Determining Your BER
Breaking Even as opposed to “Breaking Bad” (a totally different topic) or determining your break even ratio (BER) is important when you are considering turning your Real Estate property into a rental.
A break even position occurs where a property eats up as much as it brings in ( debt service & expenses) and a negative cash flow occurs when rental properties don’t generate enough income to cover all expenses. This results in the owner having to “cash feed” the property to make up the difference. This is a problem real estate investors want to avoid under any circumstance however the market is the market and there is a cap on how much the public will pay. By knowing this, a strategic rental plan can offset losses in just about any market.
I guess the first thing your accountant or Real Estate agent will explain to you is how to find out “the break even point” for an income property. This tells you what you need to be bringing in to make the property viable. Another measure is the BER, a ratio that shows what percentage of gross revenue is required to sustain the property. As you already know, to be profitable, an income property’s annual gross income must be greater than the cost of it’s annual debt service plus annual operating expenses.
For example a BER of 85 tells us that 85% of revenue is used to cover costs. The lower the BER – the better – as less money is needed to feed the “beast”. This indicator also tells us that the rental value could decrease by 15% before the property is simply breaking even.
BER = (Debt Service + Operating Expenses) / Gross Operating Income (rent)
Beside just operating expenses and debt servicing the BER is also affected by the property’s annual vacancy rate. A good property manager can reduce vacancies by keeping rents at market value. This is key in aiming for profitability. Each month your rental sits vacant or underutilized represents an income drop and that means money from elsewhere will be needed to cover costs.
It it more prudent to rent a property at the market value rate for a longer term than leave it languish because the rent is too high. At that point the revenue is “0” and that is never good.
A client of mine has calculated an annual operating budget at $27,300. The market will pay up to $3500/month all in so annual gross revenue = $42,000. Using the above formula the BER for this property is 65. A pretty good number – 65% of gross rent is used to cover basic costs leaving a 35% return to the owner. The market rental value would have to fall 35% for the property to break even. *The owner does carry a very low mortgage on the property which contributes to making this number possible. On average, homeowners of upper end properties see a BER of 75-85% Very Upscale properties worth over a million $ probably see a lower return only because the carrying costs are usually higher that what the rental market will bear.
ANNUAL VACANCY RATE: and how that affects the bottom line.
Let’s look at how vacancy rates affect the bottom line. In the above scenario (assuming a one year lease) if the $3500/month property rents within 30 days of being listed, the owner will realize $42,000/year in gross rents with a BER of 65%. If it sits on the market for 60 days the annual return drops to $35,000 with a BER of 78% and if it sits for 90 days on the market the gross annual income goes to $31,500 causing the BER to rise to 86%. If the owner still hasn’t rented the property within the first 4 months of listing he will likely be in a negative cash flow position. The better strategy would be to have priced it correctly in the first place or failing that, correct the price long before reaching a negative cash flow.
60 Days or more is far too long for a property to sit on the market and there are only a couple of reason for that.
- the market has contracted and with it demand
- the property lacks the qualities the market is looking for
- it is priced too high
On average a property correctly priced with all the desirable features in a growing market should rent within 30 days (or less) of marketing it to the public giving the owner the best BER possible.
The longer the property languishes on the market the less annual income it will produce leaving the owner carrying the costs in full for all the vacant months.
It is far more desirable to price correctly from the start or at the very least to begin correcting the rental rate to avoid further losses.