Real Estate Math: Expense Ratio (OER)

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!