The Break-Even Ratio
Break-even ratio (or BER, and sometimes called default ratio) is a ratio often used by lenders when they are considering to underwrite a loan for investment real estate properties.
In effect, BER tells the lender how vulnerable a property might be to defaulting on its debt in the event the rental income stream derived from the property should decline.
Here's the idea.
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. The difference of course results in "cash flow".
Okay, now given that cash flows are what typically define an income property's financial performance it stands to reason that cash flow is what lenders would like to see a property producing plenty of for them to want to underwrite it with a loan.
Like wise, it also makes sense for lenders to gauge the income. For should the inflow of cash drop off and decrease the amount of cash flow, it could become a level dangerously close to a point that would cause the investor to perhaps miss a payment and thus the purpose for the ratio.
Break-even ratio is an analytical tool that gives the banks a benchmark of what percentage revenue must decline before cash flow would break even with the loan payment.
In other words, BER computes the ratio between a property's cash outflow to its gross operating income and displays it as a percentage rate.
(Debt Service + Operating Expenses) / Gross Operating Income
- Debt Service is the annual loan payment amount.
- Operating Expenses is the total amount of annual expenses required to keep the property in service such as property taxes, utilities, trash removal and so on.
- Gross Operating Income is the total amount of annual income collected from rents less the vacancy allowance plus the income collected from other sources such as coin-operated washers and dryers, storage units and so on.
Let's say that the subject rental property's first-year operating expenses are $20,000, the annual debt service is $25,000, and the gross operating income is $50,000.
(25,000 + 20,000) / 50,000 = 90.00%
Lenders commonly look for a BER of 85% or less because they want the assurance that rents can decline 15% (100 - 85) before the property breaks even.
Since our subject income property has a BER of 90%, it means that the income stream can only drop off by 10% before the cash flow breaks even with the mortgage payment. So it might not qualify for a loan from a bank that holds to that standard.
Rule of Thumb
Successful real estate investing requires some knowledge of ratios like break-even ratio. So it's always a good idea to work the numbers before you make the offer in order to prevent wasting a lot of time on a losing investment opportunity.