As 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
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
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
divided by 200,000
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
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.
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
divided by .17
equals $441,000 (rounded down)
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.
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.