The operating expense ratio in real estate measures the operational costs of a property compared to the overall income of that property.
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. A good OER is between 60% and 80% (although the lower it is, the better).
The formula for Operating Expense Ratio (OER)
OER = (total operating expenses) / gross revenue
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 the potential rental income (rental income minus average vacancy rate 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 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:
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:
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.
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 two-thirds of the revenue generated by this property.
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.
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 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.