Importance of Operating Expenses & Operating Expense Ratios
Any type of expense is something you pay for. If you paid for it, then is it an operating expense? Just because you paid for something is not necessarily an operating expense.
An operating expense is an item that will ensure that the property will continue to produce income. Examples of these expenses are; property taxes, utilities, supplies, property management fees, the cost of repairs and maintenance, snow & trash removal, advertising, accounting or legal fees, lawn care and insurance.
Expenses in the operation of an income property are not; mortgage or loan payments, tax depreciation, capital additions or improvements and personal income tax. These items do not help in the continual production of income.
When you start comparing income properties to purchase, one element you will focus on will be your potential expenses. How will those expenses compare across each property? You will want to look at each and every item while comparing those properties.
Looking at the actual expense amounts could be helpful, but it would be better to look at ratios. The Operating Expense Ratio or OER is the ratio of the expenses to the income received minus vacancy and credit loss, in other words, the Gross Operating Income.
OER = operating expense / Gross Operating Income
It is very useful to calculate the OER of each expense for an income producing property. The OER of each expense could pinpoint the spending trends of an apartment.
Time for an example, you are looking at three apartment buildings before deciding upon one building. The three buildings have the same Gross Operating Income of $85,000. The table below shows the OER results.
Management fees = $10,000 OER = 11.76%
Advertising = $500 OER = 0.59%
Management fees = $9,750 OER = 11.47%
Advertising = $250 OER = 0.29%
Management fees = $12,975 OER = 15.26%
Advertising = $1,500 OER = 1.76%
Focusing on the OER percentages, you are looking for values that are noticeably higher or lower than the other apartments' percentages. In the above table, look at the Property Management fee expense of Apartment C at 15.26%. Compare it to 11.76% and 11.47% of Apartments A and B. Why is Apartment C paying such a high property management expense? Does the property management company provide better or more services than the property management companies for the other two apartment buildings?
Another OER value that stands out is the advertising percentage for Apartment B. Only 0.29% of the gross operating income is spent on Apartment B's advertising. Apartment A spends 0.59% and Apartment C spends 1.76%, why such a wide spread? What is happening with Apartment B that justifies such a small expense? Why and how is Apartment B saving money?
We can see that operating expenses are not to be overlooked. They can tell us about overspending or possible savings. The ratios can give us a quick look at the spending trends when comparing properties.
Operating expenses are an important indicator of spending. Know where or how these amounts were obtained. Were the expenses coming from the current landlord, a property management company, the real estate broker or are they an estimate of values from a specific area or neighborhood of apartment buildings?
There is an old saying in the computer industry; "garbage in, garbage out." This is true with operating expense values. Start with inaccurate values and you will end with worthless ratios and useless spending trends. You do not want to base your investment decisions on faulty expenses and ratios.