Dean Graziosi

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. 

1. 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.
2. 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.
3. The debt service is the total of all principal, interest or loan charges paid on the mortgage for the year. 
4. 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.

When purchasing a multi-family or other rental property, part of the due diligence on the financial side is the careful examination of all financial reports, profit and loss, assets and liabilities.  One of the items an investor must give some attention is the vacancy and credit loss history of the property.  If the seller cannot provide adequate records to indicate their vacancy rate, as well as the non-payment history, be very careful.

Assuming the seller has great records, what has been their historic vacancy rate?  Let’s say that records show a rate of 6% for vacancy.  If this were a six unit property, that would only be about 4.32 months of vacancy out of the 72 month rental year.  However, if the average rent is $900 per month, this is $3888 in lost revenue.  And the vacancy rate could be higher. 

Whatever it is, don’t just take the last year as an indicator.  Look several years back and see if there is a trend in either direction.  If vacancy has risen over the last couple of years, factor in an increase for the next year for your valuation research.  Don’t’ stop there either, as you should try to find figures for comparable properties in the area.  This is more difficult, as landlords don’t advertise these numbers.  A search on the Internet for “apartment vacancy rates” yields a great deal of data, some of it specific to urban areas.

If the property you are considering has a vacancy rate significantly lower or higher than others in the area, determine the probable reason(s).  If higher, is there something you can correct or change economically that will bring it more into line with others, as well as increase profitability.  If lower, you might want to tack a little on to the number you’re using for the valuation to provide a “worst-case” scenario.

When examining the non-payment of rent, or credit losses, it isn’t just numbers.  You might even have to ask the seller some questions about how they go about rent collection, particularly when a tenant becomes delinquent.  If the seller is a bit laid-back in their style and collection practices, you can possibly look forward to better results with a strict policy that’s enforced with speed.  Of course, a firm grasp of your legal rights and responsibilities as a landlord will go a long way in this regard.

The important thing is to make the vacancy and credit loss numbers a part of your due diligence and financial evaluation of any rental property.  It could save you from a financial mistake or it could show you hidden opportunity in a property.

We diligently search advertisements, work with property bird dogs, and do extensive research trying to locate that excellent rental property investment.  For multi-family properties, we want all the normal things, like reasonable condition, good location, a below-market purchase price, and stable market leases.  It’s the leases that bear really close scrutiny.  We have honed our skills at condition, remodel/repair estimating, and valuation, but we must be very careful when it comes to leases.  We know that WYSIWYG in computer talk means “What You See is What You Get.”  Unfortunately, we can’t count on that with leases.

The first, and most obvious, thing to check is the duration of the current leases.  Are most of them rolling over in the next six months or less?  What is the anticipation of renewals by the current tenants?  If they are at market levels, you’ll really want to get new leases without having to get new tenants.  If the lease terms are out a year or more, examine them to make sure that they don’t have loopholes or easy escape clauses.  There’s no fun in having a number of tenants bale on you unexpectedly a couple of months after you buy the property.

Are the rents at current market levels?  If they are below market, you really want to see shorter terms before expiration, giving you the ability to raise rents sooner.  If they are at market level, are they really paying what it says in the lease.  This is one area in which buyers have been very upset after purchase.  Just because a lease says that Tenant Smith pays $900 per month, it doesn’t mean that the really do.  Check lease rental terms against actual rental deposits.  You don’t want to buy and then find out that several tenants are trading out services for rent.

Dean Graziosi, in instructing his real estate investment clients, is very clear with tips about getting the real information behind leases.  Do the tenants have options to renew?  Do these options allow rent increases, or can they renew at their current rate?  This could be a very important factor in your purchase decision.  Are there automatic rent increase escalator clauses?  With long leases, you want to be sure that the increases negotiated will cover inflation.

When you think you’ve found that perfect multi-family investment, pay extra attention to the leases currently in place.