Complete Guide to Tracking and Understanding Operating Expenses for Rental Properties

Operating expenses for a rental property are the costs required to maintain the building and generate rental revenue. Similar to running a business, there are regular expenses that need to be paid to keep the building in good condition. These expenses can be categorized into hard and soft maintenance costs. Here is a basic list of operating expenses:

It's important to note that each of these items can have sub-items. Here is a more detailed breakdown of operating expenses:

What is not included in operating expenses?

The expenses that are not part of the day-to-day operation of the building are not considered operating expenses. This includes renovation, rehabilitation, or capital expenditures (cap-ex), which are not regular expenses and may not be required for a building for a long period of time. For example, a newly constructed rental building may not have any rehab or capital expenditures for 20 years. Expenses that depend on the financial position of the ownership group are also not considered as operating expenses. For example, financing expenses vary from owner to owner and depend on their cash position rather than the building's operation. Therefore, mortgage payments are not considered operating expenses. Non-cash expenses such as depreciation are also not considered operating expenses. Here is a list of expenses that are NOT considered operating expenses:

• Capital Expenditure
• Mortgage Payments
• Income Taxes
• Investor Return and Distributions
• Depreciation
• Vacancy and Bad Debt

Why tracking operating expenses is critical

There are two key reasons why it is crucial to have a good system for tracking operating expenses in rental properties. Firstly, as the saying goes, "if you cannot measure it, you cannot improve it." To run an efficient business, you need to know the detailed cost items, the factors contributing to these costs, and how to manage and lower them. Without a list of operating expenses, building management often overlooks certain costs that may later require expensive capital expenses. Keeping track of operating expenses helps avoid these scenarios and allows for more efficient building management.

Operating expenses are also used to estimate the net operating income (NOI) of a property, which is crucial in determining its fair market value through the cost-method of appraisal. By keeping track of operating expenses, you can present your case better and instill confidence in potential purchasers that the risk is known and managed. A well-run building can command a higher sales price, and this will be evident in your rent roll and detailed operating expenses statement.

Operating expenses as a percentage of revenue

We humans prefer simplicity over complexity. That's why we try to come up with key performance indicators (KPIs) to provide a brief overview of complex analyses. The same applies to managing rental properties. We often seek to understand what constitutes a healthy operating expenses-to-revenue ratio. The answer is: it depends. Factors such as the type and quality of the building, the scale of operation, architectural style, and more play a significant role in determining operating expenses. For instance, a building with good overhang to protect its exterior against the elements will have lower maintenance costs. Commercial-grade flooring is generally less costly to maintain compared to beautiful hardwood floors. Pools can be expensive to maintain, and the ratio of elevators to the number of units affects elevator maintenance costs as a percentage of revenue. The more units a building has, the better the economy of scale, resulting in lower operating expenses relative to revenue. Luxury single-family homes with pools and elevators usually have a higher ratio of operating expenses to revenue compared to a four-story walk-up rental building with 100 units and no pool or elevator. Additionally, older buildings tend to have higher ratios of operating expenses to revenue. Imagine an old apartment building with two elevators that require regular maintenance, unit repainting, carpet replacement, and other ongoing costs, independent of major rehabilitation expenses, which are not considered operating expenses. These costs are definitely higher than those of a brand new building. While a well-maintained, relatively new apartment building may have an operating expense-to-revenue ratio of 25%, the same ratio could increase to 35% for older buildings and 50%+ for luxury single-family properties.

Summary

In summary, operating expenses are essential for valuing and managing rental properties. They represent the regular costs of operating a building. Comparing the operating expenses-to-revenue ratio can help determine how well-managed a rental property is. The more detailed the cost breakdown, the lower the risk for potential purchasers when considering a building purchase.