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I haven't looked at any ESC numbers for a while, but they used to quote after-tax cashflow, as well as being a bit miserly on the maintenance allowance - one spreadsheet I saw allowed $300 per year, which is about the cost of getting a plumber to answer the phone!
Here is how I do my numbers.
I use a purpose built calculator to ascertain whether it is pre-tax positive cashflow and then measure the cashflow per $100,000 invested (using a concept I have pioneered) so i always compare every property purchase on a consistent basis irrespective of the variable purchase price, income and expenses.
Interesed to know how people calculate cashflow, and what the error in the ESC calculation, (as mentioned above by Gerrard) is.
Hi Lycylou - there is no error as such - more that I disagree with their approach to it. As Cube said, maintenance is often low, they also ignore property management costs, and I've seen claims about the level of "cashflow" being achieved when "cashflow" takes into account only income and mortgage interest (what happened to insurance, rates, maintenance, etc).
Oops, this isn't meant to be an ESC bashing thing - that's been done enough before. What I'm trying to get across is that property investing is a business and everyone say emotions should not come into it. When big profits / numbers start to get thrown around I believe it becomes a lot more emotional (greed).
I'd rather plan for the likely to worst case and know I can deal with it, rather than plan for the best and be disappointed (or in trouble financially) when it doesn't happen.
and then measure the cashflow per $100,000 invested (using a concept I have pioneered) so i always compare every property purchase on a consistent basis irrespective of the variable purchase price, income and expenses.
Why not use the cap rate, which is widely used in commerical property investment, if you are interested in comparing properties?
Cap rate is irrelevant because it fails to account for variable expenses...
i.e. just because a property shows an 11% cap rate that doesn't mean it must be a good buy with good cashflow.
i.e. Buy a flat with 11% yield
$100/wk x 52 = $5,200 divided by purchase price of $47,272 gives an 11% yield
BUT what about expenses i.e.
Rates $850 p.a
Insurance $220 p.a.
Body Corp $900 p.a.
R&M $500 p.a.
Interest on $47,272 x 7.5%p.a. = $3,545
So expenses total $6,015 (ie negative cashflow pre tax)
The same can apply to any property depending on the variable expenses but is most notable when a body corporate exists or the property is leasehold or has any other abnormal expense (ie some small towns have very higfh annual rates etc) which reduces cashflow but is never evident when just focusing on cap rates (or yield).
Cashflow is an absolute measure not a relative one which is why you need to be careful when interpreting quoted percentages.
In simple terms cashflow is calculated as follows:
Rental Income
Less Expenses (including interest but excluding depreciation)
Less or Plus the tax effect of your taxable loss or profit.
Also you need to conisder as a cash outflow cash items that do not register as income or expense Eg if you a Principal and interest loan the principal repayment is also a cash outflow and would be deducted from the above numbers.
While before tax cashflows have some limited use value it is the after tax cashflow that is important as you have to live on "after tax" dollars.
I use an analysis service provided by QED reporting services which breaks out before and after tax cashflows based on the parameters relating to any investment I am considering
My understanding of cap rate is net operating income divided by the purchase price, so that takes care of all expenese (except for the interest). So a cap rate is say 10% is attractive when considering the 7-8% interest rate. Of course, cap rate (and so are many orther financial ratios) doe not touch on the qualitative aspects such as rezoning possibility.
Yes, In commercial terms that is sometimes refered to as 'capitalisation or cap' rate but most residential investors seem to be of the understanding that the 'yield' is a gross yield (ie pre expenses,tax etc) and this is also sometimes referred to as a 'cap' rate.
let's say you buy a block of units which is a commercial deal and you buy it on a 'whatever' yield, (let's say a yield that was the current going cap rate for that area and type of property and location) then if you say kicked the tenants out, renovated the whole block inside and out, re-tenanted the whole block for more, and got it revalued, you'd have increased the value because of the cap rate as much as the physical improvements.
If you had just renovated and stuck the tenants back in on the same rent (why would you, but let's say you did) then I doubt the property would value up much higher than what you'd spent on it.
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