BATTLECALL GUEST EXPERT: Robert J. Abalos, Esq., InvestingInLand.com

Operating expense ratio analysis is the key to positive cash flow rental property management. It is more than the mathematical relationship between the operating expenses of a rental property or real estate investment and the total or gross operating income of that same property. It is one of the most crucial of all real estate measurements because it determines not only the profitability and efficiency of a real estate operation but likely whether the property brings in cash for an investor every month or instead bleeds them white with negative cash flow losses.

Unfortunately, it is also one of the most overlooked types of analysis by investors who even when they take the time to calculate the ratio often get it wrong. Calculating operating expense ratios ("OERs") the right way is a focus I emphasize because it is a powerful technique to make sure your rental property is performing at peak and optimal cash flow efficiency.

What Is Operating Expense Ratio Analysis?

To put it simply, the OER of any rental property or real estate investment is the ratio between the total operating expenses of the property against its total gross operating income or GOI.

Simple, isn't it? Not so fast. Here's where most investors make their first mistake.

GOI is not the total amount of income a property should collect but what the property actually does collect.

Put another way, gross operating income is from an accounting perspective total gross income minus vacancy and miscellaneous credit losses and allowances.

Gross operating income tells you how much money a rental property is actually making, not how much in could make or should make.

So, the first step in calculating the OER of a rental is to accurately calculate the GOI by factoring in a vacancy allowance and tallying up any other credit losses that need to be subtracted.

Then, calculating OER is simple.

OER=Total Operating Expenses Divided By GOI

So let's assume that a rental property has a Total Gross Income of $100,000 and we use a 5% vacancy and credit allowance. The total operating expenses of this property are $27,000.

The analysis is $27,000 divided by $100,000 minus $5,000 (5% of Total Gross Income) or $95,000 which is .2842 or 28.42%

For the record, what are legitimate operating expenses? Everything you would expect to run a rental property such as:

• Insurance premiums
• Property taxes
• Utility Bills
• Repair Costs
• Cleaning Supplies
• Advertising Costs
• Legal and Accounting Costs
• Employee Wages
• Maintenance Expenses and many more

But notice mortgage interest is NOT an operating expense. This is another common mistake of novice investors.

Using the Operating Expense Ratio to Make Real Money

Calculating the OER tells you a great deal about a rental property. It shows you how much of the money coming in versus how much is going out just to maintain the current cash flow. Older properties as you imagine have higher OERs generally because they need more repairs and maintenance and are less fuel and energy efficient. The OER will tell how how inefficient they are compared to newer properties.

But to really use the OER properly, an investor needs to break the OER into its component parts to see where the OER inefficiencies really are.

By improving operating inefficiencies in a rental property of any kind, the new owner can instantly reap incredible gains in equity and cash flow, far more than any physical rehab could ever offer.

So let's take the above rental property mentioned above and assume there are just three operating expenses. (In real life, there would be many many more.)

The total was $27,000. Here is the breakdown.

• Property taxes is $15,000
• Repairs is $8,000
• Utilities is $4,000

The trick most investors fail to do is calculate the individual OERs for each operating item by dividing them against GOI. This way, you can learn which components are too high and too low relative to the total OER.

Here the calculations are:

• Property taxes: $15,000/$95,000 (the GOI) or .1578 or 15.78%
• Repairs: 8.42%
• Utilities: 4.21%

Calculating each individual ratio lets the numbers that are too high or too low stand out. Most rental properties of a single class (residential, commercial, industrial, etc.) fall into fairly predictable expense formulas starting with total expenses at about 40% or so of GOI and each component item can easily be compared against other properties in an area. In other words, if nearly all apartment buildings in your area have a component utility cost OER of 5%, when you see one with 10% you can get very happy. This means with some effort, hopefully easy cheap and quick effort, if you can get that property back in line with all the others at 5%, you have just earned 5% of your operating income back each and every year. Even better, with a cap rate of ten on this property, you just earned ten dollars for every one you saved in new equity. That's the power of this technique.

Some Advice For Investors On Operating Expense Ratios

There are lots of computer and spreadsheet options for doing the above but on simple properties, even small apartment buildings, it really is best to run the numbers by hand using a pocket calculator. This is what I do and it brings me closer to the analysis than just filling in boxes on a spreadsheet.

You want to get a handle on where the operating income is really going on a property. Sometimes the overall OER is perfectly normal but the component ratios that add up to the total are quite bizarre and instantly point to either a problem property (a high repair and maintenance ratio, for example) or a windfall opportunity (high utility, heating, legal, advertising, or other very soft costs). The only way you can learn the truth about the OER is by breaking down the numbers one ratio at a time. Gross OER numbers are helpful but can also really hide the truth about a property.

Comparing OERs not just against the current year but prior years is also important. Here you will be able to see certain OERs rising and others falling. If repair OERs are constantly rising, there is trouble. Property tax OERs nearly always rise at a slow but upward rate but can be trimmed with careful tax planning or by challenging assessments that are out of line. Most OERs should be fairly consistent, the same with minor variations year-to-year. Excessive variations outside any normal mean should be a red flag for an investor and require much more additional information from the property owner on the discrepancies.

Yes, calculating numbers can be boring. Sure, I'd rather be out on my boat than sitting in my office figuring the ratio of GOI versus heating oil costs. But this is the core of real estate, calculating the numbers and operating expense ratio is one of the most important. This is basic high school addition, subtraction, and division. No calculus or fancy math required. Investor who put up money and take out loans without running these numbers are being reckless and just plain lazy.

Because knowing how to calculate and use OERs can not only keep the negative cash flow alligator away from your door but make you a great deal of instant equity on cap rate boosts in property valuations.

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