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From: Ric Gordon


Guys,

Quite a long and technical post- would like to know if I've got it right (get those spreadsheets working guys)...

I'm reading API magazine and something's distrubing me. On pp 30-33 there's an article entitled "Property Peas and Profit" by Ian Ryan. Now Ian's talking about how financial advisers often mislead property investors. But the result I intuitively get from his calculations (see table bottom page 31) differ considerably to his.

Here's what he gives us:
$300 property
5% yeild ($15,000 rent p.a)
7% interest ($21,000 p.a)
$3,000 expenses p.a. (or 20% of rent)

Now he says our deductible losses are $3,000 = ($21,000-$15,000-$3,000)

But I figure they are $9,000:

Deductible losses:
$21,000+$3,000 =$24,000

Rent: $15,000

Therefore net deductible losses: $9,000

Therefore, the tax deduction @48.5% is $4,365
leaving the investor to pay $4,635 per annum (as opposed to Ian's $1,455 and $1,545 respectively).

So after 5 years the investor has paid $23,175 (NOT $7,725 - ie. they have paid about 3 times what Ian Ryan reckons they paid).

But this isn't where it stops. Capital gains tax is no longer indexed: you take 50% of the nominal gain and then are taxed on that. So in year 5 the CGT would be [($356,305 - 300,000) * 50% * 48.5%] = $13,653 (instead of $8,696). This leaves an after tax gain of $42,651, before inflation.

Sooo (I'm getting there) nominal ROI is 184% [(42,651-23,175)-1], over the 5 years, NOT the 510% that Ian would have us believe. SO, rather than an IRR of 39% per annum (after inflation), the actual IRR is 11% BEFORE inflation (after inflation would be worse). When you consider that the (adjusted, reconstructed) All Ords have returned about 14% per annum (after tax, before inflation) since 1926 this is fairly similar. As far as I can see I think Ian shouldn't be so quick to have a go at the accountant's/advisers. I can only assume he works with a Gold Coast marketing company.

So, should I

a) go back to high school and repeat my maths courses

b) reread the info (have I misinterpreted assumptions)

c) write to API and complain about such misleading, disgraceful journalism - ;)

Did anyone else feel this was wrong? Can anyone confirm/deny my calcs, or am I just a technical geek :)


Ric G
 
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Reply: 1
From: Pierre .


Rick,

I haven't got the article, so I can't fill in a few blanks that you need. I have punched your figures into Pierre's IP Calculator (available here: http://www4.tpg.com.au/users/pjnoake) and have made some assumptions that need to be clarified:

Assumptions

Capital Growth - I used 10% (this will affect your CGT calculations)

Income of Owner - I used $50000 (this will affect your tax calculations. You have used highest marginal rate which means the salary must be over $80000 to allow for decuctions and still tax at the highest rate.)

Date of Construction - I assumed the property was new. (This determines capital allowance. Is the house new? Does the cost include GST?)

Cost of depreciable fittings - I used $30000 over 5 years. (Again, this will have a major effect on your calcs in the first 5-7 years.)

Borrowing costs? - I calculated them to be $1750. This assumes no LMI. If you add LMI, borrowing costs go up to aprox $5750. (Same as above - claimable up-front expense.)

So, bottom line with my additional figures in the first year:

Pre-tax cashflow = -$189.55 per week

Cash deductions = $24857 per annum
Non-cash deductions = $13100 per annum
Total deductions = $37957

Net income = -$22957 per annum

Pre IP salary = $50000
Pre IP Tax paid = $11380
Post IP Salary = $27043
Post IP Tax Payable = $4493
Tax Credit per annum = $4493
221D Tax Credit per week = $86.40

After Tax Cashflow = -$2970 per annum
After Tax Cashflow = -$57.11 per week

Performance:
Yield = 5.2% gross
IRR 5 Years = 97.4% (assuming 10% CG)
IRR 10 Years = 50.85%
IRR 15 Years = 36.79%

So, there you have it. If my assumptions don't match yours or the article's, then I've just wasted 10 minutes typing this. Have a look at my spreadsheet and put in your own figures. Change the figures and see what sort of effect they have.

Pierre
 
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Reply: 1.1
From: Ric Gordon


Thanks Pierre, I should have been specific.

The article assumed capital growth of 3.5%, and that the applicable marginal tax rate was 48.5% - so I did the same. As I read it there was no talk of depreciation or anything.

Now, how realistic these assumptions are (I would hope to get more than 3.5% CG) is a different matter. Thanks for the input.

BTW - it is nice to know that the output from your spreadsheet is the same as the output from my spreadsheet - so I didn't waste all those hours on excel!

Cheers

Ric G
 
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Reply: 1.2
From: Ian Ryan


Hi Ric (and others trying to work out the math in the API article I wrote).

There's not much point in trying to resolve the calculations because no matter how you try to slot them into your spreadsheet, you just won't come up with a sensible answer - as Ric found out.

The fact is that the entire original article - which appeared in a very high profile Australian business publication - was clearly written by someone who did not understand property investment and had simply followed the standard line that property is not a good vehicle for wealth creation.

Ric has correctly pointed out that the deductible loss calculations are incorrect - and he is right, but that's precisely how the original article was written. I didn't try to point out the many absurdities in the original article. I simply stated that I was re-using the figures that were used in the article (they aren't my figures as some seem to think) and then exploded what I felt was the most serious error.

None of this affects the purpose of my article in showing that it is incorrect to deduct the inflation of the whole investment from the investor's portion. I felt that was the most devious trick in the original article - I think the other faults in the original figures are simply the original writer's unclear thinking on the whole subject.

I have written a second article that will probably (the editor willing) appear in the next edition of API that looks further into this whole subject. I have already looked at a number of issues mentioned by Ric. In that article I pose the question:

One odd figure used was that an investment property would grow at 3.5 per cent annually for five years. How did the writer of the original article derive this growth rate?

We may have more invigorating discussions after that article appears.

Ian Ryan
 
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Reply: 1.2.1
From: Gary Smith


Hi Ian,

> None of this affects the purpose of my article in showing that it is
incorrect to deduct the inflation of the whole investment from the
investor's portion. I felt that was the most devious trick in the original
article - I think the other faults in the original figures are simply the
original writer's unclear thinking on the whole subject. <

I don't agree that this is wrong. Mind you, I wouldn't argue that you are
wrong, just there are different interpretations. It is perfectly arguable
that the inflation amount should be calculated from the total value of the
investment - regardless of the source of that money; your own pocket, the
bank, a gift. If your rich uncle gives you a house, does that mean that
inflation doesn't cost you anything because you have used none of your own
money? When you claim depreciation on a air-conditioner, do you claim on the
total cost of the air-conditioner, or just your equity in it?

But in any case, whether doing that is right or wrong is irrelevant. What is
relevant is that when comparing investments you use the same accounting
methods. I'll bet that the author of those figure went on to show how
wonderful other investments were, but used a different method of measuring
performance. Whether you calculate inflation losses using total value or
equity is not nearly as important as being consistent.

Gary
 
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Reply: 1.2.2
From: Ric Gordon


Thanks for clearing that up Ian - I look forward to the next instalment.
 
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