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Cashflow
Cashflow is income derived from a business usually on an ongoing basis. In terms of property investment cashflow is usually derived primarily from rent although alternative sources of cashflow may be available (see Lease Options, Billboards & Storage Rental).
Gearing
The overall cashflow of a property is commonly referred to as positive, neutral or negative. This depends on whether the income is greater than (positive), equal to (neutral) or less than (negative) the expenses. This can be calculated either pre or post tax.
Pre-tax cashflow
Pre-tax cashflow is calculated by adding together all the property related expenses (i.e. Rates, Interest payments, Principal payments, Repairs and Maintenance, Property Manager fees, Insurance) and subtracting this from the total rent and any other income received from the property. If this is positive (i.e. makes a profit and adds to the investor's income) then the property is described as being cashflow positive, if this is zero then the property is described as being cashflow neutral (i.e. neither makes a profit nor a loss) and if it is negative then the property is described as being cashflow negative (i.e. makes a loss and requires financial support from the investor's other income).
Post-tax cashflow
Post-tax cashflow is calculated as above, however the tax rebate due from actual or paper losses (i.e. from Depreciation) from the property is added to the total rent.
Examples
(Note: these are rounded figures for the sake of simplicity)
Suppose you purchase a $200,000 property which rents for $300 a week. To work out the cashflow you multiply the weekly rent by 52 - many people use 50 to build in some allowance for vacancies - in this case it is: $15,600
The expenses are then totalled:
- Rates: $1,500
- Insurance: $350
- Property Management (8.5% of rent + GST): $1,500
- Repairs & Maintenance: $4,000
- Interest and Principal Repayments: $21,000
Total: $28,350
Income - Expenses
$15,600 - $28,350 = -$12,750
As such, it is a pre-tax negative cashflow property (also referred to as negatively geared).
To be pre-tax cashflow positive (also referred to as positively geared), it would need to bring in another $12,750. In other words another $245 a week.
In post-tax terms however we also need to take into consideration the tax rebate. Let us suppose that you earn $80,000 a year. To work out the total tax rebate we need to figure out the Depreciation Let us suppose that of the $200,000 purchase price $100,000 is allocated to land, $80,000 to the building and $20,000 to the fittings and fixtures. (For the sake of simplicity we will take the depreciation rates for buildings to be 3% and 15% for fixture and fittings, for more accurate rates see Depreciation or IRD Depreciation rate finder.
As such the depreciation is:
- Building: $2,400
- Fixtures and Fittings: $3,000
Total: $5,400
This is then subtracted from the total profit or in this case loss:
-$12,750 - $2,400 = -$15,150
Because it is in the highest tax bracket 39% of these losses can be reclaimed: $5,908
As such the $12,750 pre-tax loss is reduced to a post-tax loss of: $6,841.
Why
The calculation of cashflow can be done for several different reasons, but primarily is done to assess how a property affects your financial position in terms of cash. It is also commonly used as a tool to assess whether a purchase is a good buy or not. There is considerable debate about which calculation (pre- or post-tax) is superior and likewise whether the full purchase price or the purchase price less deposit should be used to determine the mortgage repayment. Likewise there is some controversy about whether the full mortgage repayment should be used or only the section of the mortgage repayment that represents interest.
Each different method of calculation gives somewhat different information and as such each should be used when appropriate. For example post-tax with full mortgage repayment on the purchase price minus deposit gives the most accurate indication of the impact of the purchase of a property on your cashflow. However post-tax with interest only repayment on purchase price minus deposit gives a better indication of the impact of a purchase on your overall financial position.
Likewise pre-tax calculations might be better for assessing whether to purchase a property or not since your tax situation can change drastically (i.e. you could lose your job or change countries) and some argue that depreciation shouldn't be factored in since this will in many cases need to be repaid if the property is sold (see Depreciation). Finally, doing the calculation at full purchase price (i.e. not subtracting the deposit) provides a way of comparing two different properties and their effects of your cashflow. This is a common buying rule, i.e. to be a good purchase a property should be cashflow positive at a pre-tax full purchase price (see Investing Rules).
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Cash flow Neutral
--Perry 10:04, 29 December 2007 (NZDT)
