Operating Expense Ratio

Definition of "Operating expense ratio"

Written by

Saba Chaudhry

JPAR Plano

If you are a real estate investor and you come across this term, you might wind up wondering … What is the operating expense ratio? The operating expense ratio (OER) is a way for investors to measure the cost of operating a property when compared to the profit gained by that property. The calculation is done by taking the operating expense of the property (without depreciation) and dividing it by the property’s gross operating income.

Real estate investors also use this type of measurement to determine which property is more profitable by comparing similar properties. Things to pay attention to when purchasing such a property are the factors that can influence the OER like maintenance expenses, operating costs, or operating income. An ideal OER would be somewhere between 60% to 80%, the lower the OER is, the bigger the profit would be.

How to calculate the Operating Expense Ratio?

The first thing an investor has to do to be able to determine the OER of a property is to know the operating expense of that property. The operating expense is a measure that includes all the costs of operating the property like repairments, fees for workers, taxes, etc. The property’s depreciation expense can be added if the property is held for a longer period of time.

The operating expense ratio can tell an investor how the property is doing over the years by keeping records of the operating expenses. If the operating expenses increase after the first couple of years, the OER also increases and the property is no longer as profitable as it was in the beginning. This tells the investor that the property is only profitable for short periods of time.

The formula for OER is:

Operating expense ratio = Total Operating Expenses - depreciation / Gross operating income

Why use the Operating Expense Ratio (OER)?

When calculating the OER, a residential real estate investor should take into account the vacancy rate of residential development. Leaving the vacancies out of the calculation for revenue will paint an inaccurate picture of the investment as vacancies also operate expenses. So rather than including an average revenue for a property with 20 units out of which 16 are occupied, sum up the income generated from each unit that is rented and keep tabs of the ones that are vacated. A poorly managed residential development is likely to have more vacancies that are reflected in the OER.

The calculation for operating expenses ratio should not only cover property management fees, repairs, property taxes, trash removal, and maintenance but attorney fees, landlord’s insurance, property insurance as well as landscaping. These are all necessary costs to ensure that a property is well managed on a daily basis.

Maintaining a lower OER is an efficient way of managing a property. But efficient does not mean careless. In order to keep a property profitable, there are investments that need to be made but done efficiently, the property’s income is covering less of the operating expenses. An OER is a tool that shows investors what needs to be done, what needs to be improved, and what can be changed so that the property is more profitable.