The operating expenses of a rental income property are an integral part of any real estate analysis because they affect a rental property’s net operating income and therein its cash flow, rates of return, and profitability.
Surprisingly, however, many novice real estate investors and others just starting to engage in real estate investing often misunderstand which items constitute rental property operating expenses and which do not.
So in this article we’ll show what rental property operating expenses you should include as legitimate claims against net operating income and those that must be excluded.
These are those expenses necessary to maintain and keep an investment in service. In other words, it includes the costs necessary to keep the revenue stream flowing and therefore must be accurately accounted for.
For example, this is a list of specific operating expenses used in an APOD created by our real estate investing software during a recent real estate analysis. Naturally, each was an annual cost that got deducted from the gross operating income to compute the rental property’s net operating income.
- Real Estate Taxes
- Property Management
Other costs might include licenses, permits, subscriptions, administration, legal fees, pest control, snow removal, etc (shown as Miscellaneous above). In other words, all costs associated with keeping the rental property in service, occupied, and the rental income flowing.
Understanding which rental property expenses to exclude is perhaps one of the more common mistakes novice investors and brokers tend to make in their real estate analysis. So here’s a list of some that are routinely attributable to the operation of rental property that shouldn’t be included.
- Debt Service (mortgage payments)
- Capital Improvements – According to the IRS, improvements intended to lengthen the life of the property, make it more useful, or increase the value of the property must be capitalized and then depreciated. Therefore they would not fall under the definition of an operating expense.
- Reserves for Replacements – These are annual allowances commonly set aside by real estate investors in anticipation of future costs that might occur during his or her ownership of the rental property. From a planning standpoint it is a smart allocation of cash flow by investors to do this, but under the federal tax code funds in anticipation of future expenses cannot be deducted until they are incurred and paid.
- State and Federal Income Taxes – Taxes owed by the investor on the income she or he receives from the real estate investment are deducted from net operating income to ultimately arrive at cash flow after tax (CFAT), but they cannot be considered as a cost to keep the rental property in service.
Rule of Thumb
Bear in mind the adage “garbage in garbage out”. Always be sure that the expenses you include in your real estate analysis for the rental property are realistic and valid. You want to avoid “pie in the sky” numbers to prevent making a real estate investment decision based upon skewed data.