GUEST POST: Carter Froelich, CPA www.thepropertyledger.com
Operating expenses are the expenses which are paid by a real estate investor which keep the property generating revenues on a monthly basis. Operating expenses do not include mortgage payments, depreciation and/or capital improvements. The table below illustrates some of the typical operating expense categories for a standard residential rental property. These categories were taken from the standard default operating expense analysis from The Property Ledger™, to the extent that a specific operating expense category or property expense is not shown below, The Property Ledger™ may be customized by the user to add such categories and/or expenses.
The most common operating expenses as they related to residential real estate analysis include:
Property taxes – Represents the property taxes which you as a property owner will pay on an annual basis related to the operation of state, county, municipal government as well as school district operations. You may obtain a property’s current property tax bill by going on line to the respective county’s treasurer or county assessor’s website and searching for the property’s tax bill by parcel number, owner and/or address. Remember, when you are purchasing a property at a price other than that which the originally owner paid and/or the current assessed valuation of the property, your property tax payment will vary from that which is shown on the current tax bill based upon your purchase price. Make sure you take this into account when estimating your prospective investment’s property tax payment or you may under estimate this expense. In my mind it is always better to be conservative (meaning selecting a higher number) when estimating operating expenses.
Also See: Analyzing a Single Family Home
Property Insurance – Property insurance is necessary to protect both you and your lender from loss in the case of a fire, flood, earthquake or other catastrophe which may damage or destroy your investment property. It also includes liability insurance to protect you in the case that a tenant or tenant’s guest is injured while on your property. As is the case with property taxes, if you are paying more for a property than that of the original owner, your insurance premiums will likely be higher than that of the current owner. The best way to zero in on this expense is to call your property insurance specialist and give them the details related to your purchase along with the coverage you desire for the property. They will then be able to give you an exact quote related to this expense category.
Also See: Analyzing a Multi Family Property
Repairs and Maintenance – Repairs represent the items which need to be fixed over the course of a tenant’s use and include such things as leaky faucets, heating and cooling repairs, minor plumbing repairs, electrical and/or appliance repairs. Repairs and maintenance represents those costs necessary to keep every running for the tenants use of the facility. They do not include replacement of an air conditioning unit, remodeling of a bathroom, replacement of windows or other improvements which increase the useful life of the property. These types of improvements are capital improvements and must be depreciated over their useful life as outlined in the federal tax code.
Also See: Replacing Proforma Estimates with Actual Operating Results
Management Fees – Management fees represent the fees paid to an outside party to manage and lease your property. Typically, these rates range from 5% to 10% of the effective gross income generated by the property. Even if you manage the property yourself you should factor in a management fee as your time is valuable and you should recognize the economics of your time. I can assure you that when you sell your property, should you present your property’s profit and loss (“P&L”) statement to a prospective buyer and a management fee is not shown on your P&L, the buyer will add one to his or her analysis thus increasing the operating costs of the property and reducing the price which they can pay for the property.
Utilities – Utilities relate to electricity, natural gas, heating oil, water, sewer, and potentially trash pick-up. Depending upon the type of property you are analyzing, the tenant may pay a majority of these costs. I know that for all my single family residential units the tenants pay all of the aforementioned utility costs. In order to get a good indication of what the tenant’s typically pay in relation to a potential acquisition, look at their individual leases. Typically, the tenant’s responsibilities related to utilities will be spelled out in the lease. Additionally, in most states you can call the respective utility company and they will provide with the actual utility billings for the property in question for the last year.
Additionally, you will want to look at the seller’s tax returns related to the property in question and compare their tax return to what the seller and the real estate broker are representing in terms of operating costs. Obviously if their costs are much higher on their tax return than their selling proforma you will want to investigate the difference. When in doubt use the higher figures as these typically will be more reflective of actual operating costs.
In our next issue we will discuss how a property’s net operating income is calculated.
Video Tutorials on Real Estate and Financial Analysis
Why Financial Literacy is Important
How To Estimate Effective Gross Income
How To Estimate Operating Expenses
Estimating Net Operating Income
The Difference Between Taxable Income and Cash Flow
Carter Froelich, CPA is the founder of The Property Ledger™ a web basedreal estate investment software. To get a free 30 day trial of The Property Ledger™ see our web site.
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