# 3 Steps to using cash flow after tax (CFAT) for property valuation

You need to understand the principles of discounting cash flows to utilize the after-tax equity cash flows to evaluate properties and their financing.

By determining their net present value or internal rate of return, the anticipated equity cash flows after taxes are compared to the current price or worth of the property.

It necessitates choosing a suitable discount rate to determine the present value of the after tax cash flow (CFAT). It can also be helpful to analyze the cash flows, determine whether the timing of returns is appropriate, and contrast the before- and after-tax cash flows of equities and real estate.

## Step 1 - Discounted cash flow analysis

### Equity cash flow after tax

The return is then computed after estimating the equity cash flow after tax during the holding period. Future cash flows are discounted to their present value to compare with the initial outlay,

According to the annual equity cash flow after tax shown in Diagram below, the table calculates the net present value of those cash flows at a 9 per cent annual discount rate.

**Interim property cash flow after tax**

The investor's needed return on equity after taxes should be used as the discount rate.

**Net present value after tax**

The net present value must be positive for the investment to be deemed acceptable. The investor should purchase the property at the current price with the proposed loan, according to the after-tax equity analysis's net present value of $18,529.

However, only if the predicted cash flows are realistic and the discount rate accurately reflects the risks to the cash flows.

You can determine this cash flow's internal rate of return in a flash using a financial calculator or computer spreadsheet. It is 10.66 per cent annually. Finding the discount rate at which the cash flow has a net present value of zero would entail performing numerous calculations to determine the internal rate of return through trial and error.

In this case, the internal rate of return is higher than the needed rate of 9 per cent annually, indicating that the investment should yield a sufficient return and that the investor should proceed with the purchase.

The net present value for various investments serves as a guide to how much more or less can be paid to achieve the desired rate of return. It is incorrect to multiply the property price or outlay by the net present value in an after-tax equity cash flow analysis to get the price that will generate the requisite return.

If the price is changed, so are the acquisition costs, the number of capital gains tax due, and the loan-to-value ratio. It is quick and easy to determine the precise price change needed to match the internal rate of return to the necessary return on a computer spreadsheet.

### Internal rates of return comparison

Understanding the sources of the return can be aided by comparing the internal rates of return on cash flows calculated on various bases.

The table below shows the internal rates of return for the four possible cash flows.

Comparing the returns on equity and real estate shows how much the return is increased by employing borrowed financing.

This example only shows a slight rise in the before-tax rate of return when borrowing roughly 65% of the price. Negative leverage could be caused by a slight decrease in net rent or a slight increase in loan interest rates.

If there is a significant risk, it will be demonstrated by testing the sensitivity of the property and equity returns to changes in rental growth and interest rates.

You can use the difference between the rates of return before and after taxes to estimate how taxes will affect an investment.

Even though the tax rate is 31.5 per cent, the drop in the return on equity owing to tax is only 0.71 per cent annually, from 11.37 to 10.66 per cent annually.

Because of the capital gains tax reduction, the depreciation and interest deductions, and the minimal difference, it is clear how little of the return is taxed.

The taxpayer's marginal tax rate decreases the before-tax rate of return once the entire return has been taxed. If the tax shelter, in this case, were removed, the before-tax equity return, which was 11.37 per cent, would drop to 7.79 per cent annually due to the 31.5 per cent tax rate.

The lower return demonstrates how crucial the tax shelter is. Some investors could be concerned that they are relying so heavily on tax shelters for their returns because they know that if their other taxable income decreases, it may be rejected or become ineffective.

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## Step 2 - Setting the discount rate

Because the discount rate significantly impacts whether the investment is accepted, it is essential to choose the correct rate when evaluating cash flows.

The rate of return necessary for the property acquisition to be appealing is known as the discount rate.

The needed, goal, and hurdle return rates are equivalent to the discount rate.

Although there are straightforward guidelines for determining discount rates, converting these into exact numbers is difficult. It is due to the regulations' subjective components, challenging projections, and dubious assumptions.

Private real estate investors, institutions, and property funds can all follow these guidelines; however, each group may do so differently and with different inputs.

It's essential to understand that the discount rate relies on the type of cash flow being assessed: Is it the equity cash flow or the property? Is it before or after tax? Given that taking on financial risk requires a higher return, discount rates for property cash flows are smaller than equity cash flows, assuming there is a loan.

Because taxpayers lose a portion of their investment and work income to taxes, discount rates for after-tax cash flows are lower than those for before-tax cash flows.

The following rules for choosing a discount rate are applicable to all four bases of cash flows, even though the necessary rates will vary.

The components of discount rates are discussed after pointing out that they must be high enough to encourage saving. The cost of capital and alternative investments are then used to calculate discount rates. The conversion of annual discount rates to rates for durations shorter than a year is covered in the final paragraph of this section.

### Choosing to invest rather than consume

Individuals choose how much of their income and capital to save rather than spend as a conceptual starting point. The decision between saving for future spending and engaging in current consumption affects discount rates across the economy.

Any investment's rate of return needs to be enticing enough to keep people from immediately spending their money. Individuals' "propensity to save" is influenced by various factors, including their family responsibilities, age, and attitudes toward the possibility of running out of money later in life—likely in retirement.

Australia's mandatory superannuation contributions have raised the savings rate for most households while displacing some private savings. The tendency to save has long-term trends and cycles that affect rates of return on all investments.

### The elements of returns

The discount rate represents three components of the return on investment.

#### 1. Time value of money

Investors anticipate a return merely because they have given up the pleasure of spending their money by locking it up. The time value of money is another name for this.

It's a "real risk-free rate," the return you can expect from an investment without the risk of default, loss of capital if held to maturity, or change in interest payments, and without the danger that consumer price inflation will diminish the purchasing power of the capital or the income.

Since capital-indexed Treasury bonds promise an interest payment from the federal government and an inflation-increasing guarantee, they are frequently used as a substitute for the true risk-free rate.

#### 2. The premium for inflation

Investors want to be protected against anticipated consumer price increases during the investment period. They demand a high enough investment return to account for inflation.

The return that would be required from assets for which there is no risk of default, loss of capital if held to maturity, or change in interest payments, such as federal government bonds, is made up of the time value of money and the inflation premium.

These bonds are frequently referred to as "risk-free," but if the holders don't hold them until they mature, they run the risk of their resale value declining if interest rates rise in the interim.

Additionally, there is a chance that inflation will exceed the premium incorporated into the return. Since there is almost little risk that the government will miss a payment of interest or repayment, they are "default-free."

The actual rate of inflation that has been recorded and the predicted inflation that is included in needed rates of return are likely to alter at different times. Investors could be hesitant to consider recent variations in the inflation rate as proof of new long-term trends.

#### 3. The premium for risk

An allowance for anticipated risks is the third component of any property's needed return.

The risk premium is an additional percentage return that is factored into the discount rate to account for the unpredictability of the anticipated cash flow and any potential challenges with a speedy sale.

Several risk analysis techniques are now attempting to quantify these risks to improve the consistency of risk premiums. The risk premium in property analysis is still primarily speculative and challenging to prove.

By contrasting the typical yields on government bonds and typical real estate returns, one can get an indication of the extent of the risk premium that has been earned.

Real estate investors bidding on homes today might need a very different risk premium than those paid in the past.

Bringing the three elements together

Even though you can combine these three factors to estimate their total influence on investors' necessary returns, the equation below is more precise since these factors' effects compound.

**Combining components**

A discount rate generated from its three components is likely only to be used as a check against a discount rate calculated from other investments and the cost of capital because it is difficult to calculate precisely.

It can only calculate an objective discount rate for cash flows from the real estate before taxes. The financing plans and tax situations of each investment affect the calculation of equity cash flows after taxes.

### Other investments

The returns on other investments with comparable risk factors partly influence the discount rate. These options include investing the equity in further properties, possibly with varying degrees of borrowing, or any other ventures needing comparable outlays.

Using the example above, a reasonable discount rate for the property's cash flow before taxes would be 10% per year if you sold residential properties of a comparable style at equal rates of return (before tax).

The constant growth model can be used to approximate the rate of return on alternative properties before taxes as follows:

**Alternative investments**

Since market expectations dictate rates of return on alternative properties, the growth rate used in this method must correspond to the growth anticipated by individuals involved in the market for this type of property.

The total return would be around 1% annually, less than before the purchase and sell charges due to the transaction costs. Another option is to analyse other investments' cash flows to estimate their internal rates of return, but this can be overly complicated given the uncertainty of growth rates.

You can't effectively compare the returns available on properties in significantly different price ranges because the real estate markets are divided into value-based segments.

The investor's objectives and financial situation may indicate that other investments with different cash flow patterns should not be considered as alternatives since they are not acceptable.

Because borrowing decisions and tax status are individual to each investor, it is practically challenging to calculate a market-based rate of return on the equity cash flows after tax on alternative properties. However, investors are expected to assess their potential rates of return from various assets and subject numerous potential acquisitions to an after-tax equity cash flow analysis.

### Expense of capital

The cost of the capital used to buy the property establishes a minimum or hurdle rate that the anticipated cash flow must surpass. The interest rate on money borrowed to buy a home can be considered the cost of money in its most basic form, even if this is the cost of debt rather than equity.

The loan interest rate suggests a minimal discount rate since it would be hard to justify buying any property if the cost of borrowing the money to buy it was higher than the return on the investment.

Compare the after-tax interest rate, the interest rate less the investor's marginal tax rate, to get the discount rate for the cash flows after taxes.

The risks to which the owner is subject are ignored if the loan interest rate is used as a discount rate for the property or equity cash flows. An upward adjustment for property and financial risk is necessary.

Use the recent capital issues to objectively establish the cost of capital, including debt and equity, for public property funds. The target debt-to-asset ratio most funds use to determine the proportions (or weights) of debt and equity. The main factor affecting discount rates for property funds is frequently the weighted average cost of loan and equity capital.

As a loan is amortized, the tax shelter afforded to the equity cash flow decreases; thus, the benefits of the tax deductions on interest are only roughly reflected in the computation of the after-tax cost of borrowing.

### Periodic effective rates

In most cases, discount rates are expressed as annual rates. When cash flow periods are shorter than a year, You must transform the discount rate into a periodic rate to get the present value.

There are two ways to go about doing this. You can convert the annual rate to a periodic rate by dividing it by the number of times in a year. Lenders typically use this "nominal conversion" to determine monthly or more frequent mortgage payments.

As an alternative, the periodic rate is determined as the rate that will match the annual stated rate after considering compound interest for each period. This is how the "effective periodic rate" is calculated:

**Effective periodic rate**

Most property investment analysis software employs the effective periodic rate when discounting cash flows that are more frequent than annual, which is the basis for conversion advised by the Australian Property Institute.

By discounting the yearly quoted rate for the number of periods expressed as years and parts of years, one can also determine the present value of cash flows at an effective periodic rate. The equation below displays both techniques.

**Present value of cash flow**

## Step 3 - Analyzing the cash flows

Viewing the anticipated annual profit or loss from the investment is one advantage of calculating cash flow. Many investors need cash from their properties at specified times and want the maximum return for a reasonable level of risk. The "pattern" of the cash flows may indicate the suitability of the financing and the property.

Even though all five of the cash flows in the table below have the same internal rate of return (10.66 per cent annually), certain investors may find one or more of them to be completely unsuitable.

The first pattern is the after-tax equity cash flow from the under-review residential unit. Only an investor who can increase their investment during the holding time to raise the terminal capital value would be acceptable for this cash flow. This pattern is characteristic of vacant land maintained until it is ready for development with the costs of ownership needing interim cash withdrawals or typical of a highly geared real estate investment with a poor rental yield.

The excess mortgage interest over net rent for negatively geared properties may lead to cash losses (as well as tax losses) that necessitate additional payments from the owner. Negative gearing, for instance, is rarely a good strategy for retirees.

Some investors are solely interested in earning a return in the form of a capital gain and are unwilling to commit further funds after the initial investment. The second pattern is ideal for them.

They can roughly accomplish this by taking on a level of debt that requires total rental income to cover loan payments or by buying a property that generates a low rent while holding out for future redevelopment.

The third cash flow pattern would be favoured by investors looking for a moderate income to pay for personal or other needs in addition to capital growth. Many properties that generate income or other growth investments follow this trend.

In this case, the beginning rent and the growth in rent and capital value each contribute precisely half of the third cash flow's 10.66 per cent internal rate of return. By changing the loan's size, cash flows like these can be changed to offer more or less interim cash.

Some investors need a lot of cash throughout the time they are holding it. It could be done to cover personal expenses like retirement living costs or make up for other assets' financial losses. When it comes to property funds, it can be to fulfill the expectations of unitholders for a specific payout or to meet accounting ratios.

The final two cash flow patterns are the most appropriate in these circumstances. The fourth pattern is characteristic of interest-bearing deposits or a piece of real estate with no chance of increasing in value or income, with the initial investment being repaid at the end of the holding period.

A terminable property interest, such as a lease, could provide the fifth pattern. The consistency of the revenue is what makes it appealing. The rate of return would not be impacted, for instance, if the first year's income was not received until the second year, but some owners may find this unacceptable risk.

Generally, it is preferable to receive a return in the form of spendable income instead of the same amount of return received through growth. It is due to the owner's ability to choose between reinvesting and using the money. This is true as long as

- The return and cash flow are calculated after deducting taxes.
- Income and growth are seen as equally risky.
- There are no obstacles to reinvesting the revenue from the early years at the same level of return as the property demonstrates.

Riskier cash flows are anticipated to exhibit minimal interim income because unanticipated events could make the cash flow negative.

An after-tax equity cash flow analysis can also be used to determine whether various methods of financing the purchase of an asset with an income stream, such as:

- If interest-only, fully amortizing, partially amortizing, or "low start" loan repayments have a significant impact on the return or cash flow.
- If tax losses must be carried forward until the asset generates taxable revenue or if they can be recovered in the year they are incurred.
- The degree to which changes in mortgage interest rates or prepayment penalties affect the after-tax equity return.
- If purchasing the property at a higher price is justified by vendor financing with a favorable interest rate or other terms.

An after-tax equity cash flow model offers insights into the return, cash flow sufficiency, and risks of the purchase and its financing. You can also use it to assess any revenue stream or financing package.

## How to present the cash flow analysis?

Poorly presented results from discounted cash flow analyses might not be helpful to real estate investors in making judgments.

The analyst must be able to clearly present the calculations and give recommendations, regardless of whether the investor is an individual buying a residential property or an institution buying a multi-tenanted commercial real estate such as a shopping center or office tower.

The property and financing report will include text and tables. The sophistication and aims of the client(s), the complexity of the income stream, and the type of advice sought will all affect the form and style of each report.

Professionals should not let a deadline or fee affect the format or calibre of their reports; instead, the cost should be based on the amount of labour necessary to conduct and deliver an accurate analysis.

Before the discounted cash flow analysis results are presented, utilise the following checklist as a guide.

**Were the investor's objectives and circumstances outlined?**

The context and justifications for the analysis should be explained, even if it is an internal report (for an investment fund, for instance). This demonstrates that the issue at hand is comprehended.

**Has the analysis's conceptual framework been described?**

A brief explanation of the cash flow length, the intervals, and whether the emphasis is on the equity or property cash flows before or after tax is helpful at the outset.

**Were the projections, estimations, and assumptions identified and supported?**

The report should separate the cash flow factors based on a supported opinion from the facts. It can be done by shading in estimate cells in the main cash flow tables and showing in separate tables rental growth per period, estimated leasing incentives planned for each year, vacancy rates each year, and other significant assumptions.

**Can the reader use a handheld calculator to duplicate the cash flow tables?**

This necessitates a carefully planned table layout with precise row and column descriptions. A summary table with a moderately giant print that fits on one sheet of A4 paper is one strategy. The reader should have no trouble understanding how all of the detailed tables' figures were incorporated into the summary table.

**Has the decision regarding the discount rate and return measure(s) been explained?**

You must justify the rate used to determine present values if the client has not provided the discount rate, and the proper return measures must be shown.

Given the cash flow's riskiness and the alternatives' performance, the analyst must generally comment on its sufficiency if only the internal rate of return from the cash flow is shown.

As part of the suggestions or results from the discounted cash flow analysis, the return(s) should be highlighted in the summary table, and their relevance should be discussed.

**Is there a crystal-clear suggestion that addresses the brief?**

Although there is frequently no clear conclusion that can be derived from the cash flows, analysts shouldn't be afraid to give the client well-reasoned advice. Does the research back up the purchase? What is the cost?

## The bottom line

The predicted net rental income can be subtracted from the loan repayments and tax liability to provide an after-tax equity cash flow for each year of the holding period. The resale proceeds are calculated by deducting the outstanding loan balance and any capital gains taxes from the estimated resale price.

The proceeds then increase the cash flow in the final year from the sale. When the equity cash flows are discounted to their present value, it may be determined by -

- Whether the investment can be expected to generate a sufficient return after taxes, considering borrowing
- The reasonable price for the property.

For private investors, discount rates are primarily dependent on alternative investments, ideally ones with comparable risk. The rates are, if necessary, subjectively changed to reflect the level of risk.

You can compare the discount rate to the cost of capital, calculated using the after-tax interest rate on the loan, and to the needed return components, which include the time value of money, the inflation premium, and the risk premium.

One advantage of outlining equity cash flows is that it allows investors to assess if the timing of inflows and outflows is appropriate for their investment goals. It's important to remember that after-tax cash flow analysis involves assumptions regarding how cash and taxable losses should be handled.

Make sure the cash flow tables and findings are presented clearly and convincingly.

**Know your numbers and control any property profit with the Property Development Feasibility suite.**

## FAQs

### How do you calculate property before tax cash flow?

Before tax cash flow from property can be calculated by taking the gross income generated from the property, subtracting any operating expenses, and then subtracting any taxes owed on the property. This will give you the net income generated from the property, which is your before tax cash flow.

### Is cash flow calculated before or after taxes?

The answer to this question depends on the specific cash flow statement being used. For example, the Statement of Cash Flows from Operating Activities section of a company's cash flow statement typically lists cash inflows and outflows before taxes. On the other hand, the Statement of Cash Flows from Investing and Financing Activities usually lists them after taxes.

In general, though, it is safe to say that cash flows are often calculated before taxes are taken into account. This is because many businesses prefer to see how their cash flows look before considering the impact of taxes. This can give them a better understanding of their financial health and how they are performing on a day-to-day basis.

### Why is it important that cash flow should be measured on an after tax basis?

There are a few key reasons why it's important to measure cash flow on an after-tax basis. First, when you're measuring the cash coming into and out of a business, you want to be sure that you're looking at all of the money that's actually available - and that means taking taxes into account. Secondly, on a personal level, if you're investing in a business or considering starting one, it's important to have a clear understanding of the after-tax cash flow situation so that you can make well-informed decisions. Finally, from a financial planning perspective, after-tax cash flow is often what matters most when it comes to things like retirement and other long-term goals.