The operating expense ratio, or “OER”, is a simple formula that’s easy to calculate and reveals how efficiently a property runs on a day-to-day basis.
The metric describes the rental income (after vacancy) that is consumed by the property's operating expenses. As such, property owners do their best to minimize their asset's operating expense ratio.
How do you calculate the operating expense ratio?
The formula divides total operating expenses by the effective gross income of a property:
Operating Expense Ratio = Total Operating Expenses/Effective Gross Income
What is included in operating expenses for real estate?
Typical operating expenses for a commercial real estate property include:
- Real estate taxes
- Property insurance
- Utilities
- Repairs and maintenance
- Janitorial services
- Property management fees
- General & administrative fees
- Advertising and marketing fees
- Payroll
The operating expense ratio focuses on the day-to-day cash costs of running a property. So, items like depreciation (non-cash), capital expenditures, and tenant improvement allowances are excluded from the ratio because they are not costs to help run the property.
Rather than Total Potential Income, it’s best to use Effective Gross Income (“EGI”) in the denominator. Effective gross income takes into account vacancy at your property.
Vacancy reflects rental income that is lost because of space (or units in the case of residential real estate) that is not leased. When there is a vacancy at a property, the landlord will still be required to cover certain operating costs, like pro-rata taxes, insurance, and repairs and maintenance.
Loss of income (especially from a large tenant) can make it harder to cover those costs. Some costs, like utilities, however, may be paid directly by a tenant and can be shut off to a vacant unit.
Calculate the operating expense ratio after vacancy with EGI for a more accurate picture of your property's operations. The larger your vacancy, the more skewed OER might be.
What is an example of an operating expense ratio?
Take a hypothetical example of Investor A who owns a 92,043 sq ft multi-tenant office building in Texas. The property generates $2,987,100 in Effective Gross Income and has total operating expenses of $1,065,000. That means the OER is 35.7%:
(1,065,000/2,987,100 = 35.7%).
The details might look like this:
Is a lower OER better?
A lower OER generally implies that a property is well-run. Likewise, a higher OER often means there is upside potential.
What is a good operating expense ratio in commercial real estate?
Different property types have different expense structures. For instance, multifamily owners can pass costs to their tenants such as electricity, heat, and other utilities. Advertising/marketing costs may be substantial for a new apartment complex in lease-up, but minimal or non-existent for an industrial property. Energy costs might significant in an office building but not so at a mobile home park.
Remember to do a year-by-year comparison of the operating expense ratio to identify trends over time. An increasing OER could mean wasteful spending, old utility equipment, bloated payroll, or any number of issues.
What is a typical operating expense ratio in multifamily?
For apartment buildings, a good operating ratio usually falls between 35% and 45%. However, it’s important to compare properties locally as expenses can vary between municipalities.
What is a typical operating expense ratio for office properties?
For office buildings, a good operating ratio usually falls between 35% and 55%, depending on the lease terms.
A low operating expense ratio would typically correspond to a property leased under a triple net lease agreement, which assigns sole responsibility to the tenant for all costs.
In a modified gross lease, the tenant and landlord share responsibility for costs. In this case, the tenant might pay for cleaning, utilities, and common area maintenance while the landlord covers taxes, insurance, and building maintenance.
Office towers typically have the highest OER. Tenants typically pay a fixed monthly rent per square foot (“gross lease''). In a gross lease (also called a “full-service” lease), landlords are responsible for all operating expenses.
What is a typical operating expense ratio for a retail property?
In retail properties, a good operating ratio falls between 20% and 30%. The low end of the range corresponds to triple-net leases where a retailer usually pays a base rent, utilities, janitorial services plus a pro-rata share (based on tenant’s sq footage) of taxes, insurance, and CAM. This is common in shopping center leases. CAM covers the upkeep for shared lobby entrances, restrooms, food courts, sidewalks, elevators, parking lots, etc. that a retailer benefits from in a shopping center or mall.
On the higher end of the range, the property likely has modified gross leases or in some cases, percentage leases. A percentage lease requires the tenant to pay rent and a percentage of monthly sales, but virtually no operating expenses.
What is a typical operating expense ratio for industrial real estate?
For industrial properties, a good operating ratio falls between 15% and 25%, depending on space build-out. On the low end are industrial properties with triple-net leases on space in raw form, such as a one-story warehouse. On the higher end are “flex” buildings, short for flexible space that offers a combination of uses, such as warehouse, office, and manufacturing/research and development space.
What is a typical operating expense ratio for hotels?
For hospitality (hotels/motels), a good operating ratio falls between 50% and 65%. The high end of the range would correspond to luxury hotels or upscale chains that provide amenities and services, such as Four Seasons or Hyatt. The lower end of the range would correspond to midscale or economy hotels like Best Western or Days Inn.
What are the limits of the OER?
The main limitation of the operating expense ratio is that it does not communicate information about the market value of a property. Instead, an investor would need to use the operating expense ratio in conjunction with a capitalization rate to evaluate the market value of a commercial real estate property.
Conclusion
The operating expense ratio can tell an interesting story about a property. Different property types have different expense structures, so compare OER results to comparable properties with comparable lease terms in comparable markets.
