1.0. ESTIMATING PROFITABILITY of a Real Estate Investment
1.1.Breakeven Point (rate)
1.1.1.
Example
Gross Possible
Income:
$680,000
Annual Operating Expenses:$250,000
Annual
Debt:
$300,000
Current Occupancy
Rate:
92%
Brake-Even Point=
Annual Operating Expenses
+ Annual Debt Service
Gross Possible Income
Brake-Even
Point =
(250,000
+300,000)/680,000
Brake-Even Point =
0.8088
≈
81%
occupancy ( 19% vacancies)
The primary analysis in estimating the potential profitability
of a real estate investment is to determine its breakeven
point, that is, the point at which the gross income is equal
to a total of fixed costs plus all variable costs incurred in
developing that particular gross income. Only when gross
income exceeds the amount required to break even will a
project begin to show a profit. For real estate it is the
occupancy rate at which gross rent is equal to expenses plus
debt service.
Conclusion:
In the example above the property
will generate a profit (a positive cash flow)
because
the current occupancy
rate
(92%)
exceeds the brake-even point
(81%).
1.1.2.
Example
Let's calculate the Cash Flow for the same property assuming its
occupancy rate is 92%.
Formula 1:
Cash Flow = (Gross Possible Inc. × Occup. Rate) - (Gross Possible Inc. ×
Break-even Rate)
= ($680,000 × . 92) - ($680,000
× . 8088)
=
$625,600 - $550,000
=
$75,600
The same result we have
when using the traditional formula of finding cash flow:
Formula 2:
Cash Flow =(Gross Possible Inc. × Occup. Rate) - (Ann. Oper. Expenses + Ann.
Debt Service)
=($680,000 × . 92) - ($250,000 + $300,000)
=
$625,600 - $550,000
=
$75,600
Conclusion:
In the example above the
property generates a profit ( positive cash flow of
$75,000) because its current occupancy rate (92%) is higher
than its brake-even point (81%). If by some reason the
occupancy rate becomes equal to or
less than the brake-even rate, the property will not show a
profit - the cash flow will be equal to zero or will be
negative.
A variation of break-even
analysis can be used to calculate the occupancy rate
required to yield a particular return of the money
invested. This is the cash-on-cash rate (Cash Flow ÷
Equity Investment) required by the investor for his/her
initial investment base.
1.1.3.
Example
Let's calculate the Occupancy Rate for
the same property if the investor requires, for example, 6%return
(cash-on-cash rate, COC) on his/her initial investment
base ($1,000,000).
Gross
Possible Income
GPINC
$680,000 (100% occupancy)
Annual Operating
Expenses:
OPEXP
$250,000
Annual Debt
Service:
ADS
$300,000
Initial
Investment Base
INVBS
$1,000,000
Cash-on-Cash return required
COC%
6%
What will be the Occupancy Rate?
?
COC % =
(Gross Possible Inc. × Occ. Rate) - (Oper. Expenses + Debt)
Conclusion:
An
occupancy rate of approximately 90% is required in order to
earn a Cash-on-Cash (COC%) return of 6%.
If the investor
requires cash-on-cash return higher (or lower) than 6% the occupancy rate is changing
accordingly as follows:
1.1.4.
Example
Occupancy Rate
Cash-on-Cash
Occupancy Rate
Cash-on-Cash
77.94%
-2%
89.71%
6%
79.41%
-1%
91.18%
7%
80.88
%
0
%
BrEvPoint
92.65%
8%
82.35%
1%
94.11%
9%
83.82%
2%
95.59%
10%
85.29%
3%
97.06%
11%
86.76%
4%
98.53%
12%
88.23%
5%
Max COC%
100%
13%
We can use the following equation as well:
BERATE% = (((COC%/100)*INVBS)+OPEXP+ADS)/GPINC*100
BERATE% = (((6/100)*1000000)+250000+300000)/680000*100
= 89.7058%
A breakeven analysis includes
an examination of the relationship between Gross Effective
Income (gross possible income x occupancy rate) and fixed and
variable costs necessary incurred to develop this gross
income. Since there is no profit until breakeven point is
passed, a careful estimate of a project's rent-up (occupancy
rate) requirements to ascertain its breakeven point is
imperative before a loan can be arranged. When a high rent-up
ratio is needed for a project to merely break even, it is not
likely to be funded.
The breakeven analysis gives the loan officer and the investor
a clear perspective from which to study the economic
feasibility of a particular investment. If a reasonable
breakeven point is determined, such as 83 percent, which is
better than many current rental markets, then the project gets
the "go" signal. On the other hand, if the analysis indicates
that 95 percent occupancy is necessary in order to breakeven,
neither the lender nor the borrower should be interested in
pursuing this venture. However, in such a situation, and
before the project is canceled, a more intensive examination
of the variables should be made to see if there is any
possibility of increasing the Gross Possible Income and Gross
Effective Income (raising the rents, lowering turnover, other
income) or lowering Operating Expenses (cost efficient
maintenance). This will increase the Net Operating Income and
a more reasonable break-even should be achieved. Also, a
reasonable breakeven can be sought by lowering the loan debt
(new more favorable mortgage terms, lower interest rate,
refinancing).
Disclaimer: Information and interactive calculators are made available to you as self-help tools for your independent use and are not intended to provide investment advice. We can not and do not guarantee their applicability or accuracy in regards to your
individual circumstances. All examples are hypothetical and are for illustrative purposes. We encourage you to seek personalized advice from qualified professionals regarding all personal finance issues.
BrEvPoint
