This 20% to 100% (pre-tax) return on equity is a very high return and much higher than without gearing. But there is, of course, a cost not yet factored in - the interest payments on the borrowed funds.

Let's now see how these examples stack up assuming a 12% total return on all property assets and an interest rate on borrowings of 8% p.a.

At 50% gearing, interest costs represent 4% (8% interest rate times 50% borrowed) of the value of the property. And, with gearing at 90%, interest costs represent 7.2% of the value of the property (8% of 90%).

• With no gearing our total rate of return is 12%
  
• At 50% gearing our rate of return on total assets is 8% (12% income - 4% interest) and our return on equity is 16% (8% return divided by 50% equity).
  
• At 90% gearing our rate of return on total assets is 4.8% (12% income - 7.2% interest) and our return on equity is 48% (4.8% divided by equity of 10%).

These examples illustrate how the return from the geared investment is the margin of ungeared return over interest costs divided by the percentage equity.

By increasing gearing from zero to 50% to 90% we increased return to equity from 12% to 16% to 48%. And so, at 50%, the gain from gearing is 4% (16% - 12%) and at 90% it is 36% (48% - 12%).

The gains from gearing in fact follow increases in the loan to equity ratio which increased ninefold as gearing moves from 50% to 90% (from 1 to 9) as did our increase in rate of return (from 4% to 36%).

From this we can define the first two basic rules of gearing.

Rule one: The gain in return depends, in the first place, on the margin of ungeared rate of return over the borrowing interest rate. For gearing to increase returns, the rate of return without gearing must be higher than the borrowing interest rate.

Rule two: Given rule one is satisfied, the gain from gearing depends on the loan to equity ratio. This increases dramatically as gearing levels move above 50%.

These examples illustrate the immense power of gearing. Identifying or creating opportunities to apply these principles should always be in the mind of the astute LPT manager.

The big gains for return on equity are delivered when the loan to equity ratio is high. At a 28% debt to total assets ratio, the debt to equity ratio is a low 0.35:1, while at 80% debt total assets the debt/equity ratio is 4:1. The benefits from gearing at 80% gearing are more than 11 times those at 28% gearing!

The graph shows that, with an average gearing of 28%, LPTs are not taking advantage of the huge increases in potential gains achievable by moving to above 50% gearing. At 28%, there are not any material leveraging advantages to be had.

LPT managers are not, therefore, delivering anywhere near the potential gains from gearing. But is this justified by the higher risks associated with higher gearing? The challenge becomes one of matching high gearing with correspondingly high quality risk management. Is this pot of gold achievable? To answer that question we have to take a closer look at the effect of gearing on risk.

Gearing and risk

Everyone knows that the higher the gearing the higher the risk. But are there opportunities for increasing gearing without increasing risk or with only a moderate increase in risk so that return to risk ratios are higher?

These are the vital questions but they are not always easy to answer. At one end of the investment spectrum, high income earners investing in well located residential property would be wasting huge opportunities if they did not gear to at least 80%. Why? Because over every decade in living memory, well located residential property has increased significantly in value. While economic growth continues so also will increases in prices of well located residential property. The property may not generate positive net income (nor income tax liability) but capital gains achieved have generated very high rates of return to highly geared investors.

Near the other end of the risk spectrum, gearing in shares differs because share prices (measured by the All Ordinaries Index) are twice as volatile as residential property prices. While long term increases in the index may be similar to those for median prices of residential property, one cannot be sure whether any of one's stocks will be still around at the end of the investment decade. (For investors, margin calls to maintain LVRs in the face of large short term fluctuations can create major cash flow problems even if large long term gains do eventuate.)

Such returns from shares also depend primarily on the continuing quality of management over the long term (uncertain) while returns from property depend less on management and far more on the increasing scarcity value of land (far more certain). (This is not to say that quality of management in property is not important.)

Risk profiles of total return components under gearing.

Compared with shares and residential property, total returns from LPTs generally rely to a greater extent on income and less on capital gain. Capital gains are smaller and less certain. Returns to unitholders include a third component, tax savings from depreciation and building allowances. Within LPTs capital gains are evidenced by increases in NTA per unit. For unitholders they take the form of increases in unit prices.

Forecasts of LPT income are generally more reliable than those for capital gain because they include the more certain short term predictions as well as medium and longer term ones. Capital growth estimates, on the other hand, are usually based on longer term predictions which are more uncertain.

'Value' LPTs which focus on achieving high income relative to capital gain are thus expected to have higher and more reliable income streams than 'growth' LPTs. Where capital gains are very uncertain, the first rule of gearing should be adapted such that the ungeared rate of return from income alone (rather than total return) should exceed forecast borrowing interest rates.

The less reliable or the lower the income stream the more likely it is that borrowing interest rates will exceed rate of return in some years.

Even if the forecast income return exceeds interest rates, there are big differences in reliability of income between sectors. Income from retail centres with monopolies in their catchment areas would generally be more reliable than income from secondary industrial properties. Multiple properties and sectoral and geographical diversification also lower risk.

For unitholders, the tax benefits from depreciation and building allowances are less risky than the cash income or capital gain components of returns because they depend only on the ability of the unitholder to maintain his tax bracket and the ability of the LPT to survive. Gearing can significantly increase this component of return (tax savings) to unitholders without extra risk. But these benefits cannot be directly utilised by the LPT manager except by transfer to 'reserves'.

Summary

In summary, the tax-advantaged components of distributions have the least volatility associated with them, followed by the income yield, and then the capital gains component. It is our contention that gearing generally transfers risks away from the higher degree certainty cash components of total returns towards the less certain capital gains components of total return. This is to be explored further in next month's article.

The other issue of relevance is that gearing by LPT manager's does little to improve the return on equity delivered by a trust to investors (but does increase Gross Assets upon which management fees are calculated). The level of gearing adopted is not sufficient to significantly increase returns. Our research indicates that gearing within the sector simply increases the risk profile of total return without materially altering the return on equity for the investor.