By Simon Newman

One of the most important things to know about our property portfolio is the gearing level. Knowing this can provide us with an indication of our exposure to market movements, our overall cash flow situation and how closely we are following our investment plan.

Our gearing level is simply the amount of funds we have borrowed in order to invest versus the value of property held. You may also hear gearing level referred to as “Loan to Value Ratio” or “Debt to Equity Ratio” but each title refers to the same thing. To calculate gearing level, simply divide the loan amount by the property value.

We should do this for each property individually as well across our whole portfolio.

Gearing Ratio = Loan/Property Value

For example, the property below is valued at $400,000 and the loan amounts are in the red box.

In devising our investment plan, one of the first things we should do is calculate our target gearing range, but there are some important factors to consider in determining where we should be geared to:

We may initially have no choice! The fact is that most of us, when commencing our investment journey, usually have to borrow a large portion of the property value (sometimes up to 95%) in order to make the initial purchase.

As time passes, your gearing level changes. This is due to the change in property values and our diligence in reducing the loan amount, eg. my first property started with a loan of $208,000 and had a value of $260,000 and so had an initial gearing level of (208,000/260,000) 80%.

Around 5 years later, the loan had been paid down to $80,000, yet the value of the property had grown to $510,000 and so at this point, had a gearing level of (80,000/510,000) 16%.

A high gearing level means greater market exposure. Case Study: an investor has $100,000 to invest in property. If a gearing level of 50% was set, the investor would then borrow $100,000 and combine this with their own funds to purchase $200,000 worth of property. A 10% increase in the property value provides a $20,000 increase in portfolio value. Alternatively, if a gearing level of 90% was set, the investor would borrow $900,000 and combine this with their own funds to purchase $1m worth of property. The same 10% increase in the portfolio would now result in a $100,000 increase in portfolio value.

Professional investors use their knowledge of gearing to measure their wealth.The gap between our loan amounts and our property values is known as equity. The more equity we can generate, hold and control, the higher our wealth or “net worth”.

Gearing levels affect the cash flow of the portfolio. Be aware that the resultant cash flow equation of a portfolio is dependent on many factors such as loan amounts, interest rates, property expenses, rental income and individual income levels. However, using the averages of all of these, we can relate cash flow to gearing levels in zones as per the below:

If an investor sits in the negative gearing zone, the interest and expenses are higher than the rental income and tax savings and therefore, the investor must provide cash to support the portfolio.

If an investor sits in the neutral gearing zone, the interest and expenses are equal to the rental income and tax savings and therefore, the investor does not need to supplement the property yet receives no income from the portfolio.

If an investor sits in the positive gearing zone, the interest and expenses exceed the rental income and tax savings and therefore, the investor receives a net income from the portfolio.

Gearing levels are dynamic, meaning that a property may start off negatively geared. But as loan amounts decrease and rents/values increase, we may find our property drops out of the negative gearing zone, through the neutral zone and into the positive gearing zone. Going back to my 1st property example, at 80% gearing, it started off negatively geared, went to neutrally geared by year 2 and positively geared by year 4 of ownership.

Set a target gearing range and adjust your portfolio to stay in that range. The target gearing range needs to be set considering the balance between market exposure and cash flow. If, due to increasing property values and decreasing loan amounts, you find yourself dropping out of your target gearing range, you may need to consider adding properties to the portfolio in order to remain in your target gearing range.

Your investing phase will direct your target gearing level. An investor in early phases of their investment life may select a higher gearing level (eg 70-80% is common) to give them larger exposure to the market whilst they have high income and low expenses. Alternatively, an investor moving towards the retirement phase may be more likely to be maintaining a low gearing level (eg 35-45%) due to reduced income levels, risk tolerance etc.

Conclusion Knowledge of the above considerations and how to apply them is one of the most important aspects in planning a long term property investment strategy.

Applying these considerations is core to the role NPA consultants play in providing service to their clients.

If you would like help in sorting out your Property portfolio, give us a call.