My insights on the power of a gearing strategy

By March 11, 2020 Mortgages
gearing strategy

Borrowing to invest, particularly in property, has been a very popular investment strategy in Australia. A mortgage is a wonderful servant but a terrible master. If you use mortgages properly, in a risk adverse way, it can be a very powerful wealth accumulation tool. However, if used poorly, it has the power to destroy more wealth than it creates. After almost 18 years since establishing this firm, I thought it was timely to share some insights and observations about a gearing strategy.

Inflation will eventually eat away at the value of debt over time.

Interest rates reflect inflationary expectations. That is, when inflation expectations are high, so are interest rates. As such, borrowers are paying for the inflationary cost of debt each year. This is evidenced by the fact that a loan’s amount does not change from year to year. If you borrow $200,000 today and don’t make any principal repayments, in 20 years’ time you will still owe $200,000.

But we know that over time, due to the impact of inflation, our purchasing power reduces. A $200,000 loan in the mid-1980’s was a big deal. Today, it is considered a small loan. Whereas a loan for $1 million today is regarded as a big loan. However, in 20 years, a $1 million loan will be equivalent to $670,000 in today’s dollars (assuming an inflation rate of 2% p.a.). And only $550,000 in 30 years.

Because interest rates include the cost of inflation, and investors pay for that each year, in real terms, the value of their debt reduces over time.

It magnifies your return on equity

Using some borrowings to fund the acquisition of an investment means you can contribute less of your own cash. For example, assuming interest rates are 5% p.a., if you contribute 60% of a property’s price in cash (and borrow the remaining 40%), I estimate the investment will be break-even from a cash flow perspective. That is, the rental income should be enough to pay for the property’s expenses and interest costs.

If you retain this $750,000 property for 20 years and it appreciates in value by an average of say 7% p.a., it will be worth circa $2.9 million. I estimate that the investor would crystallise approximately $2.05 million of cash after selling the property (net of costs, repaying the loan and CGT) after 20 years. So, the initial cash contribution of $450k (60% of the purchase price) has grown to $2.05 million after 20 years. That equates to a compounding annual growth rate of 7.9%. Without any gearing, the net return would have been only 5.9% p.a. So, the existence of a modest gearing rate (40%) has increased the investors return on equity by 2% p.a. This is the power of gearing.  

Return on cash is even more impressive

What if you don’t contribute any of your own cash savings when you purchase the property? That is, you borrow the total cost. In this situation, your only cash contribution will be to fund the holding costs. That’s because if you borrow 100% of the acquisition costs, the property’s income will probably not be enough to pay for its expenses and loan interest. As such, you will have to contribute some of your salary income towards meeting these expenses.

I estimate the cash flow holding cost of a $750,000 property to be conservatively circa $175,000 after-tax over 20 years. If you sell the property after 20 years, you will walk away with $1.58 million in cash after repaying the loan, selling costs and CGT. Therefore, your cash contribution of $175,000 over 20 years has generated net cash gain of $1.58 million. That equates to an annual compounding rate of return of 11.6%. That is referred to your return on cash, since you didn’t contribute any equity (cash) at the beginning.

Gearing allows you to invest your future income today 

What do you think is a better strategy? Option one is to invest $20,000 each year for the next 30 years i.e. $900,000 in total. Option two is to borrow $900,000 and invest it all today and then repay $20,000 of the loan each year for the next 30 years. You don’t need to be a mathematician to realise that investing the lump sum today will likely yield much better results. 

This is the power of a gearing strategy; borrowing your future expected surplus income and investing it today. This allows you to enjoy the benefits of compounding capital growth.

An alternative way to look at a gearing strategy

The traditional way to look at a gearing strategy is that you borrow money to buy an investment and then, over time, you gradually repay the loan. One day, you plan to own the asset and be debt free.

An alternative way to view borrowing is that it allows you to own an asset for a finite period of time and enjoy the investment returns over that period. Then, one day, you will eventually sell the asset and repay the loan. This strategy doesn’t assume that you will ever make any repayments towards the loan. The loan is merely a financial facility that allows you to hold an asset and participate in its appreciation in value over time. Given how expensive property has become in blue-chip locations, I think a growing number of people will adopt this approach.

A gearing strategy only works if you do two things successfully

It is foolish to believe that borrowing to invest is a guaranteed way to build wealth. In fact, the reverse is true. In my experience, the majority of investors achieve very poor results.

I have said many times that investing successfully is not difficult. It is routed in simple logic and evidenced based strategies. This is simple to understand but now always easy to implement correctly.

If you are going to borrow to invest, you must do two things very well:

Step 1: Borrow safely

Investing is a marathon, not a race. Building wealth safely takes time, often many decades. The aim is to enjoy the process i.e. spend a little today and save a little for tomorrow. This means its critical to borrow within your safe limits. Be prudent. And always consider possible changes.

But most importantly, it is prudent to prepare for unexpected changes. No one could have predicted the coronavirus a year ago. Or the oil price shocks that occurred a few days ago. The point is that you have to be careful and to some degree, expect the unexpected. It is the unpredictable events that cause the biggest shocks to markets and volatility. That is not to say that you should be controlled by fear – quite the opposite. My point is that borrowing conservatively is typically the most sensible approach.

Step 2: Quality assets + low volatility + patience

The second thing you need to do is invest in the right assets and have patience.

Assets that have lower levels of volatility are better suited to gearing strategies. Lower volatility means values/prices are more stable. The share market has a historic volatility rate of about 20% whereas residential property has a volatility rate of 10% (see page 80 of Investopoly). This is why people typically feel more comfortable borrowing to invest in property compared to shares.

It stands to reason that you cannot expect above average investment returns from average quality investments. The quality of your investments will determine your investment returns. So, if you are going to borrow to invest, make sure you invest in the highest quality assets your budget will allow.

The last element is patience. Few people get rich overnight. It typically takes many decades of astute decision making and the fortitude to ride out any challenging times (which share market investors are currently experiencing).  

Low rates and higher growth

A few weeks ago I wrote a blog that highlighted how cheap money is at the moment. For example, a $800,000 investment property costs only $6,000 p.a. to hold. Because of that, borrowing to invest has never been a more powerful and effective strategy.

Of course, if you need help working out your personal borrowing strategy, don’t hesitate to reach out to our Associate Director, Jodi McKeown.