The other day I was called by the listing agent about a multi-unit apartment complex and told it had a 7.2% capitalization rate. This is very a favorable ratio for residential income property in Salem, Oregon so I requested an APOD and called my real estate investor.
Upon receipt of the APOD, however, a closer examination revealed that the listing agent computed the operating expenses at just 13% of the rental income; naturally, too low for an income property, and the full explanation for the favorable cap rate.
It was clearly a rookie error that could have been avoided with a simple rule of thumb about an income property’s operating expense ratio.
Of course I am not advocating a rule of thumb. Operating expenses need to reflect current and reasonably anticipated expenses required to keep the property in operation, and should never be inserted irresponsibly as if one-size-fits-all. A rule of thumb, however, might help new investors and real estate agents just starting to work with real estate investment property to track their numbers in accordance with some level of real estate investing reality.
1-4 Units
Operating expenses for single-unit, duplex, tri-plex, and four-plex units are typically between 25-35% of the property’s gross scheduled income.
5 + Units
Operating expenses for larger complexes range between 35-45% of gross scheduled income.
Why the difference? Owners of the smaller units generally shift the cost of water and sewer, trash, and landscaping to the tenant; whereas, owners of the larger complexes often pay for these charges as a normal operating expense. Why the range? Costs vary from city to city, and in some cases may even warrant a much higher percentage rate. One real estate investor I work with, for example, automatically calculates an operating expense of no less than 45% based upon other property’s he owns in his area.
If you plan to work with rental income property, you would be best served to a little homework about typical operating expenses ratios used for residential and commercial real estate in the geographic location where you work.
Once you discover a commonly-used range, use it to test the validity of any numbers you run. It helps to know what is realistic, and might spare you from getting overly excited about nothing later.
