The break even ratio is part of an important analysis method that is used by real estate investors and mortgage lenders alike. It’s an effective way of assessing the financial viability of an investment property. The break even ratio can help streamline loan applications or ensure that funds are being invested wisely. In this article, we’ll highlight the importance of the break even ratio in real estate and detail how it can be used to great effect when financing a real estate investment.
The Break Even Ratio Formula
Before getting to the formula, we first need to go over the variables that comprise it. Here’s a brief overview of the components that make up the break even ratio formula:
- The debt service of the property. This refers to the payments that are geared towards reimbursing the interest and principal on a loan. The sum of all periodic payments is called an annual debt service (ADS).
- The operating expenses of the property. These are all the yearly costs that come with managing real estate investment properties. This includes marketing, insurance, taxes, utilities, maintenance and repairs, accounting and legal, and trash collection among many other expenses.
- The gross operating income of the property. The gross operating income is the effective gross income of the property. In other terms, it’s the result of subtracting vacancy loss and credit loss from the gross potential income.
The break even ratio formula is quite intuitive and straightforward. You simply add the operating expenses to the debt service, subtract any reserves, and divide by the gross operating income. Below is an example that illustrates how to calculate the break even ratio.
Break Even Ratio= [(Operating Expenses + Debt Service)- Reserves]/ Gross Operating Income
Let’s take a rental property that has a debt service of $10,000 and operating expenses of $8,000. This means that the total yearly expenses for this property are $18,000. Now let’s posit that this investment property generates a gross income of $24,000. In this case, the break even ratio is: 18,000/24,000 = 0.75%. This percentage represents the break even point. In other words, 75% is the occupancy rate that you need to cover all your expenses and break even.
Keep track of expenses and get operating income estimates using Mashvisor’s rental property calculator.
The Importance of Break Even Analysis
As we stated above, the break even ratio is valuable for both the investor and the lender. This metric gives them a clear idea about the property’s cash flow potential. For example, a very high ratio means that any drop in occupancy rate will result in negative cash flow. Conservative real estate investors and lenders would think twice before committing to a property with a break even ratio above 90%. On the opposite end of the spectrum, a low break even ratio is a good sign for investors and lenders. A low ratio means that even with a high vacancy rate, the property will still be breaking even.
What Is a Good Break Even Ratio?
Like any metric in a typical investment property analysis, the ideal break even ratio depends on many factors. Some private lenders have a high level of risk tolerance and are more likely to underwrite a loan despite a high ratio. Furthermore, many experienced investors acquire underwater properties with the aim of turning them around. The break even ratio of these properties can reach a staggering 95%.
Having said that, most real estate investors and lenders prefer to stay on the side of caution. The figure that is considered optimal by most industry experts is 85% or less. Investment property with this break even ratio will break even if the rental income drops by 15%.
Reducing the Break Even Point of a Rental Property
A high break even point is not an ideal situation for rental property owners. Not only are their loan options limited, but they will also have trouble attracting investors. Reducing the break even point is feasible, but it does require a complete restructuring of how the rental property is managed. Since the break even ratio involves expenses and income, the way to reduce it is by doing the following:
- Boost collected revenue
- Lower operating expenses
- Reduce fixed costs
- Reduce cash investment
Improving these parameters requires year-around diligence and strict adherence to a coherent overall strategy. Here’s a breakdown of what real estate investors can do to tackle each one.
Boost Collected Revenue
There are several ways you can increase the revenue that a real estate investment property generates. Since you can’t just increase the rental rate on a whim, you need to explore other revenue channels that allow you to increase your rental income. This includes introducing new services and benefits such as accommodation for pets, cable TV, etc..
Another effective strategy is to get aggressive and proactive when it comes to increasing occupancy. Start looking for good tenants even where there is no vacancy and keep them interested in your rental property. In the event of a vacancy, you will have a list of potential good tenants to choose from.
Lower Operating Expenses
The easiest way to reduce operating expenses is to simply scan the market for competitive prices. A good way to do this is to create a spreadsheet of different providers and prices. This makes finding the best deals quite easy and convenient. The other effective way of reducing operating expenses is to avoid excessive repair and maintenance costs. This can be achieved by carrying out preemptive maintenance on things like appliances and air-conditioning units.
Reduce Fixed Costs
The first step to reducing fixed costs is to lower your tax bill. Directly appealing to tax authorities and requesting a reduction works in certain cases, but it is far from guaranteed. The best strategy is to seek the assistance of a third party that handles your case in exchange for a percentage of the savings.
Reduce Cash Investment
You can reduce cash investment through several simple methods. Bringing in a partner to inject some cash in exchange for a fair split is a way to do it. You can also free up capital by doing a sale and a leaseback of part of the rental property. This will get you your initial investment back plus extra cash.
The break even ratio is an indicator that every housing market participant should be aware of. Having a clear grasp of what this ratio entails allows both investors and lenders to screen investment properties in an effective manner.