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Example 1 – non-geared (no borrowing) – 20% rise in value
Investment £100,000
Property bought for £100,000
Rises in value to £120,000
Net gain £20,000
Example 2 – geared - 20% rise in value
Investment £100,000
Borrowing £100,000
Property bought for £200,000
Rises in value to £240,000
Net gain £40,000
So the gain is multiplied because of the borrowing. Remember, though, that out of any gain you need to pay interest on the loan.
Example 3 – non-geared – 20% fall in value
Investment £100,000
Property bought for £100,000
Falls in value to £80,000
Net LOSS £20,000
Example 4 – geared - 20% fall in value
Investment £100,000
Borrowing £100,000
Property bought for £200,000
Falls in value to £160,000
Net LOSS £40,000
So the LOSS is multiplied because of the borrowing. Remember also that you need to pay interest on the loan, which is a further loss.
Example 5 – highly geared (heavy borrowing) – 30% fall in value
Investment £50,000
Borrowing £200,000
Property bought for £250,000
Falls in value to £175,000
Net LOSS £75,000
Now there is insufficient to repay the borrowing, AND the loan interest has to be paid
This last example helps to illustrate clearly the possible negative effects of gearing. If a non-geared investment of £50,000 had been made, a 30% fall in value would have resulted in a loss of £15,000, but there would still be value of £35,000 remaining. By gearing, the losses were multiplied to the extent that the entire investment was lost, and a debt was created.
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