Real Estate Math: Expense Ratio (OER)

May 28, 2014

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!

 

 

 

 

 

 

 

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