Understanding Operating Expense Ratio (OER)
In real estate, the operating expense ratio (OER) is a crucial measurement that compares the cost of operating a property to the income generated by it. It is calculated by dividing a property’s operating expense (excluding depreciation) by its gross operating income.
OER enables investors to compare the expenses of similar properties. High operating expenses, increased maintenance costs, or hefty utility bills may signal red flags that deter investors from purchasing certain properties.
The ideal OER ranges between 60% and 80%, though a lower ratio indicates better efficiency.
Key Takeaways
- The operating expense ratio (OER) in real estate measures the cost of operating a property against the income it generates.
- OER is computed by dividing total operating expenses less depreciation by gross operating income.
- Lower OERs are more attractive to investors as they signify minimized expenses relative to revenue.
How to Calculate Operating Expense Ratio (OER)
Formula for Operating Expense Ratio (OER)
OER = (Total operating expenses - Depreciation) / Gross revenue
In determining the OER for a property, it’s essential to identify the operating expenses, which encompass all fees and costs incurred as normal business expenses. Additionally, calculating the property’s depreciation expense, which varies by the accounting method used, is necessary.
Calculating OERs annually assists investors in tracking expense trends. If a property’s expenses increase faster than its income, the investor could suffer losses the longer they hold the property.
For apartment building owners, factoring in vacancies for effective rental income—potential rental income minus vacancy and credit losses—provides a clearer view of operational expenses. Properties with higher vacancy rates usually showcase inefficient management, which is evident in their OER.
Included Elements in OER Calculation
Property management fees, utilities, trash removal, maintenance, insurance, repairs, and property taxes all factor into the OER. Other operational expenses include landscaping, legal fees, landlord’s insurance, and basic property insurance. Loan payments, capital improvements, and personal property are excluded from the operating expenses.
A lower OER suggests efficient property management and increased profitability, highlighting reduced covers for operational and maintenance costs. For scalable businesses, rent hikes could come with minimal increases in operating expenses. OER serves as an early indicator of potential issues like rising utility bills, enabling timely problem-solving and profit protection.
Practical Example of Operating Expense Ratio (OER)
Consider an example where Investor A owns a multi-family apartment building generating $65,000 monthly in rental income. The investor incurs $50,000 in monthly operating expenses, including mortgage payments, taxes, and utilities. The property also depreciates by $85,000 annually.
The annual OER is calculated as follows:
((50,000 * 12) - 85,000) / (65,000 * 12) = 66%
This means that operating expenses consume approximately two-thirds of the revenues generated by this property.
Comparison: Operating Expense Ratio (OER) vs. Capitalization Rate
The capitalization rate (cap rate) measures the expected return on a real estate investment property. Computed as net operating income divided by current market value, it estimates potential investment return annually if the property is bought outright.
Cap Rate Formula
Cap rate = Net operating income / Current market value
While both OER and cap rate measure property profitability, OER doesn’t account for market value. It considers gross revenue for calculation, unlike cap rate, which uses net income.
Limitations of Operating Expense Ratio (OER)
Two main limitations of OER include:
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Market Value Exclusion: It does not reflect the market value, thus revealing only operational efficiency, not the property’s valuation at purchase or sale. Coupling OER with cap rate simplifies comprehensive assessments.
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Depreciation Variance: Different methods of accounting for depreciation can manipulate the OER, making it less reliable if gamed with favorable depreciation techniques.
Related Terms: capitalization rate, depreciation, gross revenue, net operating income.
