How a Property’s Operating Expense Ratios Might Expose Possible Problems

A close examination of operating expense ratios can alert you to possible problems that exist with the rental property you consider purchasing, and in this article, I want to give you some examples.

Before we get started, however, let me briefly explain what operating expenses are and how operating expense ratios are computed.

Operating expenses are costs incurred by an owner to keep a property in service. These include such expenses as property tax, insurance, utilities, repairs and maintenance, property management, trash and so on. They do not, however, include the debt service which in turn is deducted from the net operating income (i.e., income less expenses) to compute cash flow as some who are new to real estate investing often mistake.

Operating expense ratio is the ratio of individual operating expenses to the gross operating income (GOI), or Operating Expense / Gross Operating Income. A rental property with \$50,000 GOI and property taxes of \$5,000, for example, would compute an expense ratio of 10.0% for property taxes (\$5,000 / 50,000 = 10.0%).

In simple terms, the ratio tells you how big a bite each operating expense partially takes from the gross operating income. If you go a step further and divide the total expenses by the GOI, you can determine what portion of gross operating income is eaten up as a whole by operating expenses.

In our case, we’ll presume that you’re examining an annual property operating data (APOD) with the expense data for a subject rental property, and compiled some data on other similar rental properties in the area and formulated some norms. In other words, that you have enough information to have reasonable expectations of what specific operating expense ratios should be for your property of interest.

1) Property Taxes

When the property tax ratios are significantly different, it might be a clue that the subject property’s data or the county tax assessor’s data is faulty. Ask for the tax statements and maybe meet with the tax assessor so you are reasonably assured that nothing hidden or misconstrued might come back later and bite you.

2) Insurance Costs

A higher than norm insurance cost ratio could spell trouble, and should prompt you (if the difference is significant) to have someone from your insurance company do a field inspection and advise you whether there are violations or other issues with the property that might affect insurability.

3) Electricity

Dissimilarities in electricity ratios could indicate that one property is separately metered and the other is not, or simply a difference in lighting of common areas. In the former case, if the subject property were not separately metered, would a new owner be compelled by local codes or ordinances to install them? If electricity is non-existent in the subject property’s operating expenses, you would want to know why.

4) Heating

A higher heating ratio than you would expect might indicate a faulty heating system or some other issue. Is it possible for you to affordably correct the deficiencies and cut costs? In any case, always verify heating and other utility costs by contacting the utility providers directly, and always conduct a careful inspection of the property.

5) Repairs and Maintenance

Several occurrences could explain why repairs and maintenance ratios differ between properties, and you should make it your business to investigate. A higher-than-norm ratio could spell a troubled property or simply indicate some recent remodeling or updating. Likewise, a lower-than-norm ratio might mean the owner neglected caring for the property, perhaps shaved costs by doing the work himself, or maybe the property simply didn’t require much maintenance this year. Whatever the reason, as you approach repairs and maintenance costs, remember to ask yourself, “What will I pay when I own this property?”

We can continue, of course, but you get the idea. When you spot notable disparity in the operating expense ratios between the property you want to buy and what is reasonably expected they are cause to ask plenty of questions.

Finally, reconstruct the APOD using income and expense projections you feel reasonably confident in and then reexamine the results to see whether the subject rental property makes sense as an investment.