?–A Study of United Kingdom Unlisted Funds.

Geurs, K. and Halden, D., 2015. 30 Accessibility: theory and practice in the Netherlands and UK. International Handbook on Transport and Development, p.459.

Grudnoff, M., 2015. Top gears: How negative gearing and the capital gains tax discount benefit the top 10 per cent and drive up house prices.

Mkumbuzi, W.P., 2016. Influence of intellectual capital investment, risk, industry membership and corporate governance mechanisms on the voluntary disclosure of intellectual capital by UK listed companies. Asian Social Science, 12(1), p.42.

Morley, B. and Thomas, D., 2016. An Empirical Analysis of UK House Price Risk Variation by Property Type. Review of Economics and Finance.

Peel, M.J., 2016. Owner-Managed UK Corporate Start-Ups: An Exploratory Study of Financing and Failure. Entrepreneurship Research Journal, 6(4), pp.345-367.

Wood, G., Ong, R. and Cigdem, M., 2016. Housing Tax Reform: Is There a Way Forward?. Economic Papers: A journal of applied economics and policy, 35(4), pp.332-346.

Wood, G.A. and Kemp, P.A., 2013. The taxation of Australian landlords: Would the British tax treatment of rental investments increase tax burdens if introduced in Australia?. Urban Studies, 40(4), pp.747-765.

Wood, G.A. and Ong, R., 2013. When and why do landlords retain property investments?. Urban Studies, p.0042098013484544.