What You Should Know About Operating Expense Ratio in Commercial Real Estate
Investors in commercial real estate who experience a lot of deal flow confront particular difficulties. To swiftly locate the properties that have the best potential for generating a significant return, they must be able to sort through voluminous financial data.
They can therefore focus their extensive underwriting efforts on these assets rather than wasting time completing due research on properties with low success rates. Efficiently computing and assessing the property’s Operating Expense Ratio, or “OER,” is one method used by investors and lenders to accomplish this.
What Is the Operating Expense Ratio, and Why Is It Important for Commercial Real Estate Investors to Understand?
The operating expense ratio (OER), used in real estate, measures the cost of operating a piece of property in relation to the income the property generates. The operating expense ratio is used to compare similar properties’ costs.
An investor should be on the lookout for warning signs that could discourage him from buying a particular property, such as increased maintenance costs, operating revenue, or utilities. The operating expense ratio is important for two reasons: first, it offers insight into how well the property is managed, and second, it offers a simple basis for comparing various properties.
Operating expense ratios include costs such as property management fees, utilities, garbage collection, maintenance, insurance, and repairs. Landscaping costs, attorney fees, landlord’s insurance, and standard property insurance are other operating expenses that investors should keep in mind.
These expenses fund daily operations at the property. Because of this, operating expenses do not include loan payments, capital upgrades, or personal property to help investors immediately fix problems and safeguard their profit margins. The operating expense ratio can also identify where prospective difficulties may arise, such as when utility expenses significantly increase.
How Can You Calculate the Operating Expense Ratio for a Property?
You must be aware of the operational costs to determine a property’s operating expense ratio. These cover all charges and expenses that are incurred regularly for conducting business. It would be best if you also estimated the property’s depreciation expense, which varies depending on the specific accounting method used.
An investor may see trends in a property’s operating expenses by doing the calculations over a long period. The operating expense ratio rises annually if a property’s costs rise more quickly than its revenue each year. As a result, the longer the investor holds the property, the more they could lose.
The formula for Operating Expense Ratio (OER) = total operating expense – depreciation
Consider a scenario where Investor A owns a complex of multi-family homes and receives $75,000 in rent each month. The investor additionally contributes $60,000 toward running costs, which include his monthly mortgage, taxes, electricity, and other expenses. Additionally, the property is anticipated to depreciate by $95,000 this year.
Hence, the annual operating expense ratio can be calculated as follows:
($60,000 × 12) – 95,000 = 69%
(75,000 × 12)
Accordingly, this property’s operational costs account for almost two-thirds of its revenue.
What Should You Do if the Expense Ratio Starts to Exceed Your Expectation?
When your expense ratio is high, it means the property is not properly managed, and the investor could lose money if that goes on for some time. But the good thing is that you can boost your operational expense ratio in a few different ways:
Increase Effective Rental Income
You achieve this by cutting credit costs and your vacancy rate. You may accomplish this by investing in property upgrades that have no impact on your operating expense ratio. Additionally, you might make your screening procedures more stringent to lower the number of problematic tenants and eviction cases.
Make sure your rent is also at least as costly as the market rate in your area. It makes sense that you should be able to charge above-market rentals if you include premium features. Additionally, gather a deposit of at least two months to offset credit fees.
Reduce Operating Expenses
Your operating expense ratio should be improved by anything you do to make operations more productive. By transferring expenses onto your lessees, you may use a triple net lease to lower your costs. But, to do that, you typically need to lower the rent compared to what you would charge for a gross lease.
However, it would help if you thought about limiting how much you will spend on a property’s operational costs. After that, you can charge your tenants for expenses exceeding the cap. Efficiency gains can be achieved by cutting wasteful spending and working with suppliers and vendors who charge less, provided their services are up to par.
Employ Stringent Accounting
Since depreciation is a non-cash item, it should always be subtracted from operating expenses. Additionally, replace actual rental income with potential rent to increase your profits.
How Does the Operating Expense Ratio Compare to Other Key Metrics, Such as Capitalization Rate and Net Operating Income (NOI)?
Operating Expense Ratio vs Capitalization Rate
The capitalization rate is a term used in commercial real estate to describe the projected rate of return on an investment property. This calculation, often known as the “cap rate,” is based on the property’s anticipated net revenue.
The cap rate shows a property’s yield over a one-year time horizon, given that the property was bought outright with cash and not with a loan. The formula defines it:
Cap rate = net operating income ÷ current market value.
While the cap rate and operating expense ratio both measure the profitability of an investment property, the cap rate varies from the former in that it uses gross revenue as the denominator rather than net income. The operating expense ratio is not taken into account the market worth of a property.
Operating Expense Ratio vs Net Operating Income (NOI)
A net operating income (NOI) calculation is used to assess the profitability of real estate assets that produce income. NOI is the sum of all property revenues minus all reasonably reasonable running costs.
On a property’s income and cash flow statement, NOI is a before-tax statistic that does not include loan principal and interest payments, capital expenses, depreciation, or amortization.
Operating Expense Ratio Limitations
The main drawback is that it only provides data on the property’s operations rather than on its present or potential future market worth. As a result, other than the capacity to make expense adjustments that affect valuation, it only offers little information about a property’s potential return on investment.
Because of this, the operating expense ratio shouldn’t be the only factor considered when assessing a property. The capitalization rate, sometimes known as the “Cap Rate,” and other helpful measures should be utilized in conjunction with it.
What Is a Good Operating Expense Ratio?
The expense structures vary depending on the type of property. For example, multi-family property owners can charge their tenants for utilities like heat and electricity. For a brand-new apartment building that is leasing up, advertising and marketing expenses might be high, but for industrial property, they might be negligible or nonexistent.
Energy expenses could be high in an office building but not in a mobile home park. To spot trends over time, always compare the operating expense ratio year over year. If it is on the high side, it may indicate wasteful spending, outdated utility equipment, bloated payroll, or other problems. The optimal operating expense ratio ranges from 60% to 80%.
A lower operating expense ratio often indicates better management and higher investment returns on the property. Essentially, a smaller portion of the property’s income is used to pay for continuing operations and maintenance expenses.
The owner may raise the rent for each unit without significantly raising running costs if the property is sustainable. Additionally, the operating expense ratio can identify future problems, such as sharply rising utility expenditures, so investors can address them sooner and maintain profit margins.
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