by In2assets  |   October 10, 2022

The Power of Gearing

By Grant Gibson Often when chatting to friends and colleagues, a general misconception is a fear of borrowing money. Forgive me if I am a bit biased after my previous career, but I believe the above could not be further from the truth. It also comes down to understanding debt, what it can unlock and using it wisely. For example, it is never a good idea to run up a massive credit card debt if you do not have the means to settle it immediately. But debt supported by properties can be a good thing, despite what happened in 2007/2008 and the world economic crisis. But new controls in the banking space should hopefully prevent this from happening again.

There is the obvious reason around buying your own home, and if you had to wait to save up enough cash to buy a R1 000 000 home, it would take you a lot longer compared to saving up for a R300 000 deposit, borrowing the balance from a bank and paying it off over time. Yes, it costs you more in interest, but it works as a forced saving which is always a good thing, and hopefully the property value increases with time. You can view the interest as the cost of occupying the home if you like. This can therefore prove to be a reasonable investment, while forcing you to save money into a historically secure asset class, at the same time as providing a home for you and your family to live in. And let’s not forget the age-old adage of not paying off someone else’s bond while you rent. 

I will get into the argument on renting your home vs buying your home another day. But for now, both sides do have merit and personal circumstances will always dictate the right answer for any individual.

But the power of gearing really comes into its own when you are looking at investment properties. Property has historically been a favourable and secure asset to gear against especially when buying properties in the right locations. This is because you are purchasing an asset that can be rented out and generate cash flows. Cash flow is the key in all of this, as it can be used to service the debt and hopefully places no additional restraints on your existing salary and living costs. If there is no cash flow for a sustained period, the banks still have a bricks and mortar asset that should always attract some sort of value, thereby providing them a way to recover the outstanding debt, and hopefully more, in the event of clients defaulting on instalments for sustained periods of time. Therefore, there should hopefully be no need for you to chip in for any shortfall after the bank has sold your property.

The Reserve Bank also views debt that is secured by property to be a safer form of debt which allows banks to reserve less shareholder capital against property loans. This means they can offer lower interest rates compared to deals backed by shares in companies or personal guarantees. I hope this ramble makes some sort of sense. But the bottom line is that banks have historically favoured property debt.

The real kicker is that property debt can be used to enhance actual return on your equity and spread your risk when it comes to property investment. 

Let’s assume you have R1 000 000 cash available, and your two options are to put it all into one property OR to use R700 000 worth of bank debt to purchase the property and you only put in R300 000 cash.

If you put all your cash into the deal, the following happens:

  • You have put all your eggs into one property therefore increasing the potential risk of tenant default and having zero cash flow with no cash safety net;
  • You have locked in a total first year return of 14.75% (income and capital returns added together), which then increases at about 7% - 8% per year, not such a bad return; 
  • You are paying income tax on the full income amount; and
  • You have no more cash reserves for a rainy day.

Alternatively, if you borrowed R700 000 the following happens:

  • You can use your R1 000 000 to purchase 3 of the same properties and borrow R700 000 against each asset;
  • This spreads your risk across three assets instead of lumping it all into one;
  • You will still have R100 000 left over for a rainy day;
  • The interest you pay to the bank is tax deductible;
  • Your first-year total return from the property is nearly 13.5%. Slightly lower than above but this grows by 15% in year 2 and thereafter increases exponentially year on year. This return is driven by the cash flow from the property paying off the bank debt each month, and the capital value of the property increasing;
  • If you decide to keep your R700 000 and earn the interest on your deposit, your real first year total return is nearly 20%. This total return also then grows at an exponential rate.

The above points are all pre-tax returns, but the difference just gets better if you compare the after-tax returns because the interest is tax deductible.

The biggest difference comes with time, towards the end of the ten-year loan term, your capital return plus your year 10 income return is over 200% when borrowing from the bank versus 72%* if you only used cash.

I have said for a long time that getting property investment right is not that difficult. But at the same time, it can be very easy to get it wrong. Sadly, the consequences for getting it wrong can be serious because you are essentially investing the banks money, and they always want to get their money back which can get ugly if things go pear shaped. 

It is always wise to do a thorough due diligence investigation on any property investment you are looking at, and chat to any qualified property professional that I am sure you have somewhere in your networks. Look at purchase prices compared to realistic market related rentals and your expected yield. Look at the perceived rental demand for the type of property you are buying. Analyse your expected expenses so that you are not caught out down the line. 

The fundamentals are the same for most types of properties, so my only advice would be to seek advice from the friendly and qualified people around you. But do not be scared to use debt, just use it wisely.

* With constant assumptions and interest rates. This gap will be smaller if interest rates increase.