Operating Expense Ratio (OER)

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.

1. Operating Expense Ratio → The OER measures operational efficiency and computes the proportion of a property’s gross operating income (GOI) spent on operating expenses.
2. 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.

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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%