How to Compute Your Investment Property's Break-Even Ratio
Anyone who has been around real estate investing for any length of time is undoubtedly familiar with the term, Break-even Ratio, yet may not have a clue what is and why it's used. So it seemed like a good idea to explain it.
Break-Even Ratio (or BER) is commonly used by lenders when they're considering to underwrite a loan for an investment real estate property. Foremost, as an analytical tool to help them 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.
Since cash flows (i.e., income stream) are what typically define an rental income property's financial performance, 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. The break-even ratio does this for lenders by computing the ratio between a rental property's cash outflow to its cash inflow
How BER Works
1. "Cash outflow" is the total of all the property's annual operating expenses plus the annual loan payment (debt service). Or, Debt Service + Operating Expenses (DS + OE)
2. "Cash inflow" is the total amount of annual rental income collected. Namely, gross scheduled rents, less vacancy, plus income collected from other sources such as coin-operated washers and dryers, storage units and so on (when applicable). Or, Gross Operating Income (GOI)
Therefore the BER formulation is used to compute this ratio (as a percentage) between outflow and inflow according to the following formula:
= Break-Even Ratio
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 as well as operating expenses of 20,000 and a loan payment of 25,000.
Here's the result:
- (DS + OE)
20,000 + 25000 = 45,000
(50,000 - 2,500) + 2,500 = 50,000
45,000 / 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.
Conversely, if the BER had been (say) 80%, that rental property probably would have qualified for the loan.
So You Know
The Agent 6 and Executive 10 real estate analysis software solutions by ProAPOD as well as Pro RE Calculator each compute the break-even ratio automatically based upon your data entries in each of the programs' user-friendly forms.