Operating expense ratio
Also called OER, Expense ratio.
The operating expense ratio is total operating expenses divided by effective gross income. It is a fast sanity check on whether an expense budget is plausible for the asset type, the market and the way the property is run.
How it works
It earns its place because it is hard to fake and easy to compare. Expense budgets can be wrong line by line in ways that are laborious to catch, but a garden-style apartment property underwritten at a 28 percent expense ratio is visibly wrong in one calculation, whether or not you can immediately say which line caused it.
The ranges are conventions, not rules, and they shift with the lease structure more than with anything else. Multifamily typically runs 35 to 45 percent because the landlord carries most costs. Net-leased industrial and retail can run below 20 percent because the tenant pays the recoverable expenses directly. A gross-leased office building sits in between and depends heavily on the base year structure. Comparing across those categories tells you nothing.
The ratio is also sensitive to the denominator in a way that trips people up. Because EGI falls when vacancy rises while most expenses do not, a property that loses occupancy shows a rising expense ratio without a single expense having changed. During a lease-up the ratio can be meaningless.
Formula
Operating expense ratio = operating expenses / effective gross income- Use EGI, not gross potential rent, or vacancy will distort the comparison
- State whether replacement reserves are included, because it moves the answer by one to two points
- For net-leased property, decide whether recoverable expenses and their reimbursements are both included, and be consistent
Worked example
The 220-unit sample property, year one.
| Effective gross income | $4,727,800 |
|---|---|
| Operating expenses | $1,708,000 |
| Expenses per unit per year | $7,764 |
| Expenses per unit including reserves | $8,014 |
| Operating expense ratio | 36.1% |
Inside the usual multifamily band and consistent with the per-unit figure, which is the second check worth running. When the ratio and the per-unit number disagree about whether a budget is reasonable, the revenue assumption is usually what is wrong.
The common mistake
Using the ratio as a target rather than a test
Solving an expense budget backwards from a 35 percent ratio produces a model that looks right and is not attached to anything. The ratio is a diagnostic: build the budget line by line from the trailing statement with taxes, insurance and management normalised, then compute the ratio and ask whether it is plausible. If it is off, the answer is in a specific line, and finding that line is the work.
Related terms
- Net operating incomeNet operating income is a property's effective gross income less all operating expenses, before debt service, income taxes, depreciation and capital expenditure. It is the figure a cap rate is applied to, the numerator of debt yield and DSCR, and the number a purchase price is ultimately negotiated against.
- Effective gross incomeEffective gross income is all the revenue a property is expected to collect in a year: gross potential rent, less vacancy, loss to lease, concessions and bad debt, plus other income. It is the revenue figure operating expenses are subtracted from to reach net operating income.
- T-12A T-12 is a trailing twelve month operating statement: every income and expense line a property actually produced over the last twelve months, normally shown as twelve monthly columns with an annual total. It reports what happened, as opposed to what a seller projects.
- Replacement reservesReplacement reserves are an annual allowance set aside for the periodic replacement of building components that wear out: roofs, HVAC, appliances, parking surfaces, elevators. They smooth lumpy capital spending into a level annual charge.
- Triple net and expense recoveriesUnder a triple net lease the tenant pays base rent plus its share of the property's taxes, insurance and common area maintenance. Expense recoveries are the mechanism that bills those costs back, normally as a pro rata share based on the tenant's proportion of the building's leasable area.
- Other incomeOther income is every dollar a property collects that is not rent for the space itself: utility reimbursements, parking, storage, pet rent, application and administrative fees, late fees, laundry, and amenity or trash charges. It is added to rent revenue on the way to effective gross income.
Every figure, traced to its source
Altyst computes these in exact decimal arithmetic, not with a language model, and clicking any number shows the formula behind it.