As a real estate investor investing for yield or passive income, the biggest risk to your investments is vacancy- the periods in between tenants whereby the property is not producing monthly income. For people who own their real estate outright with no mortgage, this will mean that during that period they are paying their annual taxes and maintenance expenses out of their own pocket until they find another tenant. For those who purchased their real estate with a loan from the bank, their out of pocket obligations will be the same as above, with the addition of monthly mortgage repayments to the bank.
Common sense dictates that you should never take out a loan for a property where you could not conceivably meet the cost of the monthly repayments yourself in a dooms day scenario where all of your tenants move out. This aside, all real estate investors should take the time to consider what their break-even point is- I.e what percentage of the total units in the building/portfolio have to be occupied by tenants for all of the annual costs to be covered by the rental income being produced.
Calculating Your Breakeven For A Real Estate Investment
Most people will think in terms of a calendar year, so you should be totalling up all the operating expenses throughout the year and adding these to the total annual mortgage repayments if you have them (i.e if repayments are monthly, multiply the amount by x12). This total should then be divided by the total rental income that can be produced by the property/portfolio if all units are filled with tenants. The result will tell you what percentage of the property needs to be occupied to cover all the expenses.
A Breakeven Case Study
An investor has just bought a 6 unit residential apartment building in Japan with an investment loan from the bank.
To keep things simple for illustration purposes we are operating on the premise that expenses will be the same for every year of ownership, which in reality is unlikely.
Looking at the table, total annual expenses are 370,600 JPY. Total annual repayments to the bank are 1,788,000 JPY. Adding these together produces an annual cost to the owner of 2,158,600 JPY.
The annual net operating income is 3,949,400 JPY.
So, ( 2,158,600 / 3,949,400) x 100 = 54.65
= a breakeven occupancy ratio of 54.65%
An investor would be happy to know that almost half of his tenants could move out before he would have to meet the operating costs of his real estate out of pocket. Essentially, the property would be profitable at 55% occupancy. This would be a robust investment.
You will note that the metric produces a percentage result. It can get complicated when a portfolio contains many units, all rented out at different prices. If you wish to guess-timate you could do the following
So in our above example we would do the following:
– Calculate the breakeven occupancy ratio, which is 54.65%, so convert this to a decimal by dividing by a hundred (54.65 / 100 = 0.5465)
– multiply 0.5465 by the number of units
= 0.5465 X 6 = 3.2 units
Now we know that we need 3.2 of our six units to be tenanted in any given year for the real estate to cover its own costs. Of course, in reality it is not possible to rent out 20% of a room for a year, but the year consists of 12 rent payments (i.e 12 months of tenancy), so with rental contracts for all units starting and finishing arbitrarily in different months, it is in fact possible for us to have a year with x3.2 rooms worth of rental payments received over a 12 month period.
It is not just savvy investors that will look at these numbers. Each and every bank that lends money for real estate investments will also be running these same numbers when making the decision whether or not to lend. They will all have differing assumptions regarding how they calculate expected annual expenses like insurance, maintenance, utilities etc, and they will all have differing levels of tolerance for the breakeven occupancy ratio.
What may be an acceptable breakeven occupancy ratio for one bank may not be sufficient for the next. Often they will look to compare the ratio of the target property to similar properties in the market to benchmark the numbers. After all, the ‘average’ will vary by property type, location and cost. So, what is the breakeven for your investments?