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.