We are all familiar with the concept of breaking even. While we invest to make money, the first rule of investing is to not lose money. Consequently, with every investment, you need to know what your break-even point is. Safety is one of many reasons why I invest in multifamily real estate. It is true that all investments have risk, but multifamily has the best risk adjusted returns of all the real estate classes over the last 30 years. In other words, multifamily real estate has the best returns and the lowest risk.
To further insure success with this superior asset class, the multifamily investor needs to be familiar with the concept of break-even occupancy. Break-even occupancy is a safety number. It is the minimum number of units that need to be occupied in order to cover all expenses including debt service (mortgage). Above this number, the owner will make a profit. Mathematically speaking, break-even occupancy is calculated as total operating expenses + debt service divided by gross income. Obviously, the lower the break-even occupancy, the higher the profit margin.
In order for me to sleep well at night, I look for real estate deals with a break-even occupancy that is 79% or lower. Top quality markets sustain year after year rent growth causing break-even occupancy to decline annually as rents rise. This is how a low risk investment becomes less and less risky over time.
Take for example a 200 unit property with a break-even occupancy of 75%. In this scenario, there would have to be 50 vacancies before the property was at its break-even occupancy. In markets with historical average occupancies of 90% – 95%, the property manager would have to be completely inept to underperform the market to that extent.
The above example is why break-even occupancy needs to be considered in conjunction with historical market occupancy. Consider a property with a break-even occupancy of 75%. Sounds good, right? What if that property is in a market with a historical occupancy of 80%? Now it sounds awfully risky.
One other caveat to consider is residential real estate. Without economies of scale, residential real estate has no margin for error. Without a cushion, I would not feel comfortable investing in residential real estate without a much lower break-even occupancy.
To illustrate this point, take a residential property with that same 75% break-even occupancy. Instead of being 50 vacancies away from breaking even, single family homes, duplexes, and triplexes are all only one vacancy away from losing money. It can be difficult sleeping at night knowing you are only one vacancy away from negative cash-flow.
If you want to make money in real estate, before investing in your next multifamily project, make sure you know the answer to these three questions:
- What is the properties break-even occupancy?
- What is the market’s current and historical occupancy rate?
- What is the property manager’s historical performance in your given market?
The greater the gap between historical occupancy rates and break-even occupancy the safer the investment will be. While everyone is different, I like to see approximately 15% difference between the two. In high quality, high rent growth markets, I still feel comfortable going as low as 10%. My comfort level expands when I know that the property manager has thousands of units in that market and historically outperforms market occupancy.
To Your Wealth!
Dennis Bethel, M.D.
P.S. The best real estate investments are multifamily and the investor can realize significant financial growth and make money in real estate if they pay attention to break-even occupancy.