Risks of gearing
We generally encourage clients to gear investments, particularly ‘representative assets’ such as blue chip shares (often held through a broad-based, index-based managed fund) and properties. Provided common sense is used, and a very long-term view taken, these investments will probably do very well.
But there are some risks. The Australian Financial Planning Handbook 2015-16 (Thomson Reuters) identifies 6 main gearing risks. These are:
- the risk that the investment’s value will fall;
- the risk that interest rates will rise, causing net returns to fall;
- the risk of a margin call, or some other form of equity contribution being needed to preserve the lender’s required debt to equity ratio;
- timing risk, ie the risk that income may lag behind interest payments causing stress;
- occupancy risk, ie the risk that a suitable tenant cannot be found or that a tenant will damage the property (only applies to geared property investments. obviously); and
- other risks, such as losing income due to unemployment or incapacity.
Noel Whittaker, in his book “Golden Rules of Wealth” (Simon and Schuster 2011) dedicates chapter 32 to a vigorous argument for never guaranteeing someone else’s loan.
We agree that clients should not guarantee someone else’s loan if they are not related to (and fond of!) that someone else. What’s the point of doing that? It’s all risk and no return. If the borrower defaults the bank will look to the guarantor first, since the guarantor normally has the deepest pockets.
Yes, the guarantor can recover from the borrower under the doctrine of subrogation, but its complex, may involve legal action and what happens if the borrower just can’t pay? (They did need a guarantee, after all).
It’s a good idea for clients to have a policy of not guaranteeing someone else’s loan. For example, clients may be asked to guarantee a friend’s loan for a business premises. Our advice to clients: don’t be intimidated or ‘guilted’ into it: if the friend says they will lose money if the client does not give a guarantee, it is almost certain the client will lose if they do.
Guarantees for a client’s spouse/life partner are a different matter. Both partners are a single economic entity and the bank will see them as in effect one client. If say the husband wants to borrow say $200,000 to buy $200,000 of shares, and offers the family home, value $650,000, as security, then realistically the bank will want a spousal guarantee particularly if the home is co-owned by both spouses.
This is fair enough. Both spouses benefit if the shares increase in value, and both spouses should secure the loan. The bank is not being unreasonable. Of course, occasionally one partner may not agree gearing shares is a good idea. Here the unhappy partner should refuse to sign the guarantee. Obviously both spouses need to agree with a big decision like this. Clients won’t go broke not offering the family home in a guarantee. But they might go broke if they do; and if one partner did not want the guarantee in the first place, they might find themselves broke and divorced.
Guarantees for a client’s children are a different matter too. We frequently suggest clients volunteer to guarantee loans to adult children as a fast track to entering the property market years earlier than otherwise would be the case. In June 2015 the Melbourne median home price was more than $670,000 and the Sydney median home price was more than $1,000,000. That’s a lot of loan. How can an average income 30-year couple wishing to start a family buy a home without parental support? The advice to clients: Take care, and make sure your adult child is buying sensibly.
Limited guarantees are a great idea here. The bank limits the guarantee to say 30% of the amount borrowed. This 30% guarantee takes the place of owner’s equity, and means the bank has met its normal debt to equity ratio of say 70:30, and is adequately secured.
Benefits of gearing
Clients who borrowed money to gear sound investments in the past two decades or so have mostly done very well. Many wish they had geared more investments. Those clients who lost money tended to sell too quickly. They did not fully appreciate that property and shares investments are long term (at least two decades) and a year or two of poor performance does not mean they should be sold.
Other clients just made poor investment decisions, but they tend to be in the minority. Diversification is the key, reducing the prospects of being left with just one or two poor performing assets.
It is hard to accumulate significant wealth without taking on at least some debt for some time. The amount of debt is a personal choice, and reflects an underlying view of, and attitude towards, risk.
Clients who take on debt to invest will probably end up wealthier than those who do not. But there are no guarantees.
If you need wish to understand more about borrowing to invest, get a copy of Borrowing to Invest: The Fast Way to Wealth. A User’s Guide for Borrowers, by Noel Whittaker and Paul Resnik (Simon & Schuster, 2002). No-one can accuse the authors of not being conservative, and they are elder statesmen in the financial advising community.
Their opening paragraph reads:
Are you prepared to use other people’s money to build a better life for yourself? Have you stopped to think about what will happen if you don’t? Chances are you would never own your own home. Every mortgage is, after all, built on someone else’s money. And, unless you are heir to a fortune, it’s just as likely that your years in retirement will be years of watching the dollars.
In Personal Finance for Dummies financial journalist Barbara Drury explores similar thoughts:
Many people still feel uncomfortable about borrowing money to invest, a practice referred to as gearing. Yet the same people cheerfully borrow to the gills to buy their own home because they understand that the only way to own such an expensive asset is to use other people’s money.
Borrowing to buy growth assets, such as shares or property, and using your own cash or equity in your home as a down payment, helps you increase your returns. You make a profit as long as the investment returns (income plus capital gains) are greater than your interest payments. Say you have $10,000 and borrow another $10,000 at 8% interest to buy shares with a dividend yield of 4%. The dividends of $400 cover your interest payments but you stand to make double the profit when you sell the shares because you bought twice as many shares as you could have done with your own money.
Gearing can substantially increase long-term investment returns, but it magnifies the potential risks as well as the potential rewards. If you choose to gear into shares or investment property, invest in a diversified portfolio of high-quality assets that have the best chance of producing solid capital growth over the long term. Never gear to invest in speculative investments, or to avoid tax.
An economically rational investor will be prepared to negatively gear an investment if the expected after-tax return, including capital gains, is greater than the expected after-tax cost of holding the investment. The after-tax return will usually be made up of the income from the investment (rents, dividends, or distributions, depending on the investment), and the increase in value, or capital gain, over time. Income can usually be predicted with reasonable certainty. Capital gain is the wild-card. No one knows the future, so the best you can do is expect a capital gain. This is where investing becomes an art rather than a science, as expectation will be the critical issue.
The Australian Master Financial Planning Guide 2015/16, published by CCH Australia, provides a useful example of how gearing engineers a greater return for the investor:
An investor has several options, based on an initial investment amount of $40,000:
- Investing $40,000 as an ungeared investment.
- Investing $80,000 as a geared investment with borrowings of $40,000.
- Investing $120,000 as a geared investment with borrowings of $80,000.
- Income from the investment is 4%.
- Capital growth is 5%.
- Interest on borrowing is 7%.
The results are as follows:
Ungeared Geared Negatively geared Equity invested $40,000 $40,000 $40,000 Borrowed Nil $40,000 $80,000 Total invested $40,000 $80,000 $120,000 Income received $1600 $3200 $4800 Less interest paid Nil $2800 $5600 Net cash flow $1600 $400 $800 Capital growth $2000 $4000 $6000 Total return $3600 $4400 $6800 Equity invested $40,000 $40,000 $40,000 Return on equity invested 9% 11% 13%
The example shows that the more the investment is geared, the greater is the return on equity invested, assuming capital growth of 5%. Clients should realise the assumed income levels and capital gains amounts are conservative. Long-term earnings rates are actually much higher, at 9%. Most clients who geared investments over the past two decades got better results than this.
The author also shows:
what would happen if the market value goes down by 5% rather than increasing by 5%. The revised table looks like this:
Ungeared Geared Negatively geared Equity invested $40,000 $40,000 $40,000 Borrowed Nil $40,000 $80,000 Total invested $40,000 $80,000 $120,000 Income received $1600 $3200 $4800 Less interest paid Nil $2800 $5600 Net cash flow $1600 $400 $800 Capital growth ($2000) ($4000) ($6000) Total return ($400) ($3600) ($5200) Equity invested $40,000 $40,000 $40,000 Return on equity invested (1%) (9%) (17%)
It is best to keep to sensible debt levels, manage interest costs and favour higher income- yielding investments if the down side of debt is to be avoided.
The Australian Master Financial Planning Guide 2015/16 says:
An investor should only make a negatively geared investment if:
- The investor has secure and permanent income from other sources sufficient to cover living expenses as well as the shortfall under the negative gearing.
- Where the gearing arrangement or borrowing includes a liability to make margin calls in certain circumstances, the investor can satisfy the margin calls by supplying further security or by payment from other sources to avoid the possibility of a forced sale [keep in mind that the economic conditions that lead to the need for a margin call will, almost certainly, mean that any forced sale will be at depressed prices and will lead to a significant loss to the investor].
- The investment is made on the understanding that it will be retained for at least 5, preferably 10 years or longer.
- The investment and borrowing have sufficient flexibility to cover events such as death, disablement, major illness or redundancy, the first three of these would normally be covered by insurance or super benefits and redundancy could be covered by an employer pay-out. However, even in these circumstances the negative gearing arrangement may need to be terminated. Check whether this can be done without incurring penalties and with the flexibility to avoid suffering loss through a forced sale of the asset.
- There is flexibility to cover changes in circumstances, such as a transfer overseas (where the tax advantages may not apply) or divorce.
- The taxpayer can take full advantage of the tax deduction. Negative gearing normally works best for investors on the highest marginal tax rate but may be of less value to low tax-rate or non-tax-paying investors.
The author warns of the danger of negatively gearing into an already geared investment, such as a listed company or a property trust. This increases both the up-side risk and the down-side risk even further.