Operating Expense Ratio

The operating expense ratio also known as the OER is the ratio between the total operating expenses and the effective gross income.

Operating expenses are costs associated with the operation and maintenance of income producing properties. They include such items as property taxes, property management fees, insurance, wages, utilities, repairs and maintenance, supplies, advertising, attorney fees, accounting fees, trash removal, pest control, etc. The following are not operating expenses; loan payments, personal property and capital improvements.

The effective gross income for a property is the actual yearly income from all sources. It is equal to the yearly gross rents possible plus

other income such as laundry receipts, vending machines, parking fees, etc. less the yearly vacancy amount.

The operating expense ratio shows the percentage of a property’s income that is being used to pay maintenance and operational expenses. Lets take a look at an example. An income producing property has potential rents of $78,000 plus $2,000 of other income for a total of $80,000. The property has 4,000 of lost income due to vacancies. The yearly operating expense are $30,400. The effective gross income for the property is $80,000 – 4,000 or $76,000. The operating expense ratio is calculated like this.

The operating expense ratio for the above property indicates that 40% of the property’s income is being spent on maintenance and operational expenses. To establish a bench mark OER, you would calculate the operating expense ratio of similar income properties. You would then calculate the average OER for the properties.

Why is the operating expense ratio important? The operating expense ratio is an indicator of how efficiently a property is being managed. The lower the operating expense ratio, the greater the profit for the investor or investors. As the owner or manager of an income producing property, you should be assessing what steps you can take to reduce vacancies, reduce operating expense items and increase income. Which operating expenses are out of line and why? You can learn a lot about an income property by examining the individual operating expense items.

Many factors can impact the operating expense ratio for income properties. Poor management will result in higher than normal vacancies. The cause might be ineffective advertising, poor maintenance, etc. Older income properties will have larger maintenance and utility expenses than newer income properties since newer income properties are usually insulated better and require less maintenance. An income property with rents below market value will have a higher operating expense ratio than one that is managed effectively. Office buildings will generally have higher OER’s then apartment buildings because they require more intensive management and maintenance.

As the owner of an income property or potential purchaser of income property, you should examine the operating expense data looking for potential problems. Compare the previous years operating expense data to the current year. Compare the data to properties you are considering purchasing. What percentage of a property’s effective gross income is being spent on maintenance and repairs? What percentage is being spent on advertising? What percentage is being spent on utilities? An abnormally high utility expense might indicate that a property is poorly insulated. Even if you don’t pay the utilities, high utility bills might be resulting in a higher than normal turnover rate. Which operating expense items are out of line and why? What actions can you take to correct the problem? When you come up with a solution, monitor the situation to determine if it has corrected the problem. Often is is necessary to spend money to improve the operating efficiency of a property.

The operating expense ratio for advertising would be calculated like this:

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