Two calculations often made by appraisers using the income approach to valuate rental property involve the profit margin and break-even ratio. In this article I will explain and show the formulas for both.
Profit margin is the result of dividing cash flow from comparative rental properties and the subject property by gross operating income. This is the gross income adjusted for likely vacancies. Since the profit margin is based on cash flow rather than tax-basis profit including depreciation is a good way for appraisers and real estate investors to determine whether one income property has better cash flow potential than either another income property or the average property in the current market.
Formula: Cash flow / Gross operating income = Profit margin
Break-even ratio is another analytical tool used by appraisers and investors that shows how well the gross operating income will cover cash requirements. When the ratio is below 1.00 it signifies that the property should be able to produce net positive cash flow. A ratio above 1.00 indicates a negative cash flow.
Formula: Operating expenses + Mortgage debt service / Gross operating income = Break-even ratio
This ratio can also be calculated to include the effect of tax reduction and provision for tax advantages. This is important to many real estate investors involved with income-producing properties because it is possible to report a tax-basis net loss but still produce a positive cash flow. When the tax benefits of the investment are substantial this formula should be given greater emphasis because for many individual investors tax benefits define the difference between positive and negative cash flow.
Formula: Operating expenses + Mortgage debt service – [(operating expenses + interest + depreciation) x effective tax rate] / Gross operating income = Break-even ratio net of taxes