Operating Expenses: What are they and what you should know.

A critical part of the underwriting process is determining your operating expenses for your pro forma. Operating expenses are the day-to-day costs of running a property and are above-the-line items (above NOI).

So, items like depreciationcapital expenditures, and tenant improvement allowances are excluded because they are not costs required to operate the property. These are all listed below NOI.

I am a firm believer that operating expenses should always be expressed using total per unit figures (this is a pet peeve of mine). Example: Insurance is $400 per unit or Payroll is $1,200/unit. Some underwriting models show a % of income but this is simply not an efficient way to compare different properties.

Tips for 3 Critical Operating Expenses:

  1. Payroll – These costs are increasing more than ever right now. Management companies are forced to increase their wages in order to find and keep qualified employees.
  2. Contracts – These can often be overlooked. If the Trailing 12 month financial statement shows the property is paying $400/unit in contract services, be aware you will more than likely be inheriting all of those contracts as the next owner. At least until the contracts expire. Therefore your pro forma number should not be less (unless you verify).
  3. Utilities – I find that utility expenses are always increasing. Be sure to look at the T3, T6, and T12 numbers to identify any unique trends. For my Year 1 pro forma, I like to use a number that is typically 5% – 10% higher than what I am seeing from the T3 or T12.

People often ask me how they should determine their operating expenses. These numbers should be determined using a combination of the historical financial data availablefeedback from your property management company, your business plan, and the property characteristics.

Generally, you can expect per unit numbers like this:

Repairs & Maintenance: $200 – $500 per unit

Administrative: $150 – $350 per unit

Unit Turnover: $200 – $300 per unit

Contract Services: $200 – $500 per unit

Utilities: $800 – $1,200 per unit

Advertising $100 – $300 per unit

Payroll $1,000 – $1,600 per unit (very market specific)

Insurance: (very market specific)

RE Taxes: (very county specific)

Again, these are very general per unit numbers but they should help provide you with guidance. Typically, your stabilized operating expense ratio (Total Operating Expenses / Effective Gross Income) should be between 35% and 50%. So if a property had $1,000,000 in effective gross income, I would expect the operating expenses to be around $450,000 (45% of income).

You can find all of operating expense line items in each of our available underwriting models.