I am mid-way through a finance course, which is interesting but creating more questions than answers. I have a couple of questions on cash flow that I hope someone can help me with.
The Cash on Cash Return (CoCR) calculation outlined in Steve’s book entirely depends on what cash you decide to inject into the new venture up front.
1). If you don’t inject cash but use another property as collateral and borrow 100% of the purchase price + fees what do you use as your ‘initial cash outlay’?
2). The lower the cash you need to come up with the better the CoCR, but the fact remains, you are still ‘using’ the full amount (cash injected + amount borrowed) and hence why wouldn’t we be looking at the opportunity cost of the full amount, not just the cash you need to come up with?
Following on from question 2 above, when calculating the NPV of a buy & hold for which you have borrowed the majority of the purchase price, do you use the cash you have injected into the deal (i.e. ignore the monies you are borrowing) or do you use the full amount (i.e. amount you have injected + the amount borrowed) in the cash flow calculation?
I hope this is clear and someone can help.
Regarding Question 1:
Initial outlay = $0
Regarding Question 2:
Opportunity cost is considered in every transaction / situation we ever undertake throughout our lives. Here are some queations people ask themselves…
If I buy this hamburger instead of this salad, will my waste line suffer?
If I travel for a year after university, how much income would I have lost?
If I buy this house instead of investing in the stockmarket, would I make more or less?
If I stick my money under my mattress, what will it be worth in ten years when considering inflation?
If I commit to a relationship, how many fun nights will I miss?
If I jump off this cliff, will I get a wedgie when I hit the water (if I live)?
Anyway, I think you get what I am getting at. The formulas are just used as a guide to determine a result.
Regarding the follow on question, for the CoCR, you only use money put into the deal. You would also consider the interest and other expenses for the cash flow calculations. For opportunity cost calculations, you would consider the returns on the whole lot as opposed to investing elsewhere or doing nothing.
Robert Bou-Hamdan
Mortgage AdviserM: 0414 347 771
E: [email protected]
W: http://www.mortgagepackaging.com.auFREE Finance-Related Newsletter: See – http://www.mortgagepackaging.com.au/index_files/newsletter.htm
Comments made are of a general nature and should not be construed as individual advice.
© 2004 Mortgage Packaging Pty Ltd
For question 1: If I was putting no cash into the deal (rather equity) I still would inc. because if you do use a % of your equity you can’t use that on other deals, therefor you have to work out how hard your cash/equity is working for you (and you want it to work hard) and to make sure the deal is worth it.
Also you will have to inc. borrowing costs when using equity (interest repayments).
Rgds.
Lucifer_auThanks for the couple of comments. Whilst I agree the forumas are only a guide, used incorectly they can be very misleading.
On question 1….
I tend to agree with Lucifer_au on the CoCR question because whether you have physically injected cash or not is really irrelevant, it has locked this equity up and hence it can not be used for any other venture. Similary, if you use equity instead of cash your ROI would be infinite which is strictly not correct either (as you have put at stake another asset and hence it is your starting invetment).On question 2….
When you, ‘The Mortgage Advisor’ say “For opportunity cost calculations, you would consider the returns on the whole lot as opposed to investing elsewhere or doing nothing.” are you suggesting that your cash flow on purchase day is -(cash injected+fees+loan) whilst on sale day the cash flow is +(sale price-loan outstannding-fees) or -(cash injected) and +(net sale proceeds)? The first usess the total capiutal employed whilst the second uses only the cash outlay. They give very different answers.Thanks,
AndrewIf you agree with Lucifer, you should not use the CoCR formula as you are not calculating CASH on CASH RETURN. You are looking at Gross Return which is totally different. The injection of cash or not is totally relevant for the CoCR formula. It is the basis of it.
Your comments about the locking up of equity go to the Opportunity Cost of having that equity available for something else or invested in something else which would be looked at in your second question.
Regarding your ROI being infinite, it is if you can keep buying property using equity. This is what is known as Gearing and, if used properly, can result in infinite returns or infinite growth.
Regarding cash flow on purchase day, I consider that simply being all income – all expenses = cash flow. This does not take into account the cash injected as that goes back to the CoCR formula.
On sale day, there is no cash flow calculation. It is more of a capital gain / loss calculation as the cash flow will cease. This calculation involves sale price – sale costs – loan – cash in = net gain / loss.
There is not one formula you can use from start to finish when you invest as you are looking at different figures at each step of the way. Your CoCR return is a formula that will help you answer the following question:
If I put my cash into this investment, what will my return be?
Comparing this figure with other possible investments will provide you with opportunity cost figures.
I hope this clears it up.
Robert Bou-Hamdan
Mortgage AdviserM: 0414 347 771
E: [email protected]
W: http://www.mortgagepackaging.com.auFREE Finance-Related Newsletter: See – http://www.mortgagepackaging.com.au/index_files/newsletter.htm
Comments made are of a general nature and should not be construed as individual advice.
© 2004 Mortgage Packaging Pty Ltd
Any equity (up to 80% of that property’s value) used to purchase another property could easily be converted to cash by use of a LOC.
So while literally not a CoCR, If you are aware of it, I would treat it as cash anyway when calculating the return you’d get from a deal.When first building a portfolio, i am really noticing how long it takes to gear into the next property using equity, it may as well be cash and the roll on effect at this stage definately isn’t infinite.
Personally, if you could easily turn it(equity) into cash, you may as well treat it as cash for a CoCr calculation to get a % that realistically reflects the value of the deal to you……
……if you get too technical, you may just miss the point of why you were doing your sums in the first place. Which is to get a simple figure on a deals worth.
Live, Learn and GrowLifexperience
Life,
Just quickly, it does not need to be a LOC.
Regarding your example, I would assume you did the CoCR calculation when you bought the first property that you now have equity in. Taking equity to buy another changes a lot of figures. I personally do not see this as a new CoCR but as a continuation of the existing CoCR figure if I have not put more money in.
I do not consider equity as cash until I sell and the funds are in my account. The new purchase is funded by your initial cash outlay so why would you calculate a new and seperate CoCR? It might be a technicality but I call this an opportunity cost calculation when deciding how to use funds raised from equity.
Maybe Steve could comment on this one????
Robert Bou-Hamdan
Mortgage AdviserM: 0414 347 771
E: [email protected]
W: http://www.mortgagepackaging.com.auFREE Finance-Related Newsletter: See – http://www.mortgagepackaging.com.au/index_files/newsletter.htm
Comments made are of a general nature and should not be construed as individual advice.
© 2004 Mortgage Packaging Pty Ltd
Hi rob,
I haven’t seen you post on the forums for a while, good to see you back….you said
“I do not consider equity as cash until I sell and the funds are in my account. The new purchase is funded by your initial cash outlay so why would you calculate a new and seperate CoCR? It might be a technicality but I call this an opportunity cost calculation when deciding how to use funds raised from equity.”
I think we are actually agreeing that equity used is an opportunity lost elsewhere. ….ok.
And I also agree that cash is not cash unless it is sitting in your bank account.
BUT, if you do not calculate a new and separate CoCr (using cash or substituting equity needed) for each deal, what other truer easier way have you got to evaluate a deal and give a simple concrete figure?……..infinty?
What is the point of doing a CoCr otherwise?
Cheers
(….and i hope you are having a relaxing saturday night…)
Live, Learn and GrowLifexperience
Good point.
I am having a very relaxing weekend overall. I am juat playing around online all weekend.
I hope yours is going well also.
Robert Bou-Hamdan
Mortgage AdviserM: 0414 347 771
E: [email protected]
W: http://www.mortgagepackaging.com.auFREE Finance-Related Newsletter: See – http://www.mortgagepackaging.com.au/index_files/newsletter.htm
Comments made are of a general nature and should not be construed as individual advice.
© 2004 Mortgage Packaging Pty Ltd
Yeah good thanks rob…..although these scotches are making me sleepy.
3am and g’nite all.
Live, Learn and GrowLifexperience
Thanks for the constructive input. Robert I understand where you are coming from with the CoCR calcualtion – thanks for the patience.
I guess am I having trouble with the principal of the calculation because the calculation revolves around a choice you make (e.g. equity based or cash down) both of which change the output but don’t change the fundamentals of the investment – that is whether it is a good investment or not (just because you turn an IP cash flow +ve or make the ROI huge doesn’t suddenly make it a good investment).Not wanting to be too painfull……
With the opportunity cash flow calculation (NPV) I think you are suggesting that you use all monies used (that is monies borrowed as well as cash / equity that you inject) – this however assumes that the bank woud lend you the same amount of money to invest elsewhere (which we know is not true). Hence how can we do an opportunity cost calculation when there really are no other opportunities for that same sum of money the bank is lending you (for example if you were to go and buy shares instead they would lend you much less than the 80%).Regarding lending for different investment types, if you are using the equity you already have, it is not an issue. You can invest in whatever you like.
If you are talking about the 80% you would borrow on the new property, well this would be part of the opportunity cost calculation because you might not be able to get the same amount of money or the same level of gearing with other investments so you might decide to stick with the property if the returns are better. This is all part of determining which route to take.
Just egarding your comments about shares, I just bought $100,000 worth of shares and I did not put in one cent. I could have taken up to $500,000 worth before I would have to prove some sort of income. I think it is possible to gear up a lot easier on shares these days than it is to do on property. By the way, I could have taken up to $500,000 per application with the different providers. This is pretty scary stuff!!!!!
Robert Bou-Hamdan
Mortgage AdviserM: 0414 347 771
E: [email protected]
W: http://www.mortgagepackaging.com.auFREE Finance-Related Newsletter: See – http://www.mortgagepackaging.com.au/index_files/newsletter.htm
Comments made are of a general nature and should not be construed as individual advice.
© 2004 Mortgage Packaging Pty Ltd
Rob,
Was that 100% finance for $500000 shares with no strings attached?Scary indeed.
Live, Learn and GrowLifexperience
Life, basically, YES it was. Obviously you have to pay interest and select your investment in a particular group of shares. I only took $100,000 worth though. I am not totally mad. I will take another 400k worth next year or the year after if the current block does well.
I will PM you a link to the product I invested in. There are heaps more out there.
Robert Bou-Hamdan
Mortgage AdviserM: 0414 347 771
E: [email protected]
W: http://www.mortgagepackaging.com.auFREE Finance-Related Newsletter: See – http://www.mortgagepackaging.com.au/index_files/newsletter.htm
Comments made are of a general nature and should not be construed as individual advice.
© 2004 Mortgage Packaging Pty Ltd
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