Benchmarking cash flow (3) – Examples

In my previous posting “benchmarking cash flow (2)” with the link below, we discussed how to calculate Cap Rate or CR% and Equity Return or ER%.

http://blog.wenxuecity.com/myblog/61110/201212/25655.html

I know that this might be a boring topic with a lot of tedious work. It can also be painful especially when you review some of your non-performing assets. However this is really a good tool to understand how well you are doing with your real estate assets and improve the overall performance by focusing on low performance assets in the next year. Further more, you will also understand which parts of cost factors are really affecting the performance. For example, is it repair related or financing related issue?

 

An Example of a rental property below illustrates how the calculation works.

 

You bought this property with closing cost in amount of $117,522 ACB (Adjusted Cost Base). Suppose that you received rent deposit in amount of $15,993 for an entire year.  Your operating expenses or OE is   $3,576. Therefore the NOI is $12,417 = ($15,993 - $3,576) and CR% is 10.6% = ($12,417/$117,522).

 

Let’s say, your Interest Cost or AFI (Annual Financing Interest) is  $3,601 for the year. The remaining principal of loan balance is $66,406. Equity amount is $51,116 = ($11,522 - $66,406). Therefore the net cash flow is $8,816 = ($12,417 - $3,601) along with ER% 17.2% = ($8,816 / $51,116).

 

As you can see, the cap rate for this property is around 10% which has nothing to do with financing. i.e., it doesn’t matter if you bought the property with cash or a loan. This CR% may vary from year to year depending on other cost factors such as management costs, maintenance costs etc. 

 

On the other hands, the ER% is better than CR% in this example. In other words, you have a good leverage by borrowing someone else’ money to invest in this property to get a return as good as 17.2% which is much better than 10.6%. Please note that ER% is not always better than CR%. If the APR was too high, you may get lower ER%. Sometimes ER% could be negative if AFI is too high especially true when you use hard money loan to leverage your financing. By using this tool, you can adjust financing strategy to optimize ER% accordingly.

 

In the next posting, I am going to talk about how to use Schedule E to fill in the data for this calculation.