Avoid Negative Cash Flow by Calculating a Price that Breaks Even

In this article, I want to acquaint you with a formula you can use in your real estate analysis the next time you’re considering an investment that will ascertain the maximum price you can pay for a rental property to break-even and thereby avoid buying a rental property that generates a negative cash flow.

But first let’s consider what cash flow is and how a rental property produces it. Please note that throughout this article we are referring to cash flow before taxes and not cash flow after taxes; a distinction important to real estate investors but adequate for our purposes.

Cash flow

Cash flow is the amount of money remaining after all the money that goes out is deducted from all the money that comes in.

Rental income less operating expenses and mortgage payment equals cash flow.

A negative cash flow occurs when a rental property fails to generate enough income to cover operating expenses and mortgage payment, resulting in the owner having to feed the property to make up the difference. A problem real estate investors generally do not want to encounter with investment property under any circumstance.

One solution is to set some parameters before you start shopping for rental properties. Simply compute the maximum price you can afford to pay and still break even. It's not a difficult computation to make but does require several steps. Here's the procedure.

Computing Maximum Price

1) Determine gross operating income This is done by taking gross rental income and subtracting an amount for vacancy and credit loss as such: Gross scheduled income - Vacancy allowance = Gross operating income.

2) Determine net operating income This is accomplished by subtracting operating expenses from gross operating income: Gross operating income - Operating expenses = Net operating income.

3) Compute net income percentage (NIP) This is achieved by dividing net operating income by gross operating income as follows: Net operating income / Gross operating income = Net income percentage.

4) Compute down payment percentage (DPP) In this case, you’ll need to know the average gross rent multiplier in your area (GRM) and the current market interest rate (I) to make this computation: 1 - (Net income percentage / GRM x I) = Down payment percentage.

5) Compute maximum purchase price To discover how much you can afford to pay to break-even, you need to apply this formula: Available down payment / Down payment percentage = Maximum purchase price.

Here’s an example.

Say you have $75,000 to invest and want to determine the maximum purchase price you can pay for the investment property without going below a break-even cash flow.

1) Compute the down payment percentage (DPP).

Let's say the net income percentage (NIP) is 75%, the average gross rent multiplier (GRM) in your area is 10, and the current market interest rate (I) is 6%. You would compute the down payment percentage as follows: 1 - (.75 / 10 x .06) = .25

2) Compute the maximum purchase price as follows: $75,000 / .25 = $300,000

In other words, with a down payment of $75,000, and given the parameters used in our example, you can avoid a negative cash if you pay no more than $300,000 for the rental property. Simply insert your own variables to make the computation and there you have it.

Here’s to your real estate investing success.

About the Author
James Kobzeff is the developer of ProAPOD® - leading real estate investment software for agents and investors. It's fast, easy, and concise. Create rental property cash flow and rate of return presentations in minutes! Learn more at => http://www.proapod.com