Gearing not Always a Plus

While gearing makes a good investment better, it also makes a bad investment worse. People who gear boost their risk.

In my last column, I wrote about a reader's investment in a rental property, and how it was not, perhaps, quite as good as he thought.

He borrowed the entire purchase price, of $35,000 in 1980, using his home as collateral.

When he sold in 1999, the property value had risen to $125,000 - a gain, I pointed out, of 7 per cent a year.

The reader contributed some cash, over and above rental income, in the first few years. Also, the depreciation he claimed was clawed back after he sold. Both of those reduced his return.

After reading this, several people emailed me, pointing out that, because the man put none of his own money into the investment at the start, his return was in fact much higher.

And that's quite true. I concentrated on what happened to the $35,000, when in many ways it would have been fairer to look at what happened to the smaller amount of money he put in over the years.

However, while I didn't acknowledge the benefit he gained from gearing, nor did I discuss the risk he took.

In Sydney, I hear, people who have borrowed against their home equity to buy flats are facing a shortage of tenants. Even after cutting their rents, some have no tenants for long periods.

Unable to cover the difference between the outgoings and income on the property, some landlords are being forced to sell for less than their purchase price. They can't then fully repay their mortgage, and are left owing the bank.

The same thing happened to some New Zealand landlords in the late 1990s. And there are rumblings of similar situations arising now or soon.

Our reader was lucky. But people who borrow heavily aren't always lucky.

Note, too, that gearing works on any investment, not just property.

Sure, some banks would baulk at lending money for share investments. But if you get a revolving credit mortgage, you can put the money into anything.

Let's say, for instance, that our man borrowed the $35,000 and invested it in a world index fund in 1980, and then sold enough units each month to pay the mortgage. He would have had about $207,000 in 1999 - much more than his property was worth.

I'm not saying he should have done that. For one thing, neither revolving credit mortgages nor investments in world index funds were easily available in 1980.

For another, that higher return comes with higher risk - as is always the case. Geared share investments are only for those who have the stomach to ride out market troughs and stay invested for decades.

I just want to point out that there's nothing magic about gearing property investments.

It often works well. As one emailer says, "For a small, semi-regular contribution the reader managed to put together a rather nice asset with no upfront."

But another emailer also sees the downside. "Without buying rentals to start with, and the drama that goes with them, I would never have obtained the money to make your theory work. This is valid for most of us who were born lacking the 'silver spoon'," he says.

But, he adds, "This is why we have this obsession with property, and is also why I believe that many will stumble and fall shortly with being over-geared."

You have been warned, and by a keen rental investor.