Operating Expense Ratio (OER)

What Is Operating Expense Ratio (OER)?

The operating expense ratio (OER) in real estate is a measurement of the operational costs of a particular property compared to the overall income that the property brings in. To calculate it you divide the operating expenses (excluding depreciation) by its gross operating income.

This is a very useful calculation when comparing similar properties. For example, if you had to choose between three properties you could calculate the OER. The one with the lowest OER has the least operating expenses relative to income. On the other hand, a property with high operating expenses may deter an investor.

Takeaways

• The operating expense ratio (OER) for real estate investments is a comparison between operational expenses and gross income.
• To calculate the operating expense ratio (OER), divide all operating expenses (excluding depreciation), and divide by operating income.
• A lower operating expense ratio (OER) is more desirable for investors because it means they have lower overheads relative to income.

Understanding Operating Expense Ratio (OER)

The formula for Operating Expense Ratio (OER)

OER = Total operating expenses ÷ Effective gross income × 100

Calculating Operating Expense Ratio

The first step to calculating your operating expense ratio is to calculate your operating expenses. You can read more about operating expenses here.

You may also need to calculate your property’s depreciation as this needs to be specifically excluded. This will be personal to your property and it’s recommended you consult with a licensed real estate accountant or CPA to ensure you calculate this accurately. However, for the purposes of this calculation you can estimate the depreciation amount so long as you know the value of the property and the value of the land it’s on. Once you have these you need to calculate the gross annual income.

Calculating the OER for a property over a number of years can highlight important trends. For example, you might find that a property’s OER increases over time. This suggests that the overall profitability will decrease the longer you hold the property. With this knowledge, you can determine strategies to combat these increasing costs such as investing in renovations to reduce maintenance costs, you can shop around for better deals to reduce things like property management fees, or increase rents to combat these rising costs.

For a multi-unit property or an apartment building, investors can figure in vacancies by calculating effective gross income: potential rent minus an allowance for vacancy and credit losses. Including vacancies in this way can help build a more accurate picture of the property’s financials. This may not be worth it for SFH’s.

Operating Expenses: Summary

Operating expenses are ongoing costs to maintain and keep a rental property investment in service. In other words, they’re the costs that affect the day-to-day operation of the investment and are considered necessary to keep the revenue stream flowing.

Here’s a brief overview of the types of costs you want to include as an operating expense, as well as expenses that you want to exclude.

1. Include expenses like these when calculating operating expenses:

• Property taxes
• Property insurance
• Water and sewer
• Utilities
• Garbage collection
• Property management
• Maintenance and repairs
• Landscaping
• Pool service

Note: These are legitimate operating expenses because they affect the day-to-day operation of the investment and contribute to the investor’s ability to rent the units. Other examples would include costs for administrative and accounting, telephone, supplies snow removal, janitorial service, pest control, rental advertising, and so on.

2. Exclude expenses like these when calculating operating expenses:

• Debt service
• Investor income taxes
• Replacement reserves
• Capital improvements
• Depreciation

Note: These are not legitimate operating expenses because they are not directly related to the investment property’s core operations. What the owner pays in federal income taxes, for instance, would not affect the property’s ability to produce rental income.

An Example of Operating Expense Ratio (OER)

The investor owns a triplex that brings in $3,600 in rent per month. We can also estimate the vacancy rate at 5% which would make the effective income $3,420. The investor pays a total of $2,000 a month in operating expenses. The property is also expected to depreciate $18,000 this year.

Therefore, the annual OER can be calculated as:

($2,000×12) / (3,420×12) = 58%

This means that operating expenses consume just under 60% of the revenue generated by this property.

What Is a Good Operating Expense Ratio?

Lower is better, but there's no single target. OER depends on the property's age, who pays the utilities, local property taxes and insurance costs. As a rough guide for small residential rentals:

A common screening shortcut, the 50% rule, assumes about half of gross rent goes to operating costs and vacancy, before the mortgage. If a deal only works at an OER far below that, double-check the seller's expense figures. Compare OERs between similar properties in the same market, and track your own OER over time: a rising OER is an early warning that costs are growing faster than rent.

Why OER Matters: Two Duplexes Compared

Two duplexes on the same street each rent for $1,500 a unit. With a 5% vacancy allowance, each brings in $34,200 of effective gross income a year.

Duplex B's landlord pays water and trash, the building is older, and its tax bill is higher. The rent is identical, but the higher OER leaves $5,800 less NOI each year. At a 6.5% cap rate, that's roughly $89,000 less in value. OER shows you the problem before you buy.

How to Lower Your Operating Expense Ratio

You can lower OER by cutting costs or by raising income. Both count.

• Re-shop insurance and appeal your tax assessment. These two lines are often the largest fixed costs. Get new insurance quotes every year and check your assessment against comparable properties.
• Rebid service contracts. Landscaping, snow removal, pest control and trash are easy to re-quote.
• Pass utilities to tenants where you can. Separate meters or a utility billing system can move water, sewer and trash costs to tenants where your state allows it.
• Do preventive maintenance. Servicing HVAC and checking roofs and plumbing costs less than emergency call-outs and water damage.
• Cut vacancy and turnover. Every vacant month lowers effective gross income, which pushes OER up. Screening, quick turnarounds and keeping good tenants all help.
• Charge market rent and add other income. Regular, fair rent increases and extras such as parking, storage, laundry or pet rent raise income faster than costs.
• Track expenses monthly. Categorizing expenses as they happen shows a rising cost line early, not at tax time.

Operating Expense Ratio (OER) vs. Capitalization Rate

The capitalization rate or cap rate is used to indicate the rate of return for an investment. Put simply it represents the yield of a property over a one-year time period. Essentially, this metric measures the potential ROI.

It is defined by the formula:

Cap rate = net operating income ÷ current market value

The cap rate and OER are similar in terms of measuring a property’s profitability, however, they differ in that OER takes into account expenses and focuses on gross revenue rather than net income. OER also does not take into account the market value of a property.

You can learn more about the capitalization rate here.

Limitations of the Operating Expense Ratio

There are several major drawbacks to OER for real estate investors. For example, it doesn’t take into account the property value. Meaning you can’t determine, using the OER, your return on investment. It only speaks of the efficiency of the ongoing expenses relative to income. As such, this calculation shouldn’t be used in solitude, but paired with other key real estate metrics such as cap rate, internal rate of return, net operating income, etc.

A low OER isn't always a good sign. Deferred maintenance flatters it in the short term, because repairs that aren't done don't show up as expenses. When you're buying, ask for several years of expense history, not just the last 12 months.

The Bottom Line

A lower OER typically means the property is being managed efficiently and is more profitable for investors. Essentially, less of the property’s income is going towards covering ongoing operational and maintenance costs. If the business is scalable, the owner may increase the rent on each unit without greatly increasing operating expenses.

In addition, the OER can show where potential issues may occur, such as utility bills increasing substantially, so investors can solve problems more quickly and protect their profit levels.

To keep accurate and up-to-date records of all your operating expenses throughout the tax year use Landlord Studio.

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