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How to Calculate a Price to Break-even and Avoid Negative Cash Flow

By James Kobzeff

Republish: EasyPublish™ Published: 25Sep2009 Word count: 579 Viewed: 1938 time(s) Get Free Content For Your Site

The surest thing that can be said about real estate investors and cash flow is that it is best for cash flow to be positive and never should be negative.

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, thus avoiding a negative cash flow.

Before we get started, let's consider what cash flow is and how a rental property produces it. It should be pointed out that throughout this article we are referring to cash flow before taxes, not cash flow after taxes; a distinction important to real estate investors, but for our purposes, adequate. Cash flow

Simply put, cash flow is the amount of money remaining after all the money that goes out is deducted from all the money that comes in.

All the rental income, less operating expenses, less mortgage payment equals cash flow.

As you might expect, a negative cash flow occurs when rental properties don't 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 easy solution is simply to set some parameters before you start shopping for rental properties. Compute the maximum price you can afford to pay and still break even. It's not a difficult computation to make but must be taken one-step at a time. Here's the procedure.

Computing the 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. To make your own computation, simply plug in your own variables and there you have it.

Hopefully this modest insight will help your real estate investing endeavors. Here's to your success.

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