Commercial real estate investors with high levels of deal flow face a unique challenge. They need to have a way to filter through large volumes of financial information quickly to identify the properties with the best chance for delivering a strong return. In doing so, they can concentrate their detailed underwriting efforts on these assets rather than waste time performing due diligence on properties that have little chance for success.
One of the ways that investors (and lenders) do this is by quickly calculating and reviewing the property’s Operating Expense Ratio or “OER” for short.
What is the Operating Expense Ratio?
When evaluating a potential commercial real estate (CRE) purchase, one of the first things that an investor will do is to ask the seller for the property’s prior year operating statement. With it, the Operating Expense ratio can be quickly calculated.
A property’s Operating Expense Ratio is simply a measure of its management efficiency and the formula used to calculate it is:
To understand how the formula works, let’s break down each component. In the numerator, total operating expenses are the categories of operating costs that it takes to run a commercial property. In most cases, this includes things like property taxes, management fees, utilities, insurance, marketing, salaries, and admin. Depreciation is subtracted because it is a non-cash expense that does not represent money actually leaving the owner’s pocket.
In the denominator, Gross Operating Income is calculated as the property’s total income less its vacancy rate. Total income includes rental income plus other sources of income from things like late fees, deposit forfeits, vending machine income, or application fees (for a multifamily property). Vacancy is defined as the income lost due to unoccupied space.
So, total operating expenses, less depreciation, divided by the property’s gross operating income results in the operating expense ratio, which can be a very useful metric when evaluating a property’s operational efficiency.
Why the Operating Expense Ratio is Useful
The Operating Expense ratio is useful for two reasons, it provides insight into how well the property is being run and it provides an easy basis for comparison between multiple properties.
There is no “right” operating expense ratio, but the result of the calculation is a quick way to make a snap judgement about how well the property is being run. In general, the operating expense ratio should be in the neighborhood of 50% so anything that is significantly different can provide helpful information. For example, if the resulting ratio is significantly higher than 50%, it means that there could be some inefficiencies in the property’s operations and there may be room for expense reductions, which can improve Net Operating Income (NOI) and the property’s value.
If the resulting operating expense ratio is significantly below 50%, it may be an indication that there could be an issue with the accuracy of the property’s data and that it needs to be inspected further. For example, if the OER is calculated as 30%, it could be possible, but it could also mean that all expenses aren’t being recorded in the general ledger and that a more thorough inspection should be done. Or, it could mean that the current owner just isn’t investing enough money in the management and upkeep of the property, which is problematic in its own right.
If an investor is trying to choose between similar investment properties, the operating expense ratio is a useful way to compare them to each other. For example, if two properties have similar income levels, but the operating expense ratio is 45% for property A and 57% for property B, there is immediate evidence that a closer look must be taken at each line item on the operating statement to determine why the discrepancy exists. For example, the closer inspection could reveal that property B is paying too much in property management fees or that the vacancy rate is too high for the market. While this is not an immediate plus, it can represent an opportunity for savvy investors. For example, in our case, we see this as an opportunity to purchase the property at a favorable price and to implement cost savings strategies to “normalize” operating expenses. In doing so, we can improve cash flow and “force” the property’s value to appreciate in the process.
Operating Expense Ratio Limitations
The major limitation to using the Operating Expense ratio is that it only reveals information about the property’s operations, not about its current or future market value. As such, it doesn’t provide much information about a property’s return potential beyond the ability to make expense adjustments that influence value. For this reason, the operating expense ratio should not be used alone in evaluating a property. It should be used in conjunction with other useful metrics like the capitalization rate or “Cap Rate.”
Operating Expense Ratio – Example
To illustrate how the operating expense ratio can be useful, an example is helpful. Assume that an investor is considering a real estate investment in the state of Florida and is comparing two different office buildings. As part of their due diligence, they have asked the seller(s) for the the prior year’s operating statements, which are summarized in the table below:
From the table, it can be seen that property B’s gross potential rental income is higher than property A and, after accounting for vacancy and other income, Gross Income is also higher. So, it makes sense that total operating expenses are higher, which they are, but as a percentage of Gross Operating Income, it is significantly higher at 56% vs. 46%. So, it is only logical to take a closer look to see why it is higher. This look reveals that the property management line item is significantly higher for property B at 4.63% of income vs. 2.81% for property A and the insurance line item is also significantly higher at 8.84% for property B and 5.91% for property A.
As a value-add investor, we may look at these two properties and see an opportunity with property B. For example, we like to bring the property management function in house, which would result in significant cost savings and we could use our extensive industry relationships to negotiate a lower insurance premium. Over the long term, the net result of these changes is increased net operating income, improved property values, and strong investment returns. And, we were alerted to this possibility by calculating the operating expense ratio.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. We leverage our decades of expertise and our available liquidity to find world-class, multi-tenanted assets below intrinsic value. In doing so, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
When evaluating potential properties for purchase, we always use the Operating Expense Ratio as a tool for evaluating the deals.
If you are an Accredited Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or info@fnrpusa.com for more information.
