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How to Use the Maximum Price Calculation to Avoid Negative Cash Flow
I would like to show you a formula that will ascertain the maximum price you can pay for a rental property and at least get a break-even cash flow.
First, let’s consider what cash flow is and how a rental property produces it. But please note 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 is straightforward. Cash flow is the amount of money remaining after all the money that goes out is deducted from all the money that comes in. That is, all the rental income less operating expenses less mortgage payment equals cash flow.
A negative cash flow, of course, occurs when rental properties don’t generate enough income to cover operating expenses and mortgage payment. Naturally, when this occurs the owner has to make up the difference by dipping into his or her pocket to feed the property--a situation no real estate investor wants to face with investment property under any circumstance.
This formula will help you to set some price parameters when you start shopping so you can avoid spending time looking at rental properties you can't afford to buy without creating a negative cash flow. The computation in not difficult but does involve a series of steps.
Here is the procedure.
Maximum Price Formulation
- 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
- Determine net operating income. This is accomplished by subtracting operating expenses from gross operating income:
Gross operating income - Operating expenses = Net operating income
- 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
- 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
- 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
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.
- 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
- Compute the maximum purchase price.
$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.
Here’s to your real estate investing success.
About the Author
James Kobzeff is a real estate professional and the owner/developer of ProAPOD Real Estate Investment Software. Nationally-distributed real estate analysis software to brokers and investors since 2000.