Net Operating Expenses

18 Replies

What do you qualify as net operating income? I've been using the Property Analysis Tool and removed all of my property expenses - taxes, mortgage, insurance, water, advertising, and some other small expenses directly from the rental income profits. I don't really consider that "net operating income". But some people said to take out 45-50% for "net operating income" (out of the income profits) but didn't explain if that is what it is for (advertising, utilities, etc.).

So, what do you consider net operating income?

OK, I guess my first post was hard to understand, lol.

Basically, what do you subtract from your "net operating income"? Mortgage, insurance, utilities, office supplies, etc.? Or do you typically just subtract office supplies or the cost of a contractor to fix a leaky toilet form net operating income?

Because on the program I used, I withdrew all expenses directly from the rental income, and I consider what's left to be the net operating income. I don't take the rental income, withdraw mortgage, and then withdraw the rest as a part of net operating income. I basically consider the net operating income as my profit before I take the taxes out of it.

Does that make sense?

This is the guideline I use to assist my clients in determining NOI:

Vacancy Factor (5%)
Offsite Management
Advertising
Administrative (G&A)
Insurance
Legal and Professional
On-site Management
Interior Cleaning and Maintenance
General Repairs and Maintenance
Exterior Cleaning and Maintainance (gardening, pool, pest control, etc.)
Supplies
Taxes
Utilities (electric and gas)
Utilities (water and trash)
Other/Misc.

Regards,

Scott Miller

Parrotletlover,

NOI (Net Operating Income) is determined by subtracting the operating expenses from the gross rents. The fact is that throughout the entire Unites States, operating expenses run 45% to 50% of gross rents. Therefore, NOI is really about 1/2 of the gross rents. It is just that simple.

It is impossible to get an accurate view of NOI by subtracting individual expenses from the gross rents. The reason is that you don't know all of the specific expenses you will incur in a given rental in a given year. For example, how many vacancies will you have in a particular rental this year? Will a tenant sue you? Will a tenant do extensive damage? How many evictions will you have?

It is far more accurate to simply consider the operating expenses to be 50% of the gross rents.

Good Luck,

Mike

I appreciate your need for brevity, but I wouldn't recommend this approach for those sincerely considering the purchase or refinance of a commercial property.

Be mindful that your lender will evaluate your property's cash flow and operating expenses prior to making a decision to lend and guidelines don't allow for estimates or the law of averages (sidebar---I would be interested in seeing some data on this national average of 45-50% you speak of).

Taking a 3-5 year viewpoint of cash flow (review leases, rent rolls, etc.) and expenses (review tax returns, P&L statements, etc.) will allow the investor to budget for such incidents you speak of and is far more exacting then the standard rationalization you suggest.

Regards,

Scott Miller

Originally posted by "MikeOH":
Parrotletlover,

NOI (Net Operating Income) is determined by subtracting the operating expenses from the gross rents. The fact is that throughout the entire Unites States, operating expenses run 45% to 50% of gross rents. Therefore, NOI is really about 1/2 of the gross rents. It is just that simple.

It is impossible to get an accurate view of NOI by subtracting individual expenses from the gross rents. The reason is that you don't know all of the specific expenses you will incur in a given rental in a given year. For example, how many vacancies will you have in a particular rental this year? Will a tenant sue you? Will a tenant do extensive damage? How many evictions will you have?

It is far more accurate to simply consider the operating expenses to be 50% of the gross rents.

Good Luck,

Mike

Be mindful that your lender will evaluate your property's cash flow and operating expenses prior to making a decision to lend and guidelines don't allow for estimates or the law of averages (sidebar---I would be interested in seeing some data on this national average of 45-50% you speak of).

Taking a 3-5 year viewpoint of cash flow (review leases, rent rolls, etc.) and expenses (review tax returns, P&L statements, etc.) will allow the investor to budget for such incidents you speak of and is far more exacting then the standard rationalization you suggest.

I completely disagree, however I am talking about residential properties (to include small commercial residential buildings). I don't have experience will large commercial projects.

While I agree with you that it is a good idea to review tax returns, leases, etc, in many instances the unsuccessful "investors" that we are buying these properties from have TERRIBLE records and they prove worthless in doing an accurate analysis. In addition, there isn't any data with REOs, foreclosure sales, estate sales, etc, etc, etc. For example, I recently looked at a 49 spot RV park. The guy literally had his expense data scribbled on an 8 1/2" X 11" piece of paper. He had no income data and certainly no P & L statement. I would guess that his lack of info was a big part of the reason that he needed to sell.

This is ESPECIALLY true of SFHs and small apartment buildings. Most of the owners are mom and pop type owners and you won't find much useful information from them. If they do provide expense information, I find that they typically GREATLY underestimate the expense information.

I have dozens of rentals and many loans. The small local banks that I use have their own formula for calculating the validity of the deal. When I first started, I listed expenses as you have done above. The president of the bank and I recently had a good laugh about that as those numbers were so innacccurate. For example, let's take legal fees. I have individual rental properties that have never had an eviction. If I used $0 for legal expenses, that would skew the expense numbers low. I have had other rentals that have had several evictions. If I used that number for legal expenses, that would skew the expense numbers high. Instead of trying to put a number on something that I can't possibly know and that is purely random, if I use the 45% to 50% total expense number that has proven true over hundreds of thousands of rental units, I will be MUCH MORE ACCURATE.

You can find the data on the 45% to 50% expense numbers that I used through any of the large apartment/landlord associations.

Mike

Originally posted by "MikeOH":
Parrotletlover,

NOI (Net Operating Income) is determined by subtracting the operating expenses from the gross rents. The fact is that throughout the entire Unites States, operating expenses run 45% to 50% of gross rents. Therefore, NOI is really about 1/2 of the gross rents. It is just that simple.

It is impossible to get an accurate view of NOI by subtracting individual expenses from the gross rents. The reason is that you don't know all of the specific expenses you will incur in a given rental in a given year. For example, how many vacancies will you have in a particular rental this year? Will a tenant sue you? Will a tenant do extensive damage? How many evictions will you have?

It is far more accurate to simply consider the operating expenses to be 50% of the gross rents.

Good Luck,

Mike

I completely disagree with the 50% rule as being accurate. It is FAR from accurate. Some properties may have operating expense which is far greater as a percentage of rents. For example, if you rent a large 2,000 sq ft house for $1,000/mo in Texas, you will incur operating expense which could easily EXCEED $500/mo. The long term maintenance/upkeep alone could be $300/mo for a large home, if not more. Then you have to add 10% property management, hazard/liability/hurricane insurance, 5% vacancy, any utilities, property taxes, etc. You're sure to be over $500/mo once all the fees are calculated.

You could also rent the same size home in Los Angeles for $3,000/mo and the total operating expense would be much lower than 50%. Since the rent is higher, chances are you can bargain with a property manager and drop the fees to 5-8% vs the 10% minimum they would require on a lower rent home (LA home would yield $150/mo income for the property manager at 5% and only $100/mo income for the manager of the Texas home but same amount of work). Property taxes and insurance would probably be higher because of the higher property value, but the scale is not linear. Even vacancy of 5% is not a good number to plug. Historically, some areas rent with 10% year round vacancy, others only 2%. Check the historical numbers. The operating expense on the LA home could be considerably lower than even 30% of gross rents. And the Texas home would be short with 50% of gross rents going to operating expense.

I wouldn't use the 50% rule ever, or ANY rule for that matter. Each property is different and you have to break down every expense applicable to the specific property, line by line. That's the only way to get an accurate figure. One exception where it's hard to find a historical number or current fixed cost is on maintenance/upkeep. It would be good to plug a number there but I'm having a hard time figuring that one out on my current properties.

I can see both sides of this argument over whether it is accurate and/or useful to use 45-50% of gross rents as a an expense estimator. On any SINGLE PROPERTY your actual expenses could be very small or could be significantly more than the 50% of gross rents figure.

The thing is, you could be getting positive cashflow on 9 out of the 10 houses you bought using a house-to-house individual expense formula and still be bleeding money on your total investments because of that 10th house. For each and every property you analyze to purchase, you have to account for ALL of your other properties. By treating the expenses of your properties as a whole you prevent cashflow catastrophes from happening. You can take it in stride when your tenant trashes one of your houses because you had accounted for that bad egg by spreading the expense over all your properties.

And when your tenants all behave and have extended stays in your houses you are pleasantly surprised. Under-calculating your expenses is as dangerous as purchasing on the basis of speculative on price appreciation.

On any SINGLE PROPERTY your actual expenses could be very small or could be significantly more than the 50% of gross rents figure.

Wakefield,

EXACTLY! I agree with tcjohnsson that in an ideal world, it would be great to be able to plug in the actual expense numbers. However, in the real world, those numbers don't exist. First, accurate historical expense numbers do not exist for the vast majority of SFHs. Even if you did have accurate historical expense numbers for a specific property, that doesn't reflect tomorrow's reality. For example, in my business, we evict about 1% of the tenants per month. That means on any given rental, it would be about 8 years before we evicted someone. So, if I had historical data for the past 5 years that showed no evictions, should I conclude that the eviction expenses are zero, even when an eviction results in about $800 in legal costs/court fees plus 2 months lost rent plus any damage the tenant does above his security deposit.

Additionally, you must account for a changing market over time. As Dal1 posted, a market can be very good in an area for many years and then seemingly overnight you have 30% vacancies. All of this needs to be put into the equation. The only way that I know to do that is to use the 45% to 50% expense number.

Yes, I fully understand that maintenance costs are lower as a proportion of gross rents in high priced rentals like LA. Unfortunately, a LOT of the other expenses are MUCH higher. For example, the socialist laws in many states mean that an eviction may take several months and result in a big loss. Check out this article:

http://realestate.msn.com/rentals/Article_bankrate.aspx?cp-documentid=4645139&GT1=9323

How long will it take this landord to make up a $20,000 expense? Just because there wasn't a major eviction/legal expense on this particular property for the past 5 or 10 years, can she simply ignore this $20,000 expense? Is it off budget? I don't think so.

The fact remains that throughout the United States, operating expenses run 45% to 50% of the gross rents. I believe this is a much more accurate way to account for expenses than to try to plug in expenses that are impossible to predict for a given property.

Mike

Originally posted by "MikeOH":
On any SINGLE PROPERTY your actual expenses could be very small or could be significantly more than the 50% of gross rents figure.

Wakefield,

EXACTLY! I agree with tcjohnsson that in an ideal world, it would be great to be able to plug in the actual expense numbers. However, in the real world, those numbers don't exist. First, accurate historical expense numbers do not exist for the vast majority of SFHs. Even if you did have accurate historical expense numbers for a specific property, that doesn't reflect tomorrow's reality. For example, in my business, we evict about 1% of the tenants per month. That means on any given rental, it would be about 8 years before we evicted someone. So, if I had historical data for the past 5 years that showed no evictions, should I conclude that the eviction expenses are zero, even when an eviction results in about $800 in legal costs/court fees plus 2 months lost rent plus any damage the tenant does above his security deposit.

Additionally, you must account for a changing market over time. As Dal1 posted, a market can be very good in an area for many years and then seemingly overnight you have 30% vacancies. All of this needs to be put into the equation. The only way that I know to do that is to use the 45% to 50% expense number.

Yes, I fully understand that maintenance costs are lower as a proportion of gross rents in high priced rentals like LA. Unfortunately, a LOT of the other expenses are MUCH higher. For example, the socialist laws in many states mean that an eviction may take several months and result in a big loss. Check out this article:

http://realestate.msn.com/rentals/Article_bankrate.aspx?cp-documentid=4645139&GT1=9323

How long will it take this landord to make up a $20,000 expense? Just because there wasn't a major eviction/legal expense on this particular property for the past 5 or 10 years, can she simply ignore this $20,000 expense? Is it off budget? I don't think so.

The fact remains that throughout the United States, operating expenses run 45% to 50% of the gross rents. I believe this is a much more accurate way to account for expenses than to try to plug in expenses that are impossible to predict for a given property.

Mike

Well, this $20,000 expense can occur in any state, any city, any town - not just LA. Yes, certain states are more landlord-friendly, and others are more tenant-friendly. I happen to be living in a tenant-friendly state - Hawaii. But to factor worst case scenarios into the budget which include evictions is not smart in my opinion. If you have to deal with an ugly eviction, you're just going to take a loss. That's one of the risks of investing in real estate. You can't plug this into your operating figures. I would gander that rentals that target the more affluent have lower default/eviction rates than rentals that target the average joe. These so called "socialist" states generally offer a better picking of properties that target the more affluent renter. That's why it's hard to find a good investment property in these areas - those residing there are either wealthy enough or savvy enough to purchase their properties instead of rent. Note of course that these are HUGE generalizations that I'm making.

And accounting for a possible future vacancy of 30%, or any vacancy figure for that matter, is impossible. For example, if you bought in a small city where 90% of the population works at a nearby Toyota assembly factory, using your logic, you better factor in some really worst case scenarios just in case the factory shut down, because your vacancy will go from whatever it was when you bought to 100% - overnight. You have to research the area, the city, the demographics. What kind of people work there? In what fields? Education level, incomes. How diverse is the employment in the area? How stable are individual industries, and how long have they had presence in the area. VERY IMPORTANT FACTORS. This will determine your risk, NOT the operating expense. You just simply don't plug these numbers in because there is nothing to work off of. You are basing things on chance, and not historical information. Please tell me how you can plug these numbers into the equation? It's impossible. You set a vacancy rate and work with that. If you come out on top, you made some gravy. You underestimate and you take a hit and come in below your expectations.

I think that about 90% of all expenses can be quite accurate (property mgmt fees, mortgage, property taxes, insurance, maintenance/repairs). Mortgage, of course, is fixed. Taxes and insurance generally move up at the rate of inflation so this can be calculated fairly safely.

Regarding maintenance, I add up the cost on all the appliances and divide by 96 (8 years = 96 months) to give me my monthly cost. For example, $3,000 worth of appliances would incur a $31/mo repair/replacement budget. I would then take the total square footage of the house and multiply by 15 cents. This would give me a relatively safe monthly repair/maintenance budget for the home itself (roof, windows, walls, flooring, plumbing, electrical, etc). For example, a 2,000 sq ft home would incur a repair maintenance budget of $300/mo. This figure can vary in different states (higher in high-labor and construction materials markets and lower in low-labor and construction materials market). And of course, if you have a simple tract home vs a fancy custom high-end home, this could bring the number up or down. My figure is just an average. Age is also a huge factor, but using a base multiplier can put you in safe zone when it comes to the uncertainty that repairs and maintenance costs offers. If you have a condo, I would take whatever the figure is for the home and divide by 3. For example, 15 cents a sq/ft for a house would be 5 cents sq ft per month for a condo. This does not include appliances.

I guess the point that I'm trying to make is that people shouldn't be scared off by a property if the annual rent isn't DOUBLE what their total expenses are. I've learned that most of the "gurus" (members with high volume postings) on this website like to tout the 50% rule, which can scare the heck out of many potential long term real estate investors. Where, outside of poorly appreciating markets and/or bad neighborhoods, can you actually find this type of property??? It is absolute fact that you could be much more profitable in the short and long term on a property with 20% of gross rents going to operating expense, than on a property with 50% of gross rents going to operating expense. There is no rule, period. All costs can be accurately determined to an extent. You just have to take your time and do your research. Don't be scared away by a "crappy" gross rental income to operating expense ratio - RUN ALL THE NUMBERS. It may not be that crappy after all. And then after you run the numbers, realize that you might lose money if your property goes unrented above your vacancy rate, and/or you get a bad apple that destroys your home and decides to never leave and live rent free. That's the big risk you take in real estate. I had a response where I was told that I was going to be $3,000/mo negative on a property I thought I was going to be break even on. I thought long and hard to try to figure out where the $36,000/year was going to. Apparently the member thought my home was in a small town where 90% of the people worked at one car factory, and was anticipating a factory closure very soon. Must have been it.

Well, this $20,000 expense can occur in any state, any city, any town - not just LA. Yes, certain states are more landlord-friendly, and others are more tenant-friendly. I happen to be living in a tenant-friendly state - Hawaii. But to factor worst case scenarios into the budget which include evictions is not smart in my opinion. If you have to deal with an ugly eviction, you're just going to take a loss. That's one of the risks of investing in real estate. You can't plug this into your operating figures.

The 45% to 50% expense figure does not factor in worst case scenarios, it factors in the average scenario. In fact, the 45% to 50% expense number comes from the owners/managers of hundreds of thousands of rental properties in the United States. Using these expense numbers only brings your expenses in line with the average expenses, certainly not the worst case.

Unfortunately, bad things do happen with regularity in the rental property business. If you have one or two rentals, you might get lucky and never have anything bad happen. On the other hand, if you have one or two rentals, you may be unlucky and have a devastating expense. Neither are the norm. As your portfolio grows, your expenses will trend more toward the statistical average of 45% to 50%. With enough rentals, evictions become a statistical certainty. Excessive damage done by tenants become a statistical certainty. Ups and downs in the business cycle are a certainty. Unless your expenses are calculated properly, you can not survive these occurrences and the majority of new investors do not.

The majority of new rental property owners fail in a short period of time. The number one reason they fail is lack of cash flow, just like every other business. Failing to account for the real world expenses is a guaranteed path to failure.

Mike

Originally posted by "MikeOH":
The 45% to 50% expense figure does not factor in worst case scenarios, it factors in the average scenario. In fact, the 45% to 50% expense number comes from the owners/managers of hundreds of thousands of rental properties in the United States. Using these expense numbers only brings your expenses in line with the average expenses, certainly not the worst case.

Unfortunately, bad things do happen with regularity in the rental property business. If you have one or two rentals, you might get lucky and never have anything bad happen. On the other hand, if you have one or two rentals, you may be unlucky and have a devastating expense. Neither are the norm. As your portfolio grows, your expenses will trend more toward the statistical average of 45% to 50%. With enough rentals, evictions become a statistical certainty. Excessive damage done by tenants become a statistical certainty. Ups and downs in the business cycle are a certainty. Unless your expenses are calculated properly, you can not survive these occurrences and the majority of new investors do not.

The majority of new rental property owners fail in a short period of time. The number one reason they fail is lack of cash flow, just like every other business. Failing to account for the real world expenses is a guaranteed path to failure.

Mike

I agree that having a portfolio of several rental properties in several different areas/markets is key in that is spreads your risk, similar to having a diversified stock portfolio.

But to try to adhere to the statistical average of 45-50%, you are really doing nothing if you're a first time buyer looking at your first investment property (there are many like this on this forum). Sure, if you own many properties in many markets, using the 45-50% rule can apply. But if I'm a newbie and looking for advice on a first possible investment property and everyone tells me "45-50% or you'll be in trouble", is just plain misleading.

Let's try to break this down and see how this works:

Property #1 (estimated figures for property I've seen available for sale)
3 bedroom, 2 bath 2,000 sq ft home in Texas
Value $120,000
Rent - $1,000
5% Vacancy - $50
Property tax (1.5% of annual value) - $150
Maintenance/upkeep - $230 (10 cents sq ft + appliance replacement) budget)
Insurance - $90 (quote from Allstate)
Property management (10%) - $100

[b]Total monthly operating costs - $710
Net operating monthly income - $290 (71% of gross rents going to operating expense)[/b]

Property #2 (actual figures on the average property in Hawaii)
3 bedroom, 2 bath, 1,400 sq ft home in Honolulu, HI
Value $600,000
Rent - $2,500
5% Vacancy - $125
Property tax (.35% of annual value) - $175
Maintenance/upkeep - $245 (15 cents sq ft + appliance replacement) budget)
Insurance - $130 (quote from Allstate)
Property management (8%) - $200

[b]Total monthly operating costs - $875
Net operating monthly income - $1,625 (35% of gross rents going to operating expense)[/b]

Using the 50% rule, you've over-budgeted on property #2, but you're WAY short on property #1. Sure, my estimates may be off. But not enough to refute my argument.

Interestingly, the CAP rate on property # 2 is actually a little better than property #1. If you were a newbie and someone said you can buy a property for $120,000 and rent if for $1,000/mo, that sounds like an OK deal. But tell the same person they can rent a $600,000 property for only $2,500. Horrible deal, right? As you can see from above, this can be very misleading.

All newbie investors should find out the average operating expense for their particular area/market. Then use that average as something to work off of when looking at individual properties. Do not use a NATIONAL average when looking at local markets. You could either pass up some good deals or get hosed.

The great thing about the internet is that everyone can have an opinion. Mine is based on the statistics from hundreds of thousands of rentals in the United States and my own experience. Yours seem to be based on your own experience, which is fine.

Using the 50% rule, you've over-budgeted on property #2, but you're WAY short on property #1. Sure, my estimates may be off. But not enough to refute my argument.

Your estimates ARE way off and you're not even includins most of the expenses.

At any rate, people are free to choose how they want to run their business. The vast majority of newbies fail in a short period of time due to lack of cash flow. If newbies want to guess on individual expenses, they are free to do so (at their own peril). In my opinion, trying to determine actual numbers for single family houses and small apartment buildings is nearly impossible and you have not included nearly all the expenses that people do incur in the real world.

I'll leave the last word to you.

Mike

Well, it is clear that we agree to disagree. You can continue to use your nationwide average as a guide when determining whether a property is a good investment in a certain city and state. I will continue to use an average specific to the locale I am investing in.

You mention that I didn't include all the expenses in my example. Yes, I understand that I may have left certain operating expenses out. But the scenario was meant to show you how the numbers are dramatically different in different parts of the US and using an average in local markets is completely useless. If I was to include all these additional expenses you say I left out, could you tell me how this would refute the point I'm trying to make? Please plug all of your numbers into the equation and see what happens. Nothing. The reality is that one property still has a much higher operating expense in percentage of gross rents than the other.

Originally posted by "MikeOH":
Parrotletlover,

NOI (Net Operating Income) is determined by subtracting the operating expenses from the gross rents. The fact is that throughout the entire Unites States, operating expenses run 45% to 50% of gross rents. Therefore, NOI is really about 1/2 of the gross rents. It is just that simple.

It is impossible to get an accurate view of NOI by subtracting individual expenses from the gross rents. The reason is that you don't know all of the specific expenses you will incur in a given rental in a given year. For example, how many vacancies will you have in a particular rental this year? Will a tenant sue you? Will a tenant do extensive damage? How many evictions will you have?

It is far more accurate to simply consider the operating expenses to be 50% of the gross rents.

Good Luck,

Mike

It is not that simple. That's my point. Let me make it clear that I'm not disagreeing with the fact that you will never know what your total expenses are on any given property. But what you're saying is that because it's impossible to even get close to the actual figures, the 45-50% rule should put you in a safe zone. Again, the illustration on my previous point outlines how this is not safe.

This doesn't have to be the last word; my eight years of experience in the real estate investment/rental industry pales in comparison to what many others on this board have. I have learned new things, disagreed and agreed with others. This is what the internet is all about - sharing opinions. And it's a wonderful thing.

I think one thing that was implied, but not mentioned to the OP was that NOI does not include mortgage expenses.

That being said, I typically use pro forma estimates over the period of my horizon (say 10 years) and then divide it to a monthly budget. That way if I can expect to have to put a new roof on in 7 years, I can budget it over the entire timeframe. Of course, at the same time, I do another calculation to place all my expected cash expenditures and make sure there are no deficiencies. (an allowance over a 10 year period isnt going to cut it when you need a roof in 3 months)

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