How to Predetermine a Purchase Price at the Break-Even Point

break-even-point

break-even-pointAs you know, one of the great challenges facing real estate investors is the ability to invest their money in rental properties that make them a profitable return, and at the very least won’t lose them money.

To cope with this challenge, the investor relies upon the basic principal of real estate investing.

Namely, to ensure that the cash flows produced by the rental property justify the amount of money the investor must invest to purchase those cash flows. In other words, the idea is to never pay more for a property where the income stream it produces doesn’t at least result in a “break-even” for the investor.

In this article, I’ll show you a technique using the break-even point that makes it possible to predetermine the maximum price you can pay for a rental property and still break even. A bit of advanced math is involved, but the calculations aren’t that tough when taken one step at a time.

The Break-Even Point

The break-even point marks the point at which all the rental property’s expenses (outflows) are equal to its revenue (cash inflows). In other words, it’s the point at which gains equal losses and the real estate investor has “broken even.”

Okay, here’s the step-by-step formulation you would make to determine the maximum amount you can afford to pay for a real estate investment property in order to meet that objective.

Maximum Purchase Price Formulation

To make this calculation, you will need to know the following financial data for the subject rental property, some data pertaining to your local market area, and the amount of cash available for your down payment. The second list shows the assumptions we’ll use in our examples.

  • Gross operating income (property)
  • Gross operating expenses (property)
  • Gross rent multiplier (current area average)
  • Interest  rate (current market)
  • Available cash down payment

Assumptions:

  • $200,000
  • $100,000
  • 10.0
  • 6.0%
  • $75,000
Step 1

First, you must determine the property’s net operating income (NOI). This is determined by subtracting its gross operating expenses from its gross operating income.

Gross Operating Income
less Gross Operating Expenses
equals Net Operating Income
or,
$200,000
less 100,000
equals $100,000

Step 2

Next, you must determine a net income percentage by dividing net operating income by gross operating income.

Net Operating Income
divided by Gross Operating Income
equals Net Income Percentage
or,
$100,000
divided by 200,000
equals .50

Step 3

Next, you’ll need to compute your down payment percentage. To do this, you will need to plug in the average gross rent multiplier in your area as well as the current market interest rate.

1 – (Net Income Percentage / Gross Rent Multiplier x Interest) = Down Payment Percentage
or,
1 – (.50 / 10 x .06) = .17

In other words, to avoid going negative, your down payment must at least be 17 percent of the purchase price.

Step 4

Finally, to determine how much you can afford to pay for the rental property you enter the amount of your available down payment and divide it by the down payment percentage.

Available down payment
divided by Down Payment Percentage
equals Maximum Purchase Price
or,
$75,000
divided by .17
equals $441,000 (rounded down)

Result

With a down payment investment of $75,000 at the above parameters, the cash flow from the rental property will be at the break-even point if you purchase the property for $441,000. If you pay less, you might enjoy a positive amount you can take to the bank after expenses. If you pay more, you might encounter a negative amount that requires you to feed the expenses out-of-pocket.

Bottom Line

This break-even point technique is a useful way for you to resolve how much real estate you can afford to minimize the necessity of feeding a negative cash flow. Just bear in mind that any number of factors such as increased vacancy, reductions in market rents, or unanticipated expenses could affect you negatively at any time in the future.

 

About the Cash on Cash Return

Cash on cash return (CoC) is a popular rate of return used by real estate investors conducting a real estate analysis because it’s easy to compute and offers investors a “quick read” on a rental property’s profitability.

It can help the investor gauge the profitability an income property against another investment opportunity such as a T-bill, for instance, or to compare similar income properties such as an apartment complex to a commercial real estate office complex.

As a result, it’s not uncommon to see this real estate investing return included in most real estate analysis presentations and typically requested by a majority of real estate investors.

Despite its popularity,  however,  cash on cash is not a particularly powerful tool for measuring the profitability of rental income property mostly due to the fact that cash on cash doesn’t take into account time value of money which in turn restricts it to measuring a property’s first year cash flow rather than cash flows generated over future years.

Nonetheless, the return is not without validity, and certainly one that those of you who are engaging in investment real estate might want to know about. So it seemed needful to show you how it works.

Formulation

Cash on cash (expressed as a percentage) is a return that measures the ratio between a rental property’s anticipated cash flow for the first year to the amount of cash a real estate investor initially invests to purchase the property.

In other words, cash on cash expresses what percent of the investor’s “initial cash investment” requirement is attributable to the rental property’s “annual cash flow” (generally before taxes). Okay, but to better understand the formulation, let’s dig a little bit deeper.

  1. The initial cash investment (or cash invested) signifies the total amount of cash the investor expects to initially invest to purchase the property. Namely, the down payment, loan points, escrow and title fees, appraisal, and inspection costs.
  2. The annual cash flow is the amount of cash generated by the investment property in the first year of operation before the investor’s income taxes are satisfied.

Here’s the formula:

Annual Cash Flow / Cash Invested = Cash on Cash Return

Example

Let’s say that a real estate investor makes an initial cash investment of $206,050 for a rental property estimated to produce a cash flow of $21,483 in the first year of operation. What is the investor’s CoC return for that first year?

$21,483 / 206,050 = 10.43%

Rule of Thumb

Real estate investment decisions are never made solely on cash on cash return because there are better ways to evaluate income-property investments.

So You Know

All ProAPOD real estate investing software solutions automatically compute CoC and include it inside each of the appropriate real estate analysis reports created by the software.