Sometimes you’ve gotta call bulls&*%, like when a seller claims their property is such a great deal because it only has a 15% expense ratio. You’ll most likely find this figure on the pro forma income statement, but you can work it out yourself from the basic financial statement.
Defined: Expense Ratio is the percentage of gross scheduled income that goes toward property expenses.
Key 1: When you think Expense Ratio, think cash flow when:
· Analyzing individual current expenses compared to the gross operating income to determine where there is excess to be cut. (i.e. For current property)
· Comparing expenses of similar properties to identify red flags during due diligence. (i.e. New acquisition or 1031 Exchange)
Key 2: When calculating Expense Ratio, first you need the following ingredients in your formula:
· The net operating income of the property:
gross operating income — expenses
· The gross scheduled income of the property:
total monthly rents X # units X 12 months
Key 3: Is the Expense Ratio...?
· OER < 30%: for sub-metered properties
· OER = 30% - 40%: average for MHPs
· OER > 40%: check for inefficiencies
Let's look at an example, work it out, and discuss our findings:
Formula: expense ratio = 1 - (NOI/GSI)
You have found a seemingly great investment property where the owner claims a 15% expense ratio. You’ve received basic financials in the initial stage of due diligence and you know the following (using Year 1 data from the figure below):
Gross Scheduled Rents: $54,000
Other Income: $2,400
Vacancy Rate: 12% or $6,480
Operating Expense: $12,751
Step 1: Calculate the effective gross income
gross scheduled rents + other income - vacancy = eff. gross income
$54,000 + $2,400 - $6,480 = $49,920
Step 2: Calculate the expense ratio
operating expenses/effective gross income = $12,751/$49,920 = 25.54%
Discussion: Despite any emphatic claims, 25.54% of this MHP’s income is being spent on operating expenses, which is still below average but certainly not supportive of the claim of 15% OER. The operating expense ratio can also be calculated on a per-expense basis and used effectively when comparing properties on individual expenses or property-wide expenses. Significant differences in the expense ratio for a single property or across properties can alert you to red flags worth examining closer. The operating expense ratio is also a great way to analytically assess management efficiency and effectiveness. The lower the operating expense ratio, the better the property is performing, and if it seems to good to be true a few keystrokes on the calculator can confirm or rebuke a stellar claim.
Stay tuned next quarter for another Real Estate Math workout!