Break-even Ratio (BER): What It Means and How to Calculate
by James Kobzeff
Break-even ratio (sometimes called default ratio) is often used by lenders when considering to underwrite a loan for an real estate investment property. In effect, it tells the lender how vulnerable a property might be to defaulting on its debt in the event rental income derived from the real estate income property should decline.
Whereas rental income represents the inflow of cash, the property's operating expenses and debt service (the loan payment) represents an out flow of cash which, of course, represents "cash flow". And cash flow is what a real estate investor (as well as the bank) like to see a property producing a lot of. When the income, however, drops off, so will the cash flow; sometimes dangerously close to a point that would cause the investor to perhaps miss a payment.
The break-even ratio, therefore, gives the banks a benchmark of what percentage revenue must decline before cash flow would break even with the loan payment.
How To Calculate
Break-Even Ratio = (Debt Service + Operating Expenses) / Gross Operating Income
Example. Let's assume that the property's first-year operating expenses are $20,000, the annual debt service is $25,000, and the gross operating income is $50,000. The BER would be 90% ($20,000 + 25,000 = 45,000 / 50,000 = 90.00%).
Interpretation of the Ratio
Because BER computes the ratio between a property's cash outflow (operating expenses plus loan payment) and its rental income, the percentage rate reveals what percent outgo is to rental income.
As a rule of thumb lenders look for a BER of 85% or less. That is, they want the assurance that rents can decline 15% before the property breaks even.
Successful real estate investing requires some knowledge of ratios like this. So it's always a good idea to work the numbers before you make the offer and perhaps waste a lot of time on a losing investment opportunity. You can certainly compute it yourself, or you might want to turn to (excuse the shameless promotion) my real estate investment software to do it for you.
So You Know
ProAPOD® Real Estate Investing Software computes the break-even ratio automatically as you enter the property data. It is recalculated in real time each time you make changes to the data so it is always accurate. Learn more at www.proapod.com
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