What is an Operating Expense Ratio in Commercial Real Estate?
An operating expense ratio, or OER, sometimes simply known as an expense ratio, is a metric comparing a property's operating expenses to the amount of income it generates. To determine a property's operating expense ratio, you can use the formula below:
Operating Expenses/Gross Operating Income = Operating Expense Ratio
For example, a building with operating expenses of $40,000 a year that brings in $100,000 of gross income would have a 40% OER.
$40,000/$100,000 = 40% Operating Expense Ratio
If a property has not yet been built, investors and developers can substitute gross operating income for gross potential rent (GPR), adding in any other estimated sources of income, and subtracting the expected rate of vacancy, to determine a realistic operating expense ratio.
In general, expenses such as utilities, waste removal, repairs and maintenance (R&M), management fees, insurance, and property taxes are included in OER. However, loan payments and capital expenditures (CapEx) designed to make a property more valuable or to replace a major system, are not.
How Commercial Real Estate Developers and Investors Use Operating Expense Ratios
In commercial real estate, operating expense ratios are most commonly used to compare similar properties in order to determine if a property is being effectively managed. For example, if an investor was looking to purchase a industrial property with a 55% OER, and most similar industrial properties in the area had a 40% OER, the investor could probably conclude that the property was not being managed effectively.
In addition to comparing different properties, a year-by-year OER comparison can also be used on the same property to determine if expenses are rising too rapidly in a particular area (i.e. utilities). That, in turn, can be used in order to determine an action plan to cut costs (i.e. energy efficient building improvements).
Overall, if a property's expenses are rising faster than its rent, than the OER will continue to rise, making the project increasingly unprofitable. If a property's operating expenses and rent rise at the same rate, the OER will stay the same, while if the property's rental income increases or stays the same, while operating expenses decrease, than the OER will decrease as well.