I see the term Expense Ratio tossed around a lot on the forums. This was not a number I have been using in my analyses so I wanted to gain some clarity on exactly what is included in this number. For instance, I believe debt service is not included from what I have read on the forums. More importantly though, I am having trouble figuring out exactly what is rolled into the debt service number. The obvious one is the loan, but do people also include taxes and insurance as part of the debt service? I tend to wrap all 3 values into the loan and let the bank pay the taxes and insurance out of an escrow account. Do others do this and do you consider this part of the debt service? What kind of expense ratio numbers do you find acceptable? I am using between 50%-55% in my analyses which does not include PITI.
The 2nd question I have regards utilities. In my market water/sewer is a leinable utility if left unpaid. Most landlords choose to wrap this into the monthly rent because of this. Does everyone on BP tend to agree with this thinking? Water and sewer tend to scare me because of the threat of a running toilet, or a tennat washing cars, etc.
I appreciate the help and guidance. Thanks again BP!
Correct, debt service is not included in operating expenses. Debt service is just the principal and interest mortgage payment (or payments if there is more than one mortgage). Its common to have insurance and taxes paid from an escrow account, as the lender has a vested interest in the taxes being paid and the house staying insured. Because of this you pay Principal, Interest, Taxes and Insurance (PITI) as one lump payment for convenience, but its important to note that taxes and insurance are operating expenses, but the principal and interest are not. From your gross operating income (rents minus vacancy allowance) then subtract all the operating expenses to find Net Operating Income or NOI. You then use the NOI to pay the debt service then keep whats left over as cash flow.
At the end of the day you are paying the same amount regardless of what we call it, so why does it matter? It matters because NOI is the income a property produces regardless of the owner's financing or personal income tax situation. This is the number another investor you try to sell it to will care about. For example, an all-cash buyer doesn't care what your loan payment is. NOI is also the number you begin with to calculate your taxable income. Taxable income is generally = NOI - deductible mortgage interest - depreciation.
I would be concerned if a property's expenses were at 50-55% of rents not including taxes and interest, as you are doing. The "big four" things that make up the bulk of your operating expenses are: Taxes, Insurance, Maintenance, and Management. Those plus any other operating expenses is what is referred to with the 50% rule.
Hope that helps!
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