When an income property doesn’t generate enough income to cover operating expenses, it results in a negative cash flow. A problem real estate investors want to avoid with investment property because it would require the real estate investor to feed the property.
Here’s a technique to help you avoid purchasing a rental property with negative cash flow. A formula you can use to conclude how much you can afford to pay and still break even. It’s not difficult to calculate provided you make the computation one-step at a time.
- Compute gross operating income Gross scheduled income – Vacancy allowance = Gross operating income.
- Determine net operating income Gross operating income – Operating expenses = Net operating income.
- Figure net income percentage (NIP) 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.
- Determine maximum purchase price Available down payment / Down payment percentage = Maximum purchase price.
Let’s consider an example. Say you have $75,000 to invest and do not want to purchase an investment property with a negative cash flow you would have to feed. You would do the following two steps to establish the maximum purchase price you can pay for the investment property and avoid having a negative cash flow.
First, compute the down payment percentage. If 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%, compute the down payment percentage as such:
1 – (.75 / 10 x .06) = .25
Secondly, plug in the down payment percentage and compute the maximum purchase price:
$75,000 / .25 = $300,000
In other words, with a down payment of $75,000 at the parameters used in our example above, you can avoid a negative cash as long as you don’t pay more than $300,000 for the real estate property. Of course, plug in your own variables to determine the results matching your particular situation. But as you can see, it’s not difficult and well worth the effort. It really does incorporate a break-even point and therein quickly helps you resolve how much real estate you can afford without dipping into your pocket and feeding a negative cash flow.
Here’s to your real estate investing success.
