In our last article we discussed the break-even ratio (BER, or default ratio) calculation used by lenders as an income property analysis to guage the vulnerability of a property’s rental income. Let’s look at a couple of examples and then discuss how lenders might use the ratio to decide whether or not to underwrite a loan request. If you are a real estate investing beginner you should find this information helpful when analyzing your next real estate investment opportunity’s ability to get funded.
Example
EXAMPLE ONE. 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. The BER would be 81% ($25,000 + 25,000 = 50,000 / 62,000 = 80.65%).
EXAMPLE TWO. Okay, now let’s assume less rental income. The property’s first-year operating expenses are $25,000, the annual debt service is $25,000, and the gross operating income is just $50,000. The BER would be 100% ($25,000 + 25,000 = 50,000 / 50,000 = 100.00%).
Interpretation
Because BER computes the ratio between a property’s cash outflow (operating expenses plus loan payment) and its rental income, the percentage rate reveals what percent outgo is to rental income. In our first example outgo is 81% of income. In other words rents would have to decline 19% before the property breaks even. This is illustrated by our second example. When rents decline $12,000 the outgo exactly equals the inflow, and thus breaks even.
As a rule of thumb, lenders look for a BER of 85% or less. That is, they want the assurance that rents can decline 15% before the property breaks even.
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 waste a lot of time on a losing investment opportunity. You can certainly compute it yourself, or you might want to turn to real estate investing programs like ProAPOD (excuse the shameless promotion) to do it for you.
