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I was asked by a Hudson member this week whether they should seek to gradually convert their property portfolio to being positively geared, so as to generate a passive income for them in retirement. This is a good question and an important consideration for anyone with an investment property portfolio.
There will always be the opportunity to reduce the debt you have against your investment properties through time, so as to gradually convert them from being negatively geared, to neutral, to positively geared and providing you with an income. You can pay the debt down gradually using surplus income, or sell a property at some stage, realising some gain and doing likewise.
HOWEVER, I would argue that the key question is not how to do this, but whether or not this is something you should be striving to do.
While working and in “accumulation” phase I would argue that assuming your taxable income is going to be anything in excess of $37,000 per annum, that the best scenario for you is to have negatively geared properties (or at the least NEUTRAL) and to reduce your taxable income to as great a degree possible, within the limits of your cashflow and lifestyle needs. It is through doing this that you strive not for income, but for increased exposure to the property market and for capital growth.
Once you approach retirement, this does of course change. The aggressive nature of gearing to invest and relying on an increase in capital growth to make investments profitable may no longer be appropriate. Secondly, if your taxable income is no longer as high as it used to be the gearing advantages may well reduce or no longer apply at all. Finally you may actually require an income from the investments to pay for your day-to-day living expenses.
Which begs the question of whether or not residential property is the best source of income in retirement, and generally speaking the Hudson Institute does not believe that it is. As stated, we do believe that in terms of capital growth and the ability to grow your asset base in time for retirement, residential property is potentially unparalleled. In terms of providing an income however property falls down in two distinct ways.
- Due to all the associated costs of property, the NET YIELD can often work out quite poor. Even assuming there is no debt against the properties, a 5% gross yield can quickly be eroded to say 3% once you take in to account rates, water, management, body corp and general maintenance. I would argue that there are lower-cost ways to have funds in growth assets, i.e. the share market.
- Furthermore, they are very illiquid investments. Therefore, should the above happen and there comes a point a few years in to your retirement where the net yield is not adequate to fund your retirement, a sale will be required, and you cannot sell a room or a floor of the property, you have to sell the whole thing. You are then left with a lump sum of funds that you potentially cannot put in to super and may even have a tax implication on the earnings outside of super.
A few possible exceptions whereby people should be looking to achieve positively geared properties while still in the workforce is if a) you have sufficiently low income that gearing is not viable, b) you are involved in commercial property which tends to have a focus on income as opposed to capital growth, or c) you are investing in a SMSF and therefore you cannot gear against other income in the trust and are looking to create tax effective income. With this last example however I would say due to the various cost disadvantages of doing property within a SMSF (higher interest rates, set up of bare trust, accountancy and audit etc) that you are usually better off focusing on individually owned property.
There is no right or wrong answer when it comes to whether to have a positive or negatively geared property. As long as you are aware that seeking positively geared property is a less aggressive approach and although will improve existing cashflow, will ultimately result in less exposure and therefore less capital growth in the long-term.