Why Is The Break Even Point Important? The break-even analysis is used buy investors of income property (and sometimes used by lenders) to show how susceptible the property is to a decline in rental income. The higher the ratio, the more susceptible the property is to adverse fluctuations.
100% is break even. A lower percentage means the property more than breaks even. A higher percentage means that the property does not generate enough income to reach break even.
This ratio is also known as the “default ratio,” because it shows how close the debt service is to the property’s ability to pay it. At 100%, the break-even ratio shows break even.
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Break Even Point = Annual Debt Service + Annual Operating Expenses/Annual Effective Gross Income
The break even point is calculated using the formula above. The components of the formula are explained below.
Operating Expenses include the following items: heat and electricity paid by the owner, property taxes, property management fees, insurance, leasing commissions, wages, pest control, advertising, accounting fees, legal fees, trash removal, etc.
Annual debt service is equal to the monthly mortgage payment or payments required to purchase an income property times 12. If you have an interest only loan, the annual debt service will include just interest. If you have a fully amortized loan, the annual debt service will include both interest and principal.
The effective gross income for a property is equal to the annual maximum gross rents possible plus other income such as laundry receipts, vending receipts, parking fees, etc. minus the annual vacancy amount. It is best to use the actual or effective gross income rather than the potential gross income when calculating the break even point.
Example: The annual debt service for an income property is 50,000. The annual operating expenses are 35,000 and the effective gross income is 100,000. Calculate the break even point.
Break Even Point = 50,000 + 35,000/100,000 = 85%
This means that it requires 85% of the property’s effective gross income to cover operating expenses and debt service.
When do Investors Use Break Even Analysis?
Apartment investments are the perfect example for using break even analysis to evaluate a deal. Most income properties or cash flow investments you find on Loopnet.com will give you enough information in the pro forma form to figure out if a property is performing as is or meeting it’s debt obligations. Here is sample of a FREE APARTMENT ANALYZER DOWNLOAD.
This example is not legal or investing gospel but use as a guide in helping you to evaluate your cash flow or income property real estate investment deals. Please always remember to consult your “legal guy”, “real estate broker” or “mentor” before making any huge real estate purchase.