What is Operating Expense Ratio?
The Operating Expense Ratio (OER) measures the proportion of a real estate investment property’s gross income allocated toward operating expenses.
Table of Contents
- What is Operating Expense Ratio?
- How to Calculate Operating Expense Ratio (OER)
- Operating Expense Ratio Formula (OER)
- What is a Good Operating Expense Ratio?
- Operating Expense Ratio vs. Cap Rate: What is the Difference?
- Operating Expense Ratio Calculator — Excel Template
- Operating Expense Ratio Calculation Example (OER)
How to Calculate Operating Expense Ratio (OER)
The operating expense ratio (OER) is determined by dividing a real estate property’s operating expenses by its gross operating income (GOI).
- Low Operating Expense Ratio → A lower OER indicates that management is running the property efficiently (and vice versa for a higher OER ratio).
- High Operating Expense Ratio → If a property’s OER is higher, its ongoing operating expenses reduce a substantial percentage of its income. In effect, the margins on the property investment decline, which causes the returns to the real estate investor to decrease — all else being equal.
The operating expense ratio (OER) can be calculated using the following four-step process.
- Determine the Operating Expenses → The operating expenses of a property include maintenance, repairs, property management fees, utilities, insurance, property taxes, and other costs incurred while running the property.
- Calculate Gross Operating Income (GOI) → The gross operating income (GOI) is a property's total income before expenses. GOI is usually composed primarily of rent payments collected from tenants. Still, any other sources of income must also be included, e.g. application fees, amenities fees, laundry fees, parking permits, or other on-premise services.
- Divide the Operating Expenses by the Gross Operating Income (GOI) → The output is the operating expense ratio (OER). However, the resulting figure will be in decimal format.
- Convert into Percentage → By multiplying the prior step by 100, the OER is converted into a percentage.
Real Estate Interview Guide | File Download Form
You’re logged in! Form submission not required. Access your file below.
Operating Expense Ratio Formula (OER)
The operating expense ratio (OER) formula is as follows.
Operating Expense Ratio (OER) = Total Operating Expenses ÷ Gross Operating Income (GOI)
Since the OER formula compares an investment property’s operating expenses to its gross operating income (GOI), the ratio shows the percentage of a property’s gross operating income that can “cover” its operating expense burden.
Continue Reading Below
The Wharton Online and Wall Street Prep Real Estate Investing & Analysis Certificate Program
Level up your real estate investing career. Enrollment is open for the upcoming Wharton Certificate Program cohort.
What is a Good Operating Expense Ratio?
Conceptually, the operating expense ratio (OER) illustrates the percentage of a property’s gross income to pay off operating expenses.
Therefore, a lower operating expense ratio (OER) is preferred because it implies that a greater percentage of the property’s gross income remains as profit after deducting operating expenses.
Since the operating expense ratio (OER) focuses on the property's operational efficiency, neither financing costs such as mortgage payments and interest nor capital expenditures (Capex) are included in the calculation.
One caveat to a low OER is that the ratio can be reduced by limited reinvestment activity, even for required maintenance Capex, which could potentially cause other issues.
Operating Expense Ratio vs. Cap Rate: What is the Difference?
The operating expense ratio (OER) and the capitalization rate, or “cap rate,” are two real estate metrics that serve distinct purposes and offer different perspectives on a potential property investment.
- Operating Expense Ratio → The OER measures operational efficiency and computes the proportion of a property’s gross operating income (GOI) spent on operating expenses.
- Cap Rate → In contrast, the cap rate measures a property’s potential return on investment. To calculate the cap rate, the property’s net operating income (NOI) is divided by the property’s current market value, resulting in the implied yield.
Therefore, the use case of OER is to grasp the cost efficiency of a property’s operations, while the cap rate estimates a property investment's potential return.
Operating Expense Ratio Calculator — Excel Template
We’ll now move to a modeling exercise, which you can access by filling out the form below.
Excel Template | File Download Form
You’re logged in! Form submission not required. Access your file below.
Operating Expense Ratio Calculation Example (OER)
Suppose a real estate investment firm acquired a residential building with 100 units and a market-rate rent of $4k per month.
- Total Number of Units = 100 Units
- Monthly Rent = $4,000
The product of the total number of units and the monthly rent is $400k, which is the building's total monthly rental income.
- Total Rental Income – Monthly = 100 × $4,000 = $400,000
Since we're calculating the operating expense ratio (OER) on an annual basis, we'll convert the monthly rental income into an annualized figure by multiplying by 12, i.e. each lease is a twelve-month arrangement.
- Total Rental Income – Annual = $400,000 ×12 = $4.8 million
Furthermore, we'll assume the other income earned on the side by the property amounts to $200k, which we'll add to our total income.
The potential gross income (PGI) comes to $5 million upon computing the sum.
- Potential Gross Income (PGI) = $4.8 million + $200k = $5 million
However, the potential gross income (PGI) metric assumes no vacancy losses or credit losses (i.e. collection issues), which is an inevitable part of property management, regardless of the methods used to mitigate risk.
For the vacancy and credit losses, we will attach an 8.0% assumption (of PGI) to estimate the projected losses.
- Vacancy and Credit Losses = 8.0% × $5 million = ($400k)
The gross operating income (GOI) is $4.6 million, which we determined by adjusting the potential gross income (PGI) by the vacancy and credit losses.
- Gross Operating Income (GOI) = $5 million – $400k = $4.6 million
Our model is now missing only one assumption—the total operating expenses—which we'll assume to be $1.85 million.
- Total Operating Expenses = $1.85 million
In conclusion, we'll divide the residential building's total operating expenses by gross operating income (GOI) to arrive at a 40.2% operating expense ratio.
- Operating Expense Ratio (OER) = 1.85 million ÷ $4.6 million = 40.2%
No comments yet.