If you’ve been doing any kind of research into property as an investment, you might have come across the term ‘gearing’ at one point or another. It’s widely regarded as one of the main reasons property is such an attractive investment.
But what is gearing? And how does it actually work?
Bill Rawson, Chairman of the Rawson Property Group, says to understand what gearing is, first take a look at a conventional investment like a savings account. If you want to earn interest on R1 000, you have to put R1 000 into the account. Your money is the only money that is working for you. This applies to most investment types, but not to buying property, he says.
The difference with property is that you can finance your investment, at least partially, through a bank, giving you access to an asset worth far more than you could afford on your own, says Rawson.
In other words, to buy a house worth R1 million, you may only have to put down R100 000 in cash. Should that house increase in value over time, any profit on the sale, after paying back your loan, is yours.
Rawson says it’s a little bit like getting the interest on R10 000 in your savings account, even though you only put in R1 000. Why? Because it’s no longer just your money working to earn profit; gearing allows you to put the bank’s money to work for you as well.
An example of a successful gearing investment can be seen at Rawson’s The Beaumont, in Rondebosch. He says a buyer bought a property off-plan, before the building’s construction started, for R1.5 million. The buyer had to put down R150 000 as a deposit and he used R1.35 million of the bank’s money in the form of a mortgage bond.
Eighteen months later, once the development was built, he sold the property for R2.5 million. The buyer had to pay a deposit, his credit for the 18 months, and a few related fees for things like attorneys. In return, he made upwards of R700 000 in profit.
That is the essence of gearing; using other people’s money, or financing, to increase the size of an investment in order to increase the returns on your own capital outlay, says Rawson. Preferably without incurring too many additional costs that eat into your profit at the end of the day.
Speaking of costs, it’s important to acknowledge that gearing isn’t a guaranteed money-making machine. Rawson says borrowing money isn’t free and not every property will increase significantly in value over time, so it’s important to investigate your costs and risk factors before committing to a purchase.
He says things like interest rates can impact on the profitability of gearing quite dramatically, as they directly affect the cost of property investments.
According to Rawson, a great way to mitigate risk and decrease your costs is to use gearing to buy an investment property with the intention of renting it out.
“This not only gives you access to all the gearing benefits of a mortgage, but it also allows the property to cover a portion, or all of its own expenses.”
Ideally, the rental you charge on the property should be equal to or greater than your mortgage repayments. This can be difficult to achieve however, and is not essential for the investment to be a profitable one.
Done right, he says gearing can be the leg-up you need to invest in a high-value asset and achieve high-value returns. It’s an opportunity limited almost exclusively to property, which is why property can be such a great investment choice.
It’s still important to invest wisely, so do your research into the property market before you buy, says Rawson.