Real estate investor software solutions

I want to acquaint you with a formula you can use the next time you’re considering a real estate investment that will ascertain the maximum price you can pay 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 is the amount of money remaining after all the money that goes out is deducted from all the money that comes in.

Cash Flow = Rental Income - Operating Expenses - Mortgage Payment

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 by computing 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:

1) Determine gross operating income - This is done by taking gross scheduled income and subtracting an amount for vacancy and credit loss. Gross scheduled income is all the income you would receive from rents if all the units were rented.

Gross operating income = Gross scheduled income - Vacancy allowance

2) Determine net operating income - This is accomplished by subtracting operating expenses from gross operating income. Operating expenses are those expenses required to keep the property in service (i.e., property taxes, insurance, utilities, etc.).

Net operating income = Gross operating income - Operating expenses

3) Compute net income percentage (NIP) - This is achieved by dividing net operating income by gross operating income

Net income percentage = Net operating income / Gross operating income

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.

Down payment percentage = 1 - (Net income percentage / GRM x I)

5) Compute maximum purchase price - This allows you to discover how much you can afford to pay to break-even.

Maximum purchase price = Available down payment / Down payment percentage

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.

To do so we have to determine the average gross rent multiplier (GRM) that properties have sold for in the local area (say 10.0), the current market interest rate to finance the property (say 6.0%), and the net income percentage (NIP). Here we divide the property's net operating income (say $7,500) by its gross operating income (say $10,000) and determine that the NIP is 75%.

Okay, now we're ready to make the final two computations that will give us our answer: the down payment percentage then the maximum purchase price.

1 - (.75 / 10 x .06) = .25
$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.

Here’s to your real estate investing success.

So You Know

ProAPOD® rental property analysis software solutions compute the break-even ratio and then post it to the appropriate reports automatically as you complete the user-friendly forms. Learn more at www.proapod.com

Feel free to share this article.