Gearing is the term used to describe the specific ratio of debt vs equity within the deal and will highlight whether the deal is worth pursuing as well as the level of risk that comes with it. If the level of debt vs equity is high, then this is considered ‘highly geared’.
The level of gearing is measured as a percentage of debt vs equity over the overall value of the property. For example, being highly geared would be a measure of debt equating to 75% LTV. A low level of gearing would be less than 50% LTV. Most developers and investors will use gearing around the 60–65% level, which ensures that if the value of the property should fall, they are not over leveraged and can afford to service the debt. If a property’s value falls by 10%, this would mean that the level of gearing would move to 70–75% LTV. Similarly, should the value of the property increase by 10%, then the level of gearing would decrease to 50–55% — reducing the level of risk and increasing the level of equity in the deal.
Gearing is your friend
Using leverage to expand your property portfolio is an extremely powerful tool when used correctly. Rather than putting 100% of your money into a single purchase, you could spread it across several purchases by using debt. This also reduces your risk or exposure on one property by spreading it across a number of properties. It also puts the risk on to the lender, who in return takes a charge over the land in the event of default.
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Companies that are looking to increase their market share and grow their business will have to ‘lever up’ and use more debt in order to buy more land and build more properties. By bringing the power of compounding into the mix — by rolling in profits created from one investment to the next — this increases the buying power even further. This enables a business to grow exponentially by utilising the same levels of gearing without becoming over geared. As a company’s portfolio matures and, therefore, the assets realise a greater value, the level of gearing will be reduced, leaving the investor with a greater percentage of the value added.
Gearing is your enemy
Gearing can also have a negative effect when used incorrectly. In a challenging economic environment, it is prudent to keep gearing to a sensible level, unless the value of the asset being purchased is at a suppressed level. If an investor is over geared in a falling market, then the debt to equity ratio can very quickly exceed the value of the property — which is known as ‘negative equity’. This means that they owe the lender more than the property is worth. In most circumstances and using past events from the global economic downturn where liquidity in the lending market dried up, lenders protect this position by keeping to sensible levels of leverage. This is supported by greater levels of compliance that keep the financial markets regulated.
The opportunity that gearing presents
The long and the short of all of this is that using a greater level of gearing at the right time, in the right market, with the right asset, can reduce a borrower’s risk by decreasing the amount of equity required. This means they can take greater opportunity in other areas of the market by using their equity more wisely. This includes holding on to their capital so when the right opportunity presents itself, they can take advantage of it. Companies that are lowly geared with a high level of equity locked up in their real estate holdings, often swap equity for debt so that they can take advantage of other investments that will add value to the company’s overall portfolio.
When measuring the success of a property transaction, most investors will look at the level of profit against the level of equity they had to put into the deal. This is known as ‘return on equity’ (ROE). The higher the gearing, the greater the ROE will be. For those companies that measure their success in this way, the power of gearing is the single most important measure of success. Generally, the greater the ROE, the better the risk profile is likely to be.