An understanding of expenses and categorization will help real estate investors analyze potential opportunities.
In previous articles, we have covered the need to understand terms, concepts and fundamentals of cash-flow analysis, as well as how to estimate effective gross income, operating expenses and net operating income.
This third installment in our series focuses your attention on operating expenses, which are those paid by a real estate investor to keep the property generating revenues on a monthly basis. Operating expenses do not include mortgage payments, depreciation or capital improvements.
The table below illustrates some of the typical operating expense categories for a standard residential rental property. These account categories were taken from the default operating expense settings from The Property Ledger™, the cloud-based real estate investment software developed exclusively to assist the average real estate investor in analyzing real estate investment opportunities.
The most common operating expenses as they relate to residential real estate include:
PROPERTY TAXES: Represents the property taxes that you as a property owner will pay on an annual basis related to state, county and municipal government, as well as for school district operations. You may obtain a property’s current property tax bill by going online to the respective county’s treasurer or county assessor’s website and searching for the property’s tax bill by parcel number, owner or address. Remember, when you purchase a property at a price higher than that paid by the previous owner, your property tax payment will increase from what is shown on the current tax bill. Make sure you take this into account when estimating your prospective investment’s property tax payment or you may underestimate this expense. In my mind, it is always better to be conservative and select a higher number when estimating operating expenses.
PROPERTY INSURANCE: Property insurance is necessary to protect both you and your lender from loss in case of fire, flood, earthquake or any other catastrophe that 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 the original owner did, your insurance premiums will likely be higher than those of the current owner. Call your property insurance specialist and provide the details related to your purchase, along with the coverage you desire for the property. The specialist will then be able to give you an exact quote related to this expense category.
REPAIRS AND MAINTENANCE: Repairs represent the items that need to be fixed over the course of a tenant’s use and include such things as leaky sinks, heating and cooling repairs, minor plumbing repairs and electrical or appliance repairs. They basically represent those costs necessary to keep everything running for the tenant’s use of the facility. They do not include replacement of an air-conditioning unit, remodeling of a bathroom, replacement of windows or other additions that increase the useful life of the property.
MANAGEMENT FEES: Management fees represent the fees paid to an outside party to manage and lease your property. Typically, these rates range from 6 percent to 30 percent of the effective gross income generated by the property and are dependent upon the type and location of 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 cost of your time. I can assure you that when the time comes to 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, that the buyer will add one to his or her analysis, thus increasing the operating costs of the property and thus reducing the price the buyer will pay for the property.
UTILITIES: Utilities relate to electricity, natural gas, heating oil, water, sewer and potentially trash pickup. 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 tenants 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 it will provide the year’s actual utility billings for the property in question.
You also will want to look at the seller’s tax returns for the property in question and compare the tax return to what the seller and the real estate broker may be representing in terms of operating costs. If the costs are much higher on the tax return than the selling pro forma, you will want to investigate the difference. When in doubt, use the seller’s tax return figures, as these typically will be more reflective of actual operating costs.