What is a Break-Even Ratio?
Break-Even Ratio (BER) is an analytical tool lenders often use when they're considering to underwrite a loan for investment real estate properties in order for them to determine how vulnerable the rental property might be to defaulting on its debt in the event the rental income stream derived from the property declines.
Here's the idea.
Cash flows (or income stream) are what typically define an rental income property's financial performance: rental income collected (cash "inflow") less the property's operating expenses and debt service (cash "outflow") equals the cash flow.
So it stands to reason that lenders would want gauge that income stream with a benchmark that shows them what percentage revenue must decline before cash flow breaks even with the loan payment. In other words, they want to know how close the investor might be to missing a loan payment in the event the property's income stream declines.
The break-even ratio does this for lenders by computing the ratio (as a percentage) between a rental property's cash outflow to its gross operating income (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). Here's the formulation.
(Debt Service + Operating Expenses) / Gross Operating Income = BER
Let's say that the subject rental property's first-year financial data indicates a Gross Scheduled Income of $50,0000, a loss due to vacancy in the amount of 2,500, and other income totaling 2,500
- - 2,500
- + 2,500
- = 50,000 (GOI)
as well as operating expenses of 20,000 and a loan payment of 25,000. Here's the result.
(25,000 + 20,000) / 50,000 = 90.00%
Rule of Thumb
Lenders commonly look for a break-even ratio of 85% or less for them to consider underwriting a loan on investment real estate. That is, they want the assurance that rents can decline at least 15% before the property breaks even (100 - 85).
Since the subject income property in our example 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.
So You Know
All ProAPOD Real Estate Investment Software solutions as well as its iCalculator solution compute the break-even ratio.