The break-even ratio (BER, also known as default ratio) is a calculation routinely made by lenders in order to decide whether or not to underwrite a loan request made by real estate investors trying to finance a rental income property.
At the same time, however, despite its importance to lenders, it is often a ratio not widely understood by real estate investors, and seldom known how to calculate.
So in this article it seemed needful to discus the break-even ratio, including the lender’s purpose for using it, how it’s calculated, followed by an example to help you understand how to interpret it when analyzing your next real estate investment opportunity’s ability to get funded.
Purpose
BER is used by lenders to gauge the proportion between the incoming and outgoing cash flow generated by a rental property. The purpose being a desire to know what percentage a property’s income can decline before cash flow derived from the investment property breaks even with the debt service (or mortgage payment).
In other words, lenders look to BER in order for them to gauge the vulnerability of a property’s rental income.
Formulation
Break-Even Ratio = (Debt Service + Operating Expenses) / Gross Operating Income
Example
Let’s assume a property’s first-year operating expenses are $25,000, the annual debt service is $25,000, and the gross operating income is $62,000.
Result
50,000 ($25,000 + 25,000) / 62,000 = 80.65%
Interpretation
As a rule of thumb, lenders typically look for a BER of 85% or less (the percentage of cash outflows to cash inflows). That is, they want the assurance that rents can decline no more than 15% for the rental property to still break even.
In our example, cash outflows (expenses) are 81% of cash inflows (income). In other words, even if the rents declined as much as 19% the rental property would still break even. In this case, this would be satisfactory to a lender willing to accept a BER of 85% or less.
Okay, it’s not rocket science. However, successful real estate investing requires some knowledge of ratios like this. So it’s always a good idea to work the numbers before you make the offer, and perhaps avoid wasting a lot of time on a losing investment opportunity.
So You Know
All ProAPOD real estate investment software solutions automatically calculate BER and post the ratio in the appropriate real estate analysis reports.
