One day I was called by real estate agent who had just listed a multi-unit apartment complex and told that it had a 7.2% capitalization rate.
In my market, that was a very favorable cap rate for rental income property at that time, so I requested an APOD and called my real estate investor for a heads up.
Upon receipt of the APOD, however, a close examination revealed that the operating expenses ratio computed by the agent was just 13%. Of course, this expense ratio is way too low for typical rental income property, and therefore explains why the agent’s listing indicated such a favorable cap rate.
It was clearly a rookie error. But it could have been avoided if the agent had a general understanding about operating expenses ratio and what they typically are relative to the number of units in the property.
So in this article I want to share a simple rule of thumb about annual operating expense ratios that might help 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.
Operating Expenses Ratio
Operating expense ratio is the ratio of individual operating expenses or (as we refer to in this article) of total operating expenses to the gross operating income (revenue after vacancy and credit loss).
For example, if the total expenses are $35,000 and the gross operating income is $70,000, then the ratio would be 50% (total expenses / gross operating income).
Of course rental property 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.
The following is merely a rule of thumb. But it should give you an idea about the ratio you might expect to see the next time you create your real estate analysis.
Rule of thumb
- 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 typically 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. So this ratio between expenses and rental income will vary.
Why the range?
The costs to operate income property vary from city to city. Real estate taxes, insurance, and utilities, for example, are established by the local market and each can impact a property’s expense ratio upward or downward compared to similar rental properties in other market areas.
Bottom line
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 a faulty number later.
So You Know
All ProAPOD real estate investment software solutions automatically compute a operating expenses ratio as you enter your rental property’s financial data.
