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What is Cost of Capital and Gearing in Real Estate
A very important concept to look at when investing is your cost of capital. All companies and investors need money in order to start or expand activities; this money comes at a price. Large companies usually have more complex structures, comprising of both funds generated through debt and issuing of equity instruments (such as shares or bonds).
However, the small property investor is usually only worried about two facets: the original capital invested in the company and any bonds applicable to the property. This cost is therefore easy to calculate. If you have a bond against an investment property of 15% per year, the cost is 15%.
This cost is very important as it defines how much a property must earn in order to remain profitable. What is alarming is that the current credit crunch is causing people to run scared as far as investments are concerned. They develop a fear of not meeting their obligation. Most of these people, however, have large opportunities sitting in their books, if only they'd take the plunge.
These people are people who are currently sitting on properties that they have been paying off for more than eight years. This in turn means that the payments on the property are now low. If it is an investment property, these people are realizing large profits, whereas private homeowners are now realizing that they are left with extra cash that generates absolutely no income and is often spent on unnecessary things.
This is where gearing comes in. By using those available funds, against your home or investment, you can purchase income-generating investments and negotiate better interest rates with the bank. This will result in practical utilization of your extra cash flow or the large profits on your investment properties and the acquisition of a larger asset base.
What one must note is that all this is a long-term investment. Therefore, careful consideration must be paid to the ability to keep paying off these properties and renting them out in order to generate income.
Another major consideration is risk! This affects both your ability to generate income and most importantly your cost of capital. A large determinant of cost of capital is risk; banks will charge higher interest rates depending on the risk profile of the property they are funding. This profile related to fluctuations in the market value of the property; the amount they could possibly realize if they were to repossess/foreclose and sell the property.
Please note that this is not financial advice in any form. The data in this article is informational only for property investors to illustrate tax issues. If you need financial advice refer to a professional that can assist you with your particular circumstances.
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