Break-even Ratio – The Lender Cares and So Should You
What is break-even ratio? Simply, it’s the point at which a rental property goes from negative to positive cash flow, or the point at which we break-even on cash flow to operate the property. This is one calculation used by lenders to determine the feasibility of lending on a real estate rental property. Too high a break-even ratio, and you’ll have trouble getting a loan. So, the lower the ratio, the better.
It is expressed as a percentage, and isn’t a difficult calculation. In your financial analysis and valuation of a potential purchase, you’ll have all of the numbers in front of you to determine the break-even ratio. We will be using Gross Operating Income or GOI, Debt Service Cost, and Gross Operating Expense.
- Our GOI, or Gross Operating Income, is the amount of money we have to spend after we’ve subtracted vacancy and credit losses (or estimates) from our gross rental income.
- The gross operating expenses are the costs to operate and manage the property. This would be all direct costs of operation, including management salaries, repairs, maintenance, taxes, insurance, office and supplies expenses.
- The debt service is the total of all principal, interest or loan charges paid on the mortgage for the year.
- The Break-even Ratio is arrived at by adding the Debt Service to the Gross Operating Expenses, and dividing the result by the GOI. Or Debt Service + Expenses / Gross Operating Income. Basically, you’re just taking the total of all the cash you’re putting in for the year and dividing it by the cash you’re getting back.
Let’s do a quick calculation for an example four unit property that you’re purchasing with a $195,000 loan at 7.0% interest. Rents average $900/month each unit, and vacancy/credit loss is 7%. You manage them yourself, so no management salaries are involved, making your annual operating expenses approximately $16,000.
· The loan is $1297/month with no other charges, for a total annual Debt Service of $15,564.
· Operating expenses are $16,000 per year.
· Gross Operating Income is $900 X 12 X 4 = $43,200 minus 7% = $40,176.
· ($15,564 + $16,000) / $40,176 = .785, or 78.5% Break-even
Generally, lenders are OK with 80% or better for this result, but you’ll need to check the market and lender criteria at the time of your evaluation of a property.