How to Use the Operating Expense Ratio

The operating expense ratio provides a lot of useful insight into a commercial property analysis, but it’s not as widely used as it ought to be. The operating expense ratio is a simple ratio that’s easy to calculate and in this article we’ll take a closer look at how to calculate the operating expense ratio, how to interpret it, and finally we’ll tie it all together with a solid example.

Operating Expense Ratio Definition

First of all, what exactly is the operating expense ratio? The operating expense ratio is simply the total of all expenses needed to operate a property divided by the potential rental income for a property. Here’s the operating expense ratio formula:

operating expense ratio

The operating expense ratio formula measures how much of a property’s potential rental income is consumed by expenses needed to operate the property. When building a multi-year proforma, it can often be helpful to calculate an operating expense ratio for each year in the holding period in order to spot trends in total operating expenses, relative to potential rental income.

Operating Expense Ratio Example

Let’s take an example to illustrate how to calculate the operating expense ratio. Suppose we have potential rental income of $100,000 and total operating expenses of $45,000. Here’s how we’d calculate an operating expense ratio for this property:

operating expense ratio example

Now, let’s further suppose that we have a 5 year proforma that looks like this:

Proforma Operating Expense Ratio
By calculating the operating expense ratio for each year in the holding period, we can quickly spot a trend in the total expenses as they relate to potential rental income.

Operating Expense Ratio Calculation

As you can see from the calculations above, the operating expenses for this property increase faster than our potential rental income does, which causes our operating expense ratio to increase over the holding period. By calculating the operating expense ratio for each year in the holding period, we can quickly spot and quantify this trend at a glance.

The Operating Expense Ratio and Vacancy

Sometimes you might also see the operating expense ratio calculated using effective rental income instead of potential rental income. Effective rental income is just potential rental income less any vacancy and credit losses. Here’s how this variation is calculated:

operating_expense_ratio_eri

Why include vacancy in the operating expense ratio? This can be useful when you want to measure how efficiently a property is being managed. Since managing vacancies is part of operating a property efficiently, including this in the operating expense ratio might make sense. For example, if a property is poorly managed then vacancy will likely be higher than it should be, and therefore including vacancy in the operating expense ratio will give an indication of this.

Conclusion

In this short article we covered the operating expense ratio, which is a helpful calculation used in the analysis of commercial real estate. It gives an indication of how much of a property’s income is consumed by operating expenses. When building a multi-year proforma it can also be helpful to calculate the operating expense ratio for each year in the holding period in order to quickly spot and quantify trends in operating expenses relative to income.