Investments: Break-Even Ratios and Sensitivity Analysis

With concern being expressed that the real estate cycle is peaking due to overpriced properties and the possibility of a recession, real estate buyers, in the classic phrase, should use a sharp pencil when analyzing a proposed investment. Two analytical tools for doing so are the break-even ratio and sensitivity analysis.

Break-Even Ratio

The break-even ratio (also known as the default ratio) shows the relationship between: (1) operating expenses and debt service; and (2) effective rental income (scheduled rent minus an assumed vacancy rate).

First and foremost, the break-even level shows the minimum rent that must be paid each month in order to cover all costs. An apartment building with a typical mortgage, for example, may have a break-even ratio of 82 percent, i.e., 82 cents of each rental dollar must be used to cover operating costs and loan payments. The remaining 18 cents is the return on the owner's  equity (before considering any tax benefits from depreciation deductions and the equity buildup from loan amortization.

From a lender's point of view, the break-even ratio is the default ratio (i.e., the point after which the borrower may be forced to default on the loan, reach into his or her own pocket to make up a deficit or engage in risky management practices such as deferred maintenance).

Sensitivity Analysis: One Component

Once having determined the break-even ratio on the basis either of existing or projected figures, the investor can take a further step. This is to determine how sensitive the ratio is to changes in any key component—rent income; operating expenses (or any separate item of expense); or debt service (resulting from a change in the interest rate or the debt service on the mortgage). A simple example of sensitivity analysis—when only one component is changed with the others unchanged—illustrates how useful it can be in quantifying an investor's concerns about what may happen in the future.

Assume an investor is considering the purchase of an apartment house of 100 units, requiring $400,000 cash over the mortgage. Current occupancy is 99 percent at an average apartment rental of $225 per month ($2,700 per year). Thus, gross rent is $267,300 (99 units x $2,700).

Annual operating expenses are $100,000 and debt service is expected to be $118,000. The break-even ratio is 82 percent ($218,000 divided by $267,300). The cash flow of $49,300 would yield 12.3 percent on the equity of $400,000.

The investor's primary concern is that vacancies may rise if some of the many new condominiums in the neighborhood are forced to convert to rentals, thus increasing the supply. The investor wishes to test the sensitivity of the projected cash flow to higher vacancies assuming rent levels are unchanged. Exhibit 1 below shows the result. If the occupancy rate drops to 91 percent, the break-even ratio rises to 89 percent ($218,000 operating expenses plus debt service divided by $245,700). The investor still is earning 6.9 percent on his capital, but the lender may begin to worry, since the original cash flow cushion of $49,300 has dropped almost in half to $27,700.