Break-even occupancy is the lender's simplest downside test, and the textbook version of it is off by a point and a half before the rate even moves.
Break-even occupancy is the occupancy at which net operating income just covers debt service. The formula a lender should use is fixed operating expenses plus annual debt service, divided by potential gross income less the expenses that vary with occupancy. On an illustrative 30,000,000 loan at 6.25 per cent against a building with 5,200,000 of potential income, break-even occupancy is 3,616,582 ÷ 4,660,000 = 77.6 per cent, against 93 per cent occupied today.
Worked in full in Real Estate Finance by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
The ratio is popular because it translates a coverage ratio into something an asset manager can see on the rent roll: how many units or square feet can go dark before the loan stops paying itself. It is also often computed wrongly, in ways that flatter or alarm by a point or more. Below, the case is built line by line, with the textbook version beside the refined one.
| Input | Value |
|---|---|
| Gross potential rent at 100% occupancy | 5,000,000 |
| Other income at 100% (parking, service charges) | 200,000 |
| Potential gross income (PGI) | 5,200,000 |
| Fixed operating expenses (tax, insurance, base staffing) | 1,400,000 |
| Variable operating expenses at 100% occupancy | 540,000 |
| Loan amount | 30,000,000 |
| Interest rate, 30-year amortisation, monthly pay | 6.25% |
| Current occupancy | 93% |
At 93 per cent the building earns 4,836,000 of income. Variable expenses run at 502,200, so total operating expenses are 1,902,200 and NOI is 2,933,800. Annual debt service on the loan is 2,216,582, a mortgage constant of 7.39 per cent, which puts today's DSCR at 1.32x.
Textbook: BEO = (operating expenses + debt service) ÷ PGI
Refined: BEO = (fixed expenses + debt service) ÷ (PGI − variable expenses at 100%)
In Excel, with the debt service from =-PMT(Rate/12,Years*12,Loan)*12: =(Fixed_Opex+Debt_Service)/(PGI-Var_Opex_Full).
The textbook formula takes today's total expenses and treats all of them as fixed:
That overstates the break-even, because some expenses fall when units empty: utilities in vacant space, cleaning, management fees charged on collected rent, turnover costs on space that does not turn over. Split them out and the variable cost comes off the denominator instead of sitting in the numerator:
Check it. At 77.6 per cent the building earns 4,035,671 of income. Fixed costs of 1,400,000 and variable costs of 540,000 times 77.6 per cent leave NOI of 2,216,582, exactly the debt service. DSCR is 1.00x. If your sheet does not land on 1.00x at its own break-even, a cost line is in the wrong bucket.
The building is 93 per cent occupied and breaks even at 77.6 per cent: a cushion of 15.4 points of occupancy, or a 16.5 per cent fall in income before the loan is uncovered. That is the number for the credit paper. It is not the number that triggers anything in the loan agreement. A DSCR covenant at 1.20x needs NOI of 2,659,898, and solving the same formula with 1.20 times debt service in the numerator gives a covenant occupancy of 87.1 per cent, only 5.9 points away. The cash sweep or default arrives long before the income runs out, which is why ranking the covenants by the income fall that breaks each one matters more than any single ratio.
Break-even occupancy is also an economic occupancy, not a physical one (the gap between the two is worked in physical versus economic occupancy). If 3 per cent of occupied rent is lost to concessions and bad debt, the building must be 77.6 ÷ 0.97 = 80.0 per cent physically let to break even.
This is the lender's test on a let commercial property, where the debt service is the fixed charge. Operating businesses run the same algebra with a different fixed charge: a care home must cover its rent times the rent cover (care home break-even occupancy for the rent), and a student scheme counts beds and tenancy weeks (student housing break-even occupancy).
| Rate | Interest only | 30-year amortisation | 25-year amortisation |
|---|---|---|---|
| 5.25% | 63.8% | 72.7% | 76.3% |
| 6.25% | 70.3% | 77.6% | 81.0% |
| 7.25% | 76.7% | 82.7% | 85.9% |
| 8.25% | 83.2% | 88.1% | 91.0% |
Each 100 basis points of rate costs about five points of break-even occupancy here, and the amortisation profile is worth as much as a rate move: 30-year amortisation instead of interest only adds 7.3 points at 6.25 per cent. A refinance into a shorter amortisation at a higher rate can take a comfortable building to 91.0 per cent without a single tenant leaving.
| Loan | Debt service | Break-even | Cushion to 93% |
|---|---|---|---|
| 24,000,000 | 1,773,266 | 68.1% | 24.9 pts |
| 27,000,000 | 1,994,924 | 72.9% | 20.1 pts |
| 30,000,000 | 2,216,582 | 77.6% | 15.4 pts |
| 33,000,000 | 2,438,240 | 82.4% | 10.6 pts |
The most frequent error is dividing by current effective gross income instead of potential gross income. On this case that gives 4,118,782 ÷ 4,836,000 = 85.2 per cent, a ratio that has already deducted today's vacancy and then asks how much more occupancy is needed. It reads as a building at 85 per cent break-even when the true figure is 77.6. The second error, treating every expense as fixed, is quieter but runs the same way: here it adds 1.6 points. Both mistakes make a loan look riskier than it is, which sounds conservative until it is used to turn down or reprice a sound credit.
The opposite mistake is to forget amortisation and run the ratio on interest alone. On a 25-year profile that understates break-even by more than ten points.
Compute break-even occupancy on potential income, with variable costs netted off the denominator and full debt service, amortisation included, in the numerator. Then compute it again at the covenant multiple, because 87.1 per cent is where this loan starts to hurt, not 77.6. The free workbooks for this book put the same building through loan-to-value, debt service cover and debt yield on one sheet, and the loan sizing calculator runs the tests on a property of your own.
Lenders generally want it well below both today's occupancy and the market's long-run vacancy, and many credit papers treat anything above about 85 per cent as thin. The number that matters is the gap: in the illustrative case the property is 93 per cent occupied and breaks even at 77.6 per cent, a cushion of 15.4 points, or a 16.5 per cent fall in income before debt service is uncovered.
No. Break-even occupancy is where DSCR reaches 1.00x. A covenant usually bites earlier. In the illustrative case a 1.20x covenant needs NOI of 2,659,898, which is reached at 87.1 per cent occupancy, so the borrower has 5.9 points of headroom to the covenant but 15.4 points to break-even.
Yes, because amortisation is part of debt service. At 6.25 per cent the 30 million loan costs 1,875,000 a year interest only and 2,216,582 on 30-year amortisation, so break-even occupancy moves from 70.3 to 77.6 per cent. A 25-year profile pushes it to 81.0 per cent.
This article is one calculation from Real Estate Finance. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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