Why Investors and Lenders Need the Break-Even Ratio

Why should you be concerned about the break-even ratio of an income producing property? If you know that the cash flow coming in meets or exceeds the cash flow going out, what else should you know? Ratios, percentages and math, are they really necessary? Which answer would you give; yes and no?

If your answer was no, then I can make some assumptions about your investing strategies.

• -  Debt was not attached to the property when purchased, you paid all cash.
  
• -  Vacancy rates are not a concern; all your tenants are long-time tenants who pay in full and on time.
• -  Your operating expenses never increase and you never have any unexpected expenses.
• -  You have never heard of negative cash flow, to you it is a foreign concept.

If your answer was no, then you have complete control over interior and exterior forces involving your property. The economy, neighborhood vacancy rates and even unexpected repairs and maintenance do not affect you.

A no answer does not sound realistic it involves controlling too many variables. I think the real answer is yes. Loan or mortgages are needed when purchasing most rent producing properties. Vacancy rates fluctuate over time. Repairs, maintenance and other expenses are part of property ownership. And never having negative cash flow is fantasy, not reality.

What makes a break-even ratio so important? The values involved are the loans, expenses and the income produced. The ratio represents the percentage of money going out to money coming in. The exact formula is:

Break-Even Ratio = (Debt Service + Operating Expenses) / Gross Operating Income

Or another way of stating it would be;

Break-Even Ratio = Money Going Out / Money Coming In

Multiply by 100, gives you the percentage of income that must decline before cash flow would break even with the loan payment. That is something you would want to keep your eye on. Guess who else will keep an eye on this ratio? Your lender uses this ratio, along with many other ratios, when determining their risk in financing your investment.

Example: You have $400,000 in money going out, loans plus operating expenses, income is $575,000. Break-Even Ratio = $400,000 / $575,000 = 0.8421 or 84%.

Most lenders require a ratio of 85% or less. The money going out represents 85% of the money coming in. An investment property where expenses dominate income will not gain the approval of most lenders.

Now, let's turn this concept around, subtract 85% from 100% the result is 15%. The 15% represents what you would have left after paying all expenses. Subtracting the break-even ratio from 100% signifies a simple means of calculating a return on an investment.