How to Avoid Negative Cash Flow by Calculating a Maximum Price to Break-even

Real estate investors invest in rental properties with the expectation that it will produce a positive cash flow, and usually avoid properties producing a negative cash flow.

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 very important distinction to real estate investors during a real estate analysis but fine for our purposes. 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.

The rental income less operating expenses and mortgage payment equals cash flow.

A negative cash flow, of course, occurs when the rental property isn't generating enough income to cover all of the operating expenses and mortgage payment; resulting in the owner having to feed the property to make up the difference. A situation even the most affluent real estate investor is not willing to encounter with investment properties under any circumstance.

One simple solution is for you to set some price parameters for rental properties before you start shopping. Compute the maximum price you can afford to pay and still break even. The computation is rather straightforward but does require a few steps to make it. 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. Simply insert your own variables to run the computation and and there you have it.

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