The Maximum Purchase Price Calculation
Although real estate investors sometimes invest in a rental income property that generates a negative cash flow for income tax purposes, or a break-even cash flow when the property has upside value potential, more often than not investors buy income property for positive cash flow.
Okay, so let me acquaint you with a formula you can use the next time you're considering a real estate investment that will ascertain the maximum purchase price you can pay for a property to at least get a break-even cash flow.
First, though, 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.
- Operating Expenses
- Mortgage Payment
= 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.
Fair enough. So here's the calculation you can use to help you avoid a negative cash flow by paying too much for a rental property.
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 scheduled income
- Vacancy allowance & credit loss
= Gross operating income
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.).
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
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.
(Net income percentage / (GRM x I))-1
= Down payment percentage
5. Compute maximum purchase price (MPP).
This allows you to discover how much you can afford to pay to break-even.
Available down payment ÷ Down payment percentage
= Maximum purchase price
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. We'll assume that you conducted both, a market study and financial analysis (per steps 1 & 2 above) and arrived at the following numbers.
- Gross Operating Income: $10,000
- Net Operating Income: $7,5000
- Gross Rent Multiplier: 10.0
- Current Interest Rate: 6.0%
1. Net Income Percentage
7,500 ÷ 10,000 = 75%
2. Down Payment Percentage
(.75 / (10 x .06))-1 = .25
3. Maximum Purchase Price
$75,000 / .25 = $300,000
There you have it. Based upon the above parameters 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.