What is gearing?
The term gearing simply means borrowing money to invest; the more you borrow, the more you will pay in interest. If you have borrowed to invest and you're making a profit, you are positively geared. If you're making a loss, you are negatively geared – like many residential properties in the major Australian capital cities.
Gearing is a tool to accelerate the process of wealth creation by allowing a larger investment that otherwise possible. You can borrow for an investment property, a business or a managed fund investment.
How to use gearing
At Charter Hall, we use gearing to acquire assets that make up our funds. Our direct property funds have individual property values that range up to $150-200 million, and we borrow a portion of this, with the goal of providing investors with distribution and capital growth.
As gearing is a means of increasing returns, the caveat is that the higher the gearing, the more risk associated with the investment.Should property values take a negative turn at a critical time, investors equity can become diluted and their capital put at risk if the investment is too highly geared.
Gearing’s 4 key considerations
Not all property fund managers have the same gearing strategy. When assessing managers, you should look out for the following:
- Level of gearing As a rule of thumb, be wary of funds with more than 50% gearing. High gearing can increase risk and dramatically erode investor equity in the case of a property down turn. Some trusts can be as high as 65% geared and should be approached with caution and awareness of the added risk. Charter Hall Direct funds have gearing targets ranging from 30- 45%.
- Ability to service borrowing costs Higher gearing means more income is required to pay interest costs. Funds with long leased assets, low vacancies and rental growth generally have more stable income and greater ability to meet these costs.
- Time frame Gearing on the upper level is most appropriate on an investment time-frame of greater than five years.
- Who is the financier Debt facilities should be sourced from major Australian and international financial institutions. Its important a manager has a strong reputation and relationship with its financiers. This helps when negotiating an extension or refinancing borrowings.
A final observation about gearing: It pays to be aware of the gearing strategy of your fund manager. While borrowing money delivers the potential for greater returns, there is the chance of greater losses too.
How to gain exposure to appropriately geared commercial property
Investing directly in property gives you control, but severely limits the number and quality of assets you can buy due to the high cost of quality assets – unless you are prepared to gear highly.
To achieve the full benefits of well-geared commercial property, you need the right investment vehicle.A common avenue to quality property exposure is by investing in arm’s length through a specialist commercial property fund manager.
Managers like Charter Hall invest in institutional grade office, industrial and retail property assets and have established funds with high quality tenants and long leases providing secure income profiles for investors.
Direct property funds offer around 6-7% running income yield and an 8%-10% total return for a relatively safe and secure investment investing in properties with longer leases and lower debt. An example of this is Charter Hall Direct’s newest fund open to investment, the Direct Consumer Staples Fund, which focuses on generating income from adiversified and growing portfolio of properties leased to distributors and producers of consumer staples goods. The fund pays distributions monthly, at a forecast income return of 6.89% per annum.
When considering gearing, or commercial property investment, seek financial advice to ensure you understand the potential risks and benefits involved.