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It is common in today’s low interest rate environment to emphasis the “cash on cash” return of an investment.
For example, consider a small commercial property that sells for $1,000,000 with an income and financing as described in the opposite box |
Purchase Price - $ 1,000,000;
Net Income - $80,000;
Tax Rate @ 50%.; Building portion depreciated - 50%;
Mortgage $750,000 @ 6.5% per annum; 25 yr amortization.
|
Year |
Payment |
Mort. Int. |
Principal |
Depre-
ciation |
Tax
@50% |
Cash Flow After Tax |
|
2 |
$60,300 |
$48,825 |
$12,015 |
$19,600 |
$5,787 |
$13,912 |
|
10 |
$60,300 |
$1,175 |
$19,125 |
$14,139 |
$12,343 |
$7,357 |
|
15 |
$60,300 |
$33,975 |
$26,325 |
$11,528 |
$17,248 |
$2,451 | |
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Initially the buyer has a great return. With the benefit of the low interest rates and the benefits of sheltering taxes through depreciation the initial return after taxes and mortgage payments is 5.57%. The investor appears to be able to get a good return and still be able to fully repay the mortgage after 25 years. The reality, however, is more complex. The purchaser will not get both good cash flow and repayment of the mortgage.
As each year goes by two important things are happening. First as the building is depreciated for tax purposes the amount that can be sheltered from tax drops. More significantly, over the term of a mortgage, the amount of each payment applied to reduce the principal balance owing, increases over time. This latter effect means that the investor is paying increasing amounts of income taxes on income that repays the mortgage instead of coming into his or her hands.
In practical terms, after 10-15 years, in order to meet the 25 year amortization of the mortgage, the investor’s income from the property goes to repay the mortgage principal and income taxes and little is left over. After the 15th year the investor may in fact have or come close to having a negative cash flow and could end up putting money into the property to meet his payments. The problem is compounded by the fact that after 10 years many property owners are looking at some potentially expensive capital upgrades, the risk of interest rate increases and the risk of economic downturns that can adversely affect tenancies and rents. Getting caught in this kind of cash flow squeeze during an economic downturn can also make refinancing your mortgage amortization/payments difficult.
The purpose of this note is to highlight the cash flow squeeze generated by high leverage and aggressive pricing. Paying attention to the amount of depreciation that is available; being prepared to refinance and extend the term of the mortgage; and negotiating longer term leases with rent increases are all ways of addressing the issue raised here. |
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