What is the Operating Expense Ratio?
In the world of commercial real estate, arranging financing is critical to the success of a project and the operating expense ratio is a critical part of that equation! Often, the sticking point isn’t the interest rate or the loan fees. Rather, the task is to obtain a large enough loan to finance the project. Cash flow and debt service coverage ratio are the important factors in determining loan size, sometimes even more so than the loan-to-value-ratio. Therefore, lenders are extremely interested in operating expenses, as they have a pivotal role in net cash flow.
In this article, we’ll examine the operating expense ratio (OER). Specifically, it’s a statistic that measures the cost to operate a property relative to the generated income. First, we’ll break down the operating expense ratio formula and show how to calculate it, and we’ll consider what a good operating expense ratio is. Then, we’ll work through an example and discuss ways to improve your operating expense ratio. Finally, we’ll conclude by answering some frequently asked questions about OER.
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The Operating Expense Ratio Formula
The most general form of the operating expense ratio formula is:
Operating Expense Ratio = Operating Expenses / Rental Income
While the formula is not complicated, it actually has a few nuances that affect its meaning.
The components are:
- Operating Expenses: These are the costs of running a property, including property management fees, utilities, maintenance, insurance, property taxes, repairs, etc. Operating expenses do not include capital costs like rehabilitation and new construction. In some formulations, the lender subtracts depreciation from operating expenses, because depreciation is a non-cash expense.
- Rental Income: You can use different values for rental income in the OER formula. Sometimes, you might choose to use potential rental income, which disregards vacancy and credit losses. Sometimes, this might make sense in an apartment building, where the vacancy rate is quite dynamic. Also, it’s common practice to use potential rent for buildings under construction. Furthermore, a lender might choose to concentrate on the best-case scenario, in which the landlord collects all potential rent. And most certainly, that is something the borrower would endorse. However, it often makes sense to use effective rental income, which is potential rent minus vacancy and credit losses. Naturally, this gives a more accurate impression of whether the property manager is efficient.
Implications of the Ratio
A relatively low OER indicates that the landlord or management company is efficiently managing the property. Obviously, this is important to potential investors because it presages profitability. That’s because less of the rent revenue pays for maintenance and operational costs. Also, a tight rental market allows the owner to raise rents without increasing operating expenses. A deteriorating OER is a red flag that requires further analysis. It could be that some cost component, such as utilities, is rising faster than usual. On the other hand, it could mean a higher vacancy rate or greater credit costs that are depressing rental income. Obviously, if property costs are increasing faster than revenues, investors may lose money unless they unload the property.
Weaknesses of the Operating Expense Ratio
From the investor’s point of view, OER has two weaknesses as follows:
- Property Value: Unlike the cap rate formula, the OER omits the property’s market value. Therefore, it provides investors no information about the property’s relative value. Truthfully, in a worst-case scenario, an investor might purchase an efficiently operating property that is grossly overpriced. Clearly, this is why you should couple OER with cap rate when considering the purchase of an investment property.
- Depreciation: It’s a good idea to subtract depreciation from operating expenses. Clearly, depreciation is a non-cash expense, while OER is all about cash flow. Specifically, lenders use OER to determine whether cash flows will enable loan payback. The problem is that you can calculate depreciation in several ways. Therefore, you must watch out for sellers who game OER by using the most advantageous accounting method for depreciation. By overstating depreciation, one can make OER look better than it should.
How to Calculate OER in Excel
Calculating OER in Excel is a cinch. Look at the following example, provided by WallStreetMojo:
Clearly, the operating expense ratio of 10% equals $40,000 / $400,000.
Operating Expense Ratio Example
Imagine you own a small apartment building that generates monthly rental income of $75,000. Factually, operating expenses run $30,000 a month, on average. Moreover, the property’s annual depreciation cost is $90,000.
To calculate OER, annualize the monthly expense and revenue figures. The annual operating expenses are 12 x $35,000 = $420,000. Annual revenue is 12 x $75,000 = $900,000. Annual depreciation is $90,000. Therefore:
OER = ($420,000 – $90,000) / $900,000 = ($330,000) / $900,000 = 36.67%.
Ways to Improve Your OER
There are a few ways to improve your operating expense ratio:
Reduce Operating Expenses
Everything you do to make operations more efficient should improve your OER. For example, you could use a triple net lease to reduce your expenses by passing them to your lessees. However, that usually requires that you reduce the rent relative to what you’d charge for a gross lease. Nonetheless, you should consider capping the amount you will pay for the operating expenses of a property. Then, you can pass along expenses above the cap level to your tenants.
You can gain efficiencies by eliminating wasteful spending and using lower cost vendors and suppliers, assuming of course that their services meet your standards. Also, try to increase your return on investment by inviting competing property managers to bid. Truthfully, when you make it a top priority, you can probably find numerous ways to reduce your operating expenses.
Increase Effective Rental Income
You do this by reducing your vacancy rate and lowering credit costs. For example, you might do this by making capital improvements to your properties which doesn’t affect your OER. Also, you might tighten your screening process to reduce the number of problem renters and eviction cases. Furthermore, ensure you are charging no less than market rent for your neighborhood. Logically, if you add premium features, you should be able to charge above-market rents. Also, collect at least two months’ deposit to help defray credit costs.
Use Aggressive Accounting
You should always subtract depreciation from your operating expenses, considering that it is a non-cash expense. Also, substitute potential rent for effective rental income to maximize your revenues.
Operating Expense Ratio FAQs
What is a good operating expense ratio for commercial real estate?
A lot depends on the property and the neighborhood. However, lenders want to see a maximum OER of 40% to 45%. On multifamily, an OER below 40% is good, but you have to make sure that the number isn’t gamed.
What is a good operating expense ratio for hotels?
Once again, much depends on the property and its location. Of course, heavy competition will drive up the OER, as there is less opportunity to raise rates. On the other hand, an OER of 50% or less is a good operating expense ratio for hotels.
What is a good operating expense ratio for retail property?
What do you include in operating costs?
Everything that constitutes the day-in, day-out costs of running a property is an operating cost. Specifically, this includes insurance, property management fees, property taxes, utilities, maintenance, repairs, collection costs, marketing costs, etc. Importantly, capital expenditures, tenant improvement allowances and loan payments aren’t part of OER.