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
The operating expense ratio has several limitations and potential issues, including the following:
Exclusion of debt service. The ratio does not account for mortgage payments or financing costs, which are critical for investors evaluating overall profitability.
Ignores capital expenditures. Major repairs, renovations, and capital improvements are not included in the ratio, potentially underestimating long-term costs.
Market variability. Different property types (e.g., multifamily vs. office buildings) and locations can have naturally varying expense ratios, making direct comparisons misleading.
Potential for manipulation. Owners may defer maintenance or misclassify expenses to make the ratio appear lower, obscuring the true financial health of the property.
Does not account for vacancy rates. A property with high vacancies may still show a favorable ratio, despite lower overall cash flow and profitability.
Due to these issues, the operating expense ratio should be used alongside other financial metrics like Net Operating Income, Cash-on-Cash Return, and Cap Rate to get a complete picture of a property's financial health.