There are a lot of ratios to look at when investing in real estate, and it can get confusing. One of the lesser used but still important ratios is the break-even ratio.
The Break Even Ratio answers the question:
At what occupancy rate am I breaking even?
Good question to know the answer to, right?
Additionally, it allows lenders and other investors to assess the rental property for its ability to meet its operating expenses, debt service, and provide a level of profit.
Break Even Ratio Formula
To calculate the break even ratio, simply take the debt service + operating expenses - any reserves and divide by the gross operating income.
Break Even Ratio Example
Let's say a given property has an annual debt service of $15,000 and it's annual operating expenses are $12,000. The total yearly expenses for this property are $27,000.
Now, let's say this property has a gross income of $33,000 (not to be confused with the net operating income).
Total Expenses / Gross Income = Break Even Ratio
$27,000 / $33,000 = 81.8%
So, you need roughly 82% occupancy to break even and cover your expenses.
Break Even Ratio vs Debt Service Coverage Ratio
The DSCR and BER are clearly related. As you might remember, the debt service coverage ratio is the NOI / Debt service. It is the relationship between the NOI and Debt Service.
The break-even ratio is the relationship between all costs and income.
So, these are very closely related but answer slightly different questions.
THE DSCR lets a lender know the borrower's ability to pay the debt service. So, a DSCR of 1.25 means the borrower net income is 25% more than all of the operating costs (including debt service). They could lose 25% of their NOI and still cover the debt service.
The break even ratio is slightly different. It tells you how much of your gross income you can lose in order to break even.
So, the debt coverage ratio compares net income to the mortgage. Break even ratio compares gross income to total expenses.
When To Use Break Even Ratio
The break even ratio is important for both investors and lenders. It's used to know what occupancy level you require in order to still cover your bills.
For example, if your break even ratio is 92%, an investor or lender may feel this deal is shaky because of the high occupancy required to keep the building afloat. It's really common for occupancy levels to drop below 90%, especially during a recession.
On the other hand, if the break-even ratio is 75%, an investor or lender would be far more confident in the deal. They will know that during the worst case scenario of a 25% vacancy rate, the property could still cover all of its expenses and obligations.
Additionally, investors may analyze a deal by looking at the break-even occupancy rate both at acquisition and after the building is remodeled and stabilized.
When To Use the Break Even Ratio - Example
For example, if we are buying a deal with a heavy rehab component, we might expect it is currently underwater or barely breaking even. So, a break even occupancy of 95% or even over 100% would be expected.
We could project out one or two years and look at what the stabilized property would look like. Then determine the break even occupancy at that point.
Let's say that in year two, the break even ratio is a much healthier 82%. So, we might choose to take this deal.
On the other hand, if we did all this remodeling and work and the break even ratio was 90%, we might reconsider investing in the deal.
Break Even Ratio Rule of Thumb
As a general rule of thumb, lenders will look for a break even ratio of 85% or less. Just like everything else in real estate, this number fluctuates and depends on the lender and property, but a ratio under 85% is good.
This means the total rent collected can drop by 15% and you still can cover all of the bills. That's pretty good for income producing property.
Analyzing Real Estate Deals
When analyzing your rental property deals, there are a number of metrics you'll want to use to determine if it's a good deal.
First, you want to know what it will be worth when any upgrades or rehab is completed. This is called the After Repair Value.
The next thing you want to look at is the average cash on cash return as well as the overall return on investment over the timeframe of the deal.
You'll want to look at the in-place cash on cash return day 1 and compare it to the cash on cash return once the work is complete and rents are pushed.
But Why, Exactly?
You do this because you want to walk into a cash flowing property day one, then add value. It's a lot harder to buy something that is cash flow negative and turn it around.
This is where you'll look at the break even ratio to see how the deal performs both day 1 and after it's stabilized.
Now, you'll want to look at overall financing and how that affects your returns. This is where the debt coverage ratio comes into play. If the DSCR is too low, you'll get less loan proceeds. That means higher cash out of pocket and lower cash on cash returns.
With all of this information, you can make an informed decision to buy or not to buy.
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