What Is Operating Expense Ratio (OER)?
In real estate, the operating expense ratio (OER) is a measurement of the cost to operate a piece of property compared to the income brought in by the property. It is calculated by dividing a property's operating expense (minus depreciation) by its gross operating income and is 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.
The operating expense ratio range is most ideal between levels of 60%–80%, where the lower it is, the better.
The Formula for OER is:
How to Calculate the OER
Operating Expense Ratio
In order to calculate the OER for a property, you need to know the operating expenses. These include all sorts of fees and costs incurred as normal costs of doing business. You will also need to calculate the property's depreciation expense, which will vary by the particular accounting method employed.
What Does the Operating Expense Ratio Tell You?
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 are 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.
Property management fees, utilities, trash removal, maintenance, insurance, repairs, property taxes and other costs are included in operating expense ratios. Additional operating expenses that investors should figure into the OER include property management fees, landscaping, attorney fees, landlord’s insurance, and basic property insurance. 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.
- The operating expense ratio is a measurement of how profitable a piece of income real estate is for an investor.
- It is calculated by dividing all operating expenses less depreciation by operating income.
- A lower OER is desired as it means that expenses are minimized relative to revenue.
Example of How to Use the OER
Take a hypothetical example, where Investor A owns a multi-family apartment building and brings in $65,000 per month in rent. The investor also pays $50,000 for operating expenses including his monthly mortgage payments, taxes, utilities, and so on. The property also is expected to depreciate by $85,000 this year.
Therefore, the annual OER can be calculated as [($50,000 x 12) - 85,000] / (65,000 x 12) = 66%. This means that operating expenses consume approximately two-thirds of revenues generated by this property.
The Difference Between the OER and the Cap Rate
The capitalization rate (or cap rate) is used in the world of commercial real estate to indicate the rate of return that is expected to be generated on a real estate investment property. Often referred to as the "cap rate," this measurement is computed based on the net income which the property is expected to generate. It is used to estimate the investor's potential return on investment in the real estate market.
The cap rate simply represents the yield of a property over a one-year time horizon assuming the property is purchased on cash and not on loan. It is defined by the formula:
- Cap rate = net operating income / current market value
While similar to OER in terms of measuring the profitability of an investment property, it differs in that the OER uses gross revenue rather than net income and places that in the denominator. OER also does not take into account the market value of a property.
Limitations of the OER
There are two drawbacks to the OER for real estate investors. First, because it does not include the market value of a property (as does the cap rate), it does not inform an investor about the relative value of a property at purchase or sale. It only speaks to the efficiency of ongoing operations. It should thus be used in conjunction with something like the cap rate when evaluating a property investment.
Second, because depreciation can be calculated in several different ways, the OER can be gamed by using a more favorable method of accounting for depreciation.