SS273: Multifamily Expense Ratio

SS273: Multifamily Expense Ratio

The Multifamily Expense Ratio measures how much of a property’s gross income is spent on operating expenses. In this episode, Charles discusses why calculating the expense ratio is important and how it assists the investor during preliminary underwriting.

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Talking Points:

  • In multifamily real estate, the Operating Expense Ratio, or sometimes just referred to as the Expense Ratio, is an important, easy-to-calculate metric used to measure a property’s efficiency. 
  • It is calculated by taking the property’s Total Operating Expenses ÷ Gross Operating Income. If a property has gross income of $100k per year and operating expenses of $50k per year, the operating expense ratio is 50%.
  • The Total Operating Expenses include property taxes, insurance, utilities, property management fees, repairs, maintenance, and payroll. It does not include mortgage payments, depreciation, or major capital expenditures (CapEx), such as a new roof or a new bathroom.
  • The Gross Operating Income is the total income actually collected, including rent, parking fees, laundry, and pet rent, minus vacancy losses.
  • How I was taught to understand the expense ratio by a mentor years back was to use 50% as a typical expense ratio. If the expense ratio is over 50%, the rents might be below market, or there may be a management issue. If the expense ratio is below 50%, there may be unaccounted expenses or deferred maintenance.
  • Typical Expense Ratios:
    • Class A properties with 35%-45% expense ratio – well-run, efficient, large complexes
    • Class B properties with a 45%-55% expense ratio – well-managed, solid tenant base
    • Class C properties with a 55%-65% expense ratio – older properties, high maintenance requirements, stagnant rent increases with increasing expenses
    • The ratios will vary by market, property age, unit count, and utility setup – so make sure to use local benchmarks. Similar to Cap Rates and property types, find out what is typical for your market, utility setup, and property type, and compare it to that.
  • A Few Common Mistakes When It Comes To Expenses
    • Investment properties are valued based on their net operating income, so it benefits sellers to show a higher NOI to boost their property’s value. Be on the lookout for unrealistic expenses and deferred maintenance during your inspection.
    • Make sure to normalize expenses when performing underwriting, like not planning for post-purchase tax increases or not getting an insurance quote yourself and using the seller’s or broker’s insurance number.
  • Why Does the Expense Ratio Matter?
    • An abnormal ratio might signal the need for more research and review before submitting an offer.
    • A high expense ratio might be a sign that there is considerable deferred maintenance, and systems have been patched instead of replaced.
    • A high expense ratio might signal that higher expenses like taxes, insurance, or payroll are unable to be recovered from tenants through rent increases. 
  • The operating expense ratio isn’t about being as low as possible—it’s about being realistic, sustainable, and appropriate for the asset and market. 
  • If you are interested in learning more about underwriting expenses for apartment buildings, check out episode SS114.

Transcript:

Charles:
The operating expense ratio gives a glimpse into a property’s operations. Two properties can earn the same income, but one may have a much different expense ratio for a number of reasons, and sometimes, a lower expense ratio does not always make it the best deal. Welcome to Strategy Saturday! I’m Charles Carillo, and today we’re discussing the Multifamily Operating Expense Ratio—what it is, how to calculate it, and how to actually use it to spot good deals and avoid bad ones. So let’s get started. In multi-family real estate, the operating expense ratio, or sometimes just refer to as the expense ratio, is an important easy to calculate metric used to measure a property’s efficiency. It’s calculated by taking the property’s total operating expenses divided by the gross operating income. So if a property has a gross income of a hundred thousand dollars per year and operating expenses of $50,000 per year, the operating expense ratio is 50%. The total operating expenses include property taxes, insurance, utilities, property management fees, repairs, maintenance, and payroll. It does not include mortgage payments, depreciation, or major capital expenditures, CapEx, such as a new roof or a new bathroom.

Charles:
The gross operating income is a total income actually collected, including rent, parking fees, laundry and pet rent, minus vacancy losses. How I was taught to understand the expense ratio by a mentor years back was to use 50% as a typical expense ratio. If the expense ratio is over 50%, the rents might be below market, or there may be a management issue. If the expense ratio is below 50%, there may be unaccounted expenses or deferred maintenance. Typical expense ratios, class A properties with 35% to 45%. Expense ratios well run efficient large complexes, class B properties with a 45% to 55% expense ratio. Well managed solid tenant base class C properties with a 55% to 65% expense ratio, older properties, high maintenance requirements, stagnant rent increases with increasing expenses. The ratios will vary by market, property, age, unit count, and utility setup. So make sure to use local benchmarks similar to cap rates and property types.

Charles:
Find out what is typical for your market utility setup and property type, and compare it to that. A few come mistakes. When it comes to expenses, investment properties are valued based on their net operating income, so it benefits sellers to show a higher NAY to boost their properties value. Be on the lookout for unrealistic expenses and deferred maintenance. During your inspection, make sure to normalize expenses when performing underwriting, like not planning for post-purchase tax increases, or not getting an insurance quote yourself, and using the seller’s or broker’s insurance number. Why does the expense ratio matter? An abnormal ratio might signal the need for more research and review before submitting an offer. A high expense ratio might be a sign that there is considerable deferred maintenance and systems have been patched instead of replaced. A high expense ratio might signal that higher expense items like taxes, insurance, or payroll are unable to be recovered from tenants through rent increases. The operating expense ratio isn’t about being as low as possible. It’s about being realistic, sustainable, and appropriate for the asset in the market. If you’re interested in learning more about underwriting expenses for apartment buildings, check out episode SS114. That’s SS114. I hope you enjoyed.

 

Links Mentioned In The Episode:

  • SS114: Most Important Expenses When Underwriting an Apartment Building

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