The Break-Even Ratio: How Lenders Use It to Evaluate Investment Properties

As a real estate investor, you have probably heard of the term Break-even Ratio, but may not fully understand its meaning and importance. So in this article, we will explain what the BER is, how it works, and why it matters.

What It Is

The Break Even Ratio (BER) is a critical metric used by lenders to evaluate the financial viability of an investment property by helping them determine the level of rental income required for a property to cover its operating expenses and debt obligations.

In other words, BER helps lenders assess the risk of default in case the property's rental income declines and thus falls short of expectations.

How It Works

Since cash flows (i.e., the income stream) are the primary indicators of a rental income property's financial performance, lenders use the BER as an analytical tool to determine what percentage of revenue must decline before the cash flow breaks even with the loan payment.

Therefore, the Break-even Ratio computes the ratio between a rental property's cash outflow and cash inflow.

To make the calculation, you need to add up the property's annual operating expenses plus the annual loan payment, which is the "cash outflow". Then, you need to calculate the total amount of annual rental income collected. Namely, gross scheduled rents (all rents as if 100% occupied), less vacancy, plus other income collected from coin-operated washers and dryers, storage units, etc., which is the "cash inflow".

Finally, divide the cash outflow by the cash inflow to get the BER.

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:

Example

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:

1. (DS + OE)
   20,000 + 25000 = 45,000
2. GOI
   (50,000 - 2,500) + 2,500 = 50,000
3. BER
   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 break-even ratio is included in these ProAPOD solutions: