What is the 'Operating Expense Ratio - OER'
The operating expense ratio (OER) is a measure of what it costs to operate a piece of property compared to the income that the property brings in. The operating expense ratio is calculated by dividing a property's operating expense by its gross operating income and used for comparing the expenses of similar properties. An investor should look for red flags such as higher maintenance expenses, operating income or utilities that may deter him from purchasing a specific property.
BREAKING DOWN 'Operating Expense Ratio - OER'Property management fees, utilities, trash removal, maintenance, insurance, repairs, property taxes and other costs are included in operating expenses. These costs help run the property on a daily basis. For this reason, loan payments, capital improvements and personal property are excluded from operating expenses.
A lower OER typically means the property is being managed efficiently and is more profitable for investors, and that less of the property’s income is covering 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.
Calculating an OER
The formula for calculating OER is operating expenses / revenues = OER. For example, Investor A owns a multi-family apartment building and brings in $50,000 per month in rent. The investor pays $17,500 for operating expenses. Therefore, the OER is 35% ($17,500 / $50,000 = 35%).
Importance of OER
Calculating OERs over a number of years may help an investor notice a property’s trends in operating expenses. If a property’s costs increase annually at a greater rate than income, the OER increases annually as well. Therefore, the investor may lose more money the longer he holds the property.
When owning an apartment building, an investor should figure in vacancies by using effective rental income, or potential rental income minus vacancy and credit losses, rather than potential rental income. Because managing vacancies is included in efficient property management, including vacancies in an OER gives a more accurate picture of operating expenses and shows where improvements may be made. For example, a poorly managed property will most likely have higher vacancy rates, which will be reflected in the OER.
Additional operating expenses that investors should figure into the OER include property management fees, landscaping, attorney fees, landlord’s insurance and basic property insurance.