Break-even Ratio in Commercial Real Estate
2018-07-20
The break-even ratio for a property is the percentage of its gross operating income that the property needs to break even, i.e. for costs to equal expenses. Investors can use a property's break-even ratio to determine if it's a good investment; too high of a break-even ratio may be a red flag. Break-even ratio can be calculated using the formula below: Debt Service + Operating Expenses/Gross Operating Income = Break-even Ratio
Key takeaways
- A property's break-even ratio is the percentage of its gross operating income that the property needs to break even.
- Investors use a property's break-even ratio to determine if it's a good investment.
- Lenders use a property's break-even ratio to determine a loan's potential risk.
- In most cases, lenders prefer a break-even ratio of 85% or less.
What is a Break-Even Ratio in Commercial Real Estate?
The break-even ratio for a property is the percentage of its gross operating income that the property needs to break even, i.e. for costs to equal expenses. Investors use a property's break-even ratio to determine if it's a good investment; too high of a break-even ratio may be a red flag. Break-even ratio is calculated using the formula below:
Debt Service + Operating Expenses/Gross Operating Income = Break-even Ratio
For example, if a property has an annual debt service of $40,000, annual operating expenses of $35,000, and a gross operating income of $100,000, we calculate the break-even ratio like so:
$40,000 + $35,000/$100,000 = 0.75 or 75% Break-even Ratio
How Lenders Use Break-Even Ratio in the Loan Approval Process
At the same time, it isn’t only investors who use a property's break-even ratio. In addition to looking at a property's LTV and DSCR, lenders also use this metric to determine a loan’s potential risk. In most cases, lenders prefer a break-even ratio of 85% or less in order to provide a reasonable financial cushion for the borrower should expenses increase or the property's occupancy rate fall unexpectedly. An 85% break-even ratio means that expenses can increase another 15% (or operating revenue can fall 15%), and the property will still be able to break even.
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Frequently asked questions
What is the break-even ratio in commercial real estate?
The break-even ratio for a property is the percentage of its gross operating income that the property needs to break even, i.e. for costs to equal expenses. It is calculated using the formula: Debt Service + Operating Expenses/Gross Operating Income = Break-even Ratio.
At the same time, lenders prefer a break-even ratio of 85% or less in order to provide a reasonable financial cushion for the borrower should expenses increase or the property's occupancy rate fall unexpectedly. An 85% break-even ratio means that expenses can increase another 15% (or operating revenue can fall 15%), and the property will still be able to break even.
How is the break-even ratio calculated in commercial real estate?
The break-even ratio for a property is calculated using the formula: Debt Service + Operating Expenses/Gross Operating Income = Break-even Ratio. To calculate the break-even ratio of a property, these are the steps to be taken:
- Add the operating expenses to the debt service
- Subtract any reserves
- Divide that result by the gross operating income
The resulting figure, once converted into a percentage, is the break even ratio. For more information, please visit www.commercialrealestate.loans/commercial-real-estate-glossary/break-even-ratio and www.hud.loans/break-even-ratio-calculator.
What factors influence the break-even ratio in commercial real estate?
The break-even ratio for a property is influenced by the property's debt service, operating expenses, and gross operating income. Lenders typically prefer a break-even ratio of 85% or less in order to provide a reasonable financial cushion for the borrower should expenses increase or the property's occupancy rate fall unexpectedly. An 85% break-even ratio means that expenses can increase another 15% (or operating revenue can fall 15%), and the property will still be able to break even.
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What are the benefits of understanding the break-even ratio in commercial real estate?
Understanding the break-even ratio in commercial real estate can be beneficial for both investors and lenders. For investors, it can help them determine if a property is a good investment, as a high break-even ratio may be a red flag. For lenders, it can help them determine the potential risk of a loan, as they typically prefer a break-even ratio of 85% or less. This provides a reasonable financial cushion for the borrower should expenses increase or the property's occupancy rate fall unexpectedly.
What are the risks of not understanding the break-even ratio in commercial real estate?
Not understanding the break-even ratio in commercial real estate can lead to a number of risks. For example, if the break-even ratio is too high, it may be a red flag for investors and lenders. Lenders typically prefer a break-even ratio of 85% or less in order to provide a reasonable financial cushion for the borrower should expenses increase or the property's occupancy rate fall unexpectedly. An 85% break-even ratio means that expenses can increase another 15% (or operating revenue can fall 15%), and the property will still be able to break even. If the break-even ratio is too high, lenders may be less likely to approve a loan for the property.
In addition, not understanding the break-even ratio can lead to an investor overpaying for a property. If the break-even ratio is too low, it may indicate that the property is overpriced and not a good investment.