A lender's review appraiser is analyzing a 20-unit apartment building with potential gross income of $400,000. Property taxes are $22,000, other operating expenses are $118,000, and annual debt service is $172,000, of which $132,000 is interest. What is the property's break-even occupancy ratio?
Correct Answer
D) 78.0%
Break-even occupancy compares all required cash outlays with potential gross income: ($22,000 + $118,000 + $172,000) ÷ $400,000 = $312,000 ÷ $400,000 = 78.0%. Debt service includes principal as well as interest, so using only the $132,000 of interest produces 68.0%. Leaving out property taxes produces 72.5%, and making both errors produces 62.5%.
Why This Is the Correct Answer
Option D is correct because the property must pay taxes of $22,000, other expenses of $118,000 and full debt service of $172,000, a total of $312,000. Dividing by potential gross income of $400,000 gives 78.0%. Below that collection level, the property cannot cover all of these outlays from its income.
Why the Other Options Are Wrong
Option A: 62.5%
Option A, 62.5%, is ($118,000 + $132,000) ÷ $400,000. It omits the $22,000 of property taxes and the $40,000 of principal. Including both gives $312,000 ÷ $400,000 = 78.0%.
Option B: 68.0%
Option B, 68.0%, is ($22,000 + $118,000 + $132,000) ÷ $400,000. It treats interest as the whole loan payment, but debt service also includes $40,000 of principal. The correct result is 78.0%.
Option C: 72.5%
Option C, 72.5%, is ($118,000 + $172,000) ÷ $400,000. It leaves out property taxes of $22,000, which the property must also pay. Adding them gives 78.0%.
Everything owed over everything possible
The top of the fraction is all expenses plus the whole loan payment. The bottom is the income available at full occupancy.
How to use: Use this to set up any break-even occupancy problem before touching the numbers.
Exam Tip
When debt service is split into interest and principal, read carefully, because break-even uses the full payment.
Common Mistakes to Avoid
- -Counting only interest instead of full debt service
- -Leaving property taxes out of the required outlays
- -Dividing by effective gross income when the measure is defined on potential rent
Concept Deep Dive
Analysis
This tests a lender's measure of risk rather than a value calculation. You must decide which outlays have to be covered, then express their total as a share of potential gross income. The traps are leaving out property taxes and counting only the interest part of the loan payment.
Background Knowledge
Break-even occupancy shows how far collections can fall before income no longer covers operating costs and the loan payment. More financing raises debt service and therefore raises the break-even point, which increases lender risk. Debt service includes both the return on the loan (interest) and the return of it (principal).
Real-World Application
A lender considering a larger loan on an apartment building checks how much the break-even point would rise. If break-even moves close to the occupancy typical of the market, the lender may reduce the loan amount.
More Income Approach Questions
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Previous Question
An appraiser is developing an overall rate for a subject 12-unit apartment building, for which typical financing is a 70% loan-to-value ratio. A comparable 12-unit building sold for $800,000 with a $600,000 market-rate loan. Its net operating income was $62,000 and its annual debt service was $42,000. Based on the mortgage constant and equity dividend rate from this sale, what overall rate does the band of investment indicate for the subject?
Next Question
An appraiser previously capitalized a property's annual NOI of $80,000 at a 6.4% overall rate. NOI remains the same, but the overall rate is now 8.0%. What is the new indicated value?