What is negative-gearing? and how does it affect my investment property?

When you first start learning about property investment you might think: “Great, I’m going to have a tenant paying off my mortgage. Easy!”

But in truth that’s not how the numbers work … most of the time (at least at the start).

For recently acquired investment properties often your rental income won’t cover your mortgage and all the costs to run a property.

What this means is investors have to contribute some of their own money to “top-up” the property and cover the cashflow shortfall.

This is called negative gearing. And a property that requires topping up can be called “negatively geared.”

But there are different perspectives on negative gearing. So, in this article you’ll learn what negative gearing is, what it means, and how properties that are negatively geared make money.

What is negative gearing?

The term negative gearing is a piece of jargon commonly used in property investor circles.

All it means is you have a cashflow shortfall between what the property makes in rent and the property’s costs/expenses.

For instance, let’s say your rental property makes $25,000 in rent each year, but your expenses tally to $30,000.

This means your property is negatively geared by $5000. So, you as the investor will have to contribute the shortfall out of your own pocket. This is known as “topping up”.

Negative gearing tends to happen when an investor borrows all of the money to purchase a property and doesn’t use a cash deposit.

So, let’s say you borrow the deposit for an investment property against your own home and you buy an investment property with 100% lending. As the biggest expense you have in investment is the cost of your mortgage, it’s likely your property will be negatively geared – especially at today’s interest rates.

Not always, but likely.

In this case you’re likely going to have to top your property up by a certain amount of money each week, at least in the short term.

How do I make money if a property is negatively geared?

Some investors then wonder: “If my property is negatively geared, how do I make money?”

The largest return an investor gets from property is the long-term increase in value – the capital gain.

Because properties are high-value assets, a small increase in the value of the asset (in percentage terms) can mean large increases in the investor’s wealth.

For instance, if a $1 million property increases in value by 10%, that means the investor gains $100,000 in capital gains.

So while an investor might top up a property by $100-$200 a week, this cash input is often outweighed by the increase in the property’s value.

For instance, here is an example of a $650,000 property that is negatively geared by $100 a week. In this example the property increases in value by 5% each year.

This is a much lower figure than the 20-year New Zealand average of 8.35% (REINZ HPI March ’02 – March ’22).

See how the increase in the value of the property per week is much larger than the amount the investor is putting in to top it up.

So, put simply, property investors can still build their wealth through the property increasing in value.

What sort of top-up should a property investor expect to invest?

What your “top-up” should be depends on a lot of factors and how you set up your property (more on this below).

That said, based on today’s market conditions here are some ballparks for what you can expect your top-up to be over the period where a property is negatively geared:

• A 2-bedroom townhouse in Christchurch will usually require a top-up of $150-$200 a week.

• A 3-bedroom townhouse in Auckland will be around $100-$200 a week.

• A dual-key apartment or dual-key townhouse in Wellington will likely be negatively geared by $25-$75 a week after you’ve initially made the purchase.

These are averages only. And the cashflow of an investment property will be different year-to-year, depending on what happens to interest rates.

For instance, here is an example of projected cashflow for a 3-bedroom townhouse in Auckland purchased by investors for $859,000.

See how the top-up required from the investor spikes in the first few years? That’s because interest rates are projected to increase.

That top-up then comes down as interest rates level out (as inflation declines).

To learn more about how to smooth out these top-ups listen to this episode of the Property Academy Podcast. Here, we share 7 strategies you can use to manage your property investment top-up.

See how the top-up required from the investor spikes in the first few years? That’s because interest rates are projected to increase.

That top-up then comes down as interest rates level out (as inflation declines).

To learn more about how to smooth out these top-ups listen to this episode of the Property Academy Podcast. Here, we share 7 strategies you can use to manage your property investment top-up.

And the reasons for properties being negatively-geared?

Cashflow is influenced by a whole heap of factors – and we’ll list a bunch of them below.

But the top thing it comes down to is your choices as a property investor. There are trade-offs that you make as an investor.

If you are following a passive buy-and-hold strategy based on New Builds, then often you can only choose two of the following:

For instance:

You can have a property where you don’t use a cash deposit (i.e. use all the bank’s money to buy it) and you can buy a high capital growth property, but you will often need to top that property up.

Alternatively, you can buy a high capital growth property that has positive cashflow, but you will need to put in a cash deposit to reduce your mortgage costs.

Or, you could buy a cashflow positive property that doesn’t require a cash deposit, but you’ll sacrifice on capital growth (since you’ll need to buy a higher-yielding property).

So, the first reason that your property might be negatively geared (if you’re using the passive buy-and-hold strategy) is that you are:

• Using all the bank’s money to invest, and
• You are purchasing a higher capital growth property.

This simple model can help you think through the trade-offs you’re making in your property investment approach.

But, as we said, there are many other reasons why the investment property you already own is negatively geared. Some of them you can control; some of them you can’t.

Here are the top 6 reasons your property might be negatively geared.

Reason #1 – You haven’t owned it long enough

Rents tend to increase faster than your costs as a property investor.

By this we mean if you hold onto your property long enough it’s likely that your rent (which over the long run has tended to increase by 4.8% a year) will eventually outstrip your costs. This means that your top-up requirement will naturally dissolve over time.

At the time of writing, interest rates are high and yields are low. So, if you’ve just bought yourself a new, growth property the chances are you are going to have to top-up to cover your costs for the initial few years.

Reason #2 – You haven’t kept up with market rent increases

If you are currently charging below-the-market rent, this is likely to be contributing to your negatively-geared status. Less rent means less money to cover costs.

This is the main thing that a lot of investors trip up on. To give you a sense of how fast rents are currently rising in New Zealand, here’s a map of where rents are rising fastest.

You can use this to figure out whether you have been keeping up with the market rent in your area.

Reason #3 – You’re paying principal and interest on your mortgage

Most investors elect to get an interest-only mortgage to keep their repayments low.

However, there are some investors out there who pay principle + interest on all their investment properties, which means their payments to the bank are significantly higher.

Investors who already have a mortgage on their own home tend to focus on paying down their personal mortgage. They then often go interest-only on their investments.

Reason #4 – Body corporate fees have hiked

Older buildings often require more maintenance. These body corporates will often have a “sinking fund”, also known as Long Term Maintenance Fund, and this covers long-term, expensive costs.

Some older apartment buildings we’ve seen have body corporate costs up to $6,500 per year to contribute towards those long-term funds.

But let’s say you’ve got an apartment in an older building that doesn’t have a sinking fund. This could be an extra expense that is sending your costs way too high.

Reason #5 – You’ve got a lot of debt

Let’s say you’ve restructured your debt to have the majority of it hanging over your investment properties, as a way of shifting it away from your personal home.

This will increase the mortgage costs associated with your investment properties, but will lower them on your personal home.

So while your investment property might now be negatively geared, you might be better off overall, since your personal mortgage repayments will have fallen.

In this case making your investment properties negatively geared could be the right thing in the context of your entire property portfolio.

Reason #6 – You’ve got a growth property

As we mentioned above, there are typically two property “types”: Growth and Yield.

The first increases in value fast but doesn’t achieve high cashflows. The second achieves better cashflow, but doesn’t grow in value as quickly (“yield”).

There is often a trade-off between the two.

For example, a 4-bedroom standalone house in Grey Lynn is going to be a growth property. This means it’s likely to grow substantially in capital growth over time, but won’t have the greatest yield while you are waiting for it to naturally grow in value.

Arguments for and against negative gearing

Not everyone is pro-buying negatively-geared properties. And it should be said that not every negatively-geared property is a good investment.

So now let’s look at the arguments both for and against negative gearing.

Arguments for negative gearing

The type of people who are pro-negative gearing tend to take a passive approach to property investment. They invest in New Builds and hold for the long term while the market appreciates in value.

These sorts of investors don’t want to get their hands dirty renovating properties, and don’t want to manage a building project.

These sorts of investors are happy to fork out $150 a week for a property because they see property as the best alternative to invest.

For instance, if they were to invest in shares they’d need to put money in, either up front or a small amount each week (e.g. $150).

When considering the return they could get from property vs these other types of investments, there is the potential to get a better return through investment property.

For example, here is the potential returns from putting an investor’s top-up into property vs shares, vs other investment types.

In this example a property bought with a lot of debt is getting the highest return. Read our shares vs property vs managed funds vs term deposits article to learn more.

In other words – if you don’t have a cash deposit but you do have usable equity within your own home, you can purchase a property with 100% lending.

In that situation, you say, “Hey, I’m going to be negatively-geared for a few years but I get the benefit of owning an investment property.”

This means that no cash deposit has been used to secure the property and the only cash that has been put into the property comes from the investor's “top-ups”.

The return on these top-ups can often be substantial.

Arguments against negative gearing

Renovations-based or BRRRR property investors sometimes argue against negative-gearing.

Often these investors will purchase a property that would be negatively geared if rented out “as-is”.

They then renovate the property, adding bedrooms and sprucing the place up to increase cashflow.

In their minds these investors think: “If I can renovate a property and increase the cashflow, why wouldn’t I do that?” In that way they can hold the property without having to top it up.

Some of the investors who hold this view have larger portfolios (10 properties +). In this instance, it wouldn’t be practical to top up 10 properties by $150 a week each because that’s $1,500 a week.

So they are willing to put in the work to renovate and improve cashflow.

Should I buy a negatively-geared property?

The bottom line here is, not all your properties should, or will, be negatively geared.

But if:

• growing your wealth is your primary goal AND
• you want to take a passive strategy focussed on New Builds AND
• you don’t want to use a cash deposit (i.e. you want to use all the bank’s money to invest)

Then negative gearing will be necessary to achieve all these factors.

But, if on the other hand it is more important to you to have a cashflow neutral property, then that is perfectly achievable. You’ll just need to adjust some of the above factors, i.e.

• Focus on yield properties rather than growth properties, OR
• Renovate properties rather than investing in New Builds, OR
• Use a cash deposit

Ultimately all investments require you to put something into them. In property investment that’s either going to be a top-up, a cash deposit, or time and effort through renovations.

The good news is – you get to choose which one is best for you.

Write your questions or thoughts in the comments section below.