Operating expense ratio
/What is the Operating Expense Ratio?
The operating expense ratio is used in real estate to measure the proportion of expenses to revenues for an income-producing property. A property is more acceptable to an investor when the operating expense ratio is as low as possible. In this situation, the property is more likely to spin off sufficient cash to make ongoing mortgage payments on the property.
How to Calculate the Operating Expense Ratio
To calculate the operating expense ratio, subtract depreciation from a property’s total operating expenses and then divide by its gross revenue. The calculation is as follows:
(Total operating expenses - Depreciation) ÷ Gross revenue = Operating expense ratio
The measure is commonly used to compare the performance of similar properties. Indicators of problems that can worsen this ratio are higher-than-normal utility charges or maintenance expenses. The ratio tends to worsen over time as a property ages, requiring higher maintenance expenditures. The ratio can also worsen due to poor property management, where a property has a higher-than-normal vacancy rate that keeps the gross revenue figure unusually low.
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Example of the Operating Expense Ratio
A small apartment complex brings in $1,000,000 of gross revenue every year, has operating expenses of $770,000 and depreciation of $70,000. This results in the following operating expenses ratio:
($770,000 Operating expenses - $70,000 Depreciation) ÷ $1,000,000 Gross revenue
= 70% Operating expense ratio
Types of Operating Expenses
Operating expenses include maintenance and repairs, trash removal, property management fees, insurance, utilities, and property taxes. Loan payments and capital improvements are excluded from this figure.
Problems with the Operating Expense Ratio
A potential problem with this measurement is that depreciation could be accelerated or straight-line, resulting in different outcomes depending on the depreciation method used.