Understanding the mathematical power of gearing

power of gearing

It’s stating the obvious to say interest rates are very low at the moment. But what can be easily underestimated is how powerful low rates can be for investors. Low rates magnify the power of gearing. And arguably, the next few decades could provide the best opportunities in a lifetime for investors, if they are diligent and invest in high quality assets.

When will interest rates rise?

That is the million-dollar question. The short answer is that no one really knows. But we should remind ourselves that interest rate expectations can change very quickly, so we must factor that into our investment decision making. That is, make sure you can afford higher loan repayments when rates eventually rise.

The RBA has been very firm in regard to its intention. It has said that it will not raise rates until the inflation rate rises above 2% p.a., which it does not expect will occur before 2024. Therefore, it seems variable rates are on hold for at least 2.5 more years.

We should consider the level of government indebtedness and the impact rising interest rates will have on the budget. Economies can become reliant on low interest rates – look at Japan as an example. It has been stuck on zero interest rates for more than 20 years.

For what it’s worth, my view is that variable rates probably won’t change materially over the next 3 to 5 years. Beyond 5 years, they are likely to rise but probably at a relatively slow pace. It is quite difficult to fathom rates rising above 5-6% p.a. over the next few decades. Low rates could be the “new normal”.

Simple math proves the power of gearing

Investors can lock in an interest rate for 5 years at 2.69% p.a. with interest-only repayments. I think we can all agree that is low (especially compared to early 1990’s rates, as shown in this image doing the rounds on social media).

Assuming you have a surplus annual cash flow of $25,000 to invest, you have two obvious options:

  1. Invest it incrementally each year in an investment such as a share market index fund; or
  2. Borrow a lump sum, buy an investment property and use the cash flow to pay for its net holding costs.

If you chose the first option and you received a return of 10% p.a. over the next 20 years (which would be a very good outcome), your investment would be worth almost $1.45 million (equivalent to circa $880k in today’s dollars).

If you chose the second option, you could purchase an investment property for $1.2 million. Because fixed interest rates are so low, the cost to hold this investment would be circa $7,000 p.a. after-tax. But you could retain the balance of your surplus cash flow ($25,000 less $7,000 = $18,000) in the loan’s offset account to provide for future interest rate increases. This option would be superior if the value of your investment property appreciated to be worth approximately $2.5 million in 20 years’ time. That equates to a compounding growth rate of only 3.8% p.a.

Assuming you buy a high-quality, investment-grade property in a blue-chip location with strong fundamentals, what’s the chance of it appreciating by at least 3.8% p.a.? It’s almost certain, isn’t it?

What if property appreciates by 6% p.a.?  

Continuing with the above example, if the property actually appreciated by 6% p.a., your equity would be worth $2.75 million in 20 years.

To achieve the same return using the first option (i.e. no gearing), you would need to generate an average compounding return of at least 15.4% p.a. over 20 years. Historical returns indicate that this target would be considered overly ambitious.

In addition, if you select well, it is my view that there is a very high probability of a quality property producing a capital growth rate materially above 6% p.a. For example, the long term average median house growth rate over the past 40 years is circa 7.5%.

And what if the growth rate is above 6% p.a.?

It is probably not unreasonable to expect a growth rate of close to 8% p.a. over the long term. Remember, this is only marginally above the median rate.

If you do achieve a growth rate of 8% p.a. over 20 years you will have over $4.5 million of equity in the property. To generate that using the first option, you would need to generate a return in excess of 19.5% p.a. over a 20 year period. I think you would agree that whilst it’s not impossible, it is very unlikely.

Of course, gearing is not for everyone

Whilst mathematically gearing is a very powerful strategy, it is not appropriate for everyone.

There are a number of matters you must consider to determine whether gearing is right for you, including proximity to retirement, future income stability and predictability, your equity position, the quantum of existing borrowings and so on.

Mortgages are fantastic servants, but terrible masters, so do not over-borrow.  

The importance of playing the long game

There are always reasons to delay investing. Over the past 20 years since founding ProSolution, there has never been a perfect time to invest where all the signals were green. There’s always uncertainties with either your personal situations and/or markets.

At the moment, investors could be concerned by the impact of money printing by central banks around the world (i.e. quantitative easing), how long it will take the global economy to recover from Covid, high share market valuations (which I discussed last week) and the list goes on.

The only solution to this is to change your perspective. Think in terms of decades, not multiple months or years. What can you invest in today that is likely to be worth 3 to 4 times more in 20 years? For example, if you buy a quality property with a strong land value component in a blue-chip suburb, do you think it’s going to be worth substantially more in 20 years from now?

Focusing on the long term invites you to drown out all the short term noise and base your decisions on long-term fundamentals.