What percentage of the gross rental income should a property owner expect to allocate toward expenses each year? The answer to this question is important, and allows you to quickly forecast whether or not a property will produce positive cash flow.
But first, some definitions:
Operating Expense Ratio is defined as the ratio between total operating expenses for a particular property and the gross effective income received for that property.
Total Operating Expenses
———————————- = Operating Expense Ratio (OER)
Gross Effective Income
The following is a non-exhaustive list of operating expenses:
- Property Taxes
- Leasing Commissions
- Property Management Fees
Notice that capital expenditures and mortgage payments are not included as operating expenses.
Capital expenditures, broadly defined for single-family investment properties, include any major additions/replacements to a property that are expected to extend its life or change its value. Examples would include a roof replacement, or a complete kitchen remodel.
Let’s say that a property rents for $1000 / mo and is rented 11 months out of the year. The Gross Effective Income received would be $11,000. After tallying up all of the operating expenses incurred during the year, it is determined that the Total Operating Expenses were $5,500. Thus the Operating Expense Ratio would be:
———— = 50%
We can use this ratio to determine if a property is expected to produce positive cash flow.
After subtracting the $5500 in expenses from the $11,000 in gross income, the remaining $5500 is called Net Operating Income (NOI).
The NOI is what you have left to pay your mortgage payments (principal and interest) and any necessary capital expenditures. If your mortgage payments and capital expenditures are less than NOI, you will have positive cash flow.
Forecasting Operating Expense Ratios for single-family investment properties can be a real challenge. Single family properties vary widely, so an accurate prediction can be elusive. However, we can get a rough idea by borrowing statistics from our bigger-real-estate-investing-brother, the multi-family apartment industry.
Data from the Institute of Real Estate Management (IREM) and National Apartment Association show that nationwide, Operating Expense Ratios for apartment complexes are roughly 45-50%. The smaller (less units) in a property, the higher that ratio tends to be.
What does all this mean to you, the single-family / duplex investor? Well, we expect this information would be surprising to many investors, even experienced ones.
The truth of the matter is that come tax time, when all expenses are entered on the tax return, an appreciable number of single-family investors will find that they had a net outflow of cash to support the investment.
If a property has negative cash flow, does that make it a bad investment? It depends on that investor’s needs. It certainly shows the investor that he or she will need to supplement the investment with other sources of cash.
However, cash flow is only one measure of performance. Investors should also look at other performance measures like capitalization rate and internal rate of return to get the whole picture. It is possible (perhaps even common) for an investment property that has a mortgage to have negative cash flow yet still produce a positive internal rate of return on invested capital. For more information on calculating these other important measures of performance, take a look at this blog post.
I hope this article has given you some useful information on an often-misunderstood (and underestimated) measure of investment performance. If you would like more information on professional property management services, give us a call today at 918-665-0212.