Gearing used correctly, is a powerful tool for any property investor.
This blog about financial gearing is split into three sections:
- What is gearing?
- How can gearing boost capital growth?
- Gearing: a property crowdfunding example
What is gearing for property investments?
Gearing an investment requires combining your own capital (money) and borrowing funds, which form the capital for an investment. Gearing is best explained in terms of the debt to equity ratio. The debt to equity ratio can be used to understand how much debt proportionally an investor combines with their own capital. A ‘highly’ geared property investment occurs when an individual borrows in a relatively high proportion compared to the equity he/she contributes to an investment – a ‘low’ geared invest is the exact opposite.
How can gearing boost capital growth?
Gearing enhances the effect of the market in determining capital growth. For the simplest example, let’s assume an investment in a property, in which no tax is paid and no dividend is generated. If an investor contributed £10,000, borrowed £90,000 and bought a property for £100,000 the debt to equity ratio would be 1:9 – indicating the investment is highly geared. In this example, if the property increased in value by 10%, the investor would see a return of 100%. Put simply, gearing has the power to greatly boost capital growth. Unfortunately, the reverse is also true. If the same property saw its value decrease from £100,000 to £90,000, the investor would lose all (100%) of their capital. Therefore, the higher an investment is geared, the higher the potential return and risk. Finding the optimum debt to equity ratio is challenging because nobody can predict the exact behaviour of the market – hence, deciding the best gearing ratio will largely be determined by your appetite for risk vs reward.
Gearing: a property crowdfunding example
Gearing’s power to boost capital growth can be applied to property investments made via a property crowdfunding platform. Using property crowdfunding, investors can invest in large-scale high-return properties by combining their equity investment with other investors’ funds. Investors get a share, proportional to their contributions, of the capital growth and dividend payments made from their combined investment. Additionally, using a property crowdfunding platforms allows for easy diversification and improved accessibility to property investments
The graph below displays gearing’s ability to boost capital growth for property crowdfunding investments. In this example, no dividend is payed and financing costs are not considered. We assume a pool of investors, using a platform, invest in a share of a property investment worth £2m. As we vary the debt to equity ratio, it becomes clear that higher geared investments generate more capital growth than lowered geared investments (assuming a positive property growth of 7%). When no gearing is present (0 : 1, debt : equity), returns are limited to the growth in the value of the property, 7%. However, with the gearing effect at its highest (0.75 : 0.25, debt : equity), investors’ equity growth is 28%, despite the value of the property only increasing by 7%.
Of course, the impact of gearing has mirror effect of multiplying negative equity growth. Additionally, the cost of financing must also be considered in determining the ideal gearing ratio – we will feature a future article on how different tax arrangements and the Bank of England base rate affect this.
In summary, the ideal ‘level’ (ratio) of gearing must balance risk appetite, reward potential and the cost of finance. A notable advantage of investments made through a platform is that property managers decide all these variables for you, making platform investments an easy way to earn passive income