For many years the 50% rule has been used to predict rental property operating expenses. This rule-fo-thumb has always been a guess, but now there is empirical research that shows exactly what this number is.
Research shows that the operating expenses of a single-family rental are 42% of the gross annual rental income. Therefore a property producing a rental income of $24,000 per year should have operating expenses averaging $10,080 per year. This excludes any mortgage payments and capital expenses.
This article will detail how these operating expenses are defined and how the average operating expense ratio is calculated. I’ll refer to academic papers and my own experience to determine the most accurate operating expense forecast. I’ll also share some data from my portfolio.
Why does the Operating Expense Ratio matter?
Positive cash flow is an essential aspect of owning a rental property. Sure, you may get some appreciation, and the tax deductions are a great perk, but without positive cash flow, staying in the game long enough to realize other benefits is challenging. Cash flow is what enables you to meet current and unforeseen financial obligations. The higher your cash flow, the easier it is to adjust to other challenges you face.
As a landlord, your primary threat to positive cash flow is your operating expenses. Many of these expenses occur over and over throughout the life of your investment. It would be best if you learned to estimate the operating expense you will encounter accurately. This article intends to present an accurate way to determine your long-term operating expenses and, therefore, your cash flow. The article will explain operating expenses and offer an easy formula for quickly estimating these expenses as a percentage of the market rent.
What are Operating Expenses?
Operating Expenses (OPEX) are the expenses that a business incurs through its regular operation. Single-family rentals include expenditures such as property taxes, insurance, management costs, and routine maintenance1https://www.investopedia.com/terms/o/operating_expense.asp. Operating expenses contrast with Capital Expenses 2https://www.investopedia.com/ask/answers/112814/whats-difference-between-capital-expenditures-capex-and-operational-expenditures-opex.asp#:~:text=Capital%20expenditures%20are%20a%20company’s,%2C%20utilities%2C%20and%20property%20taxes., which are major long-term expenses such as a replacing a roof. As a generalized rule, operating expenses are tax deductible, while capital expenditures depreciate over several years (this is not accounting advice).
Below are some examples of expenses you are likely to incur. It’s not an all-inclusive list; some costs may vary based on the legal environment in a different area. The overarching goal of this article is to determine a simple and quick formula to estimate these expenses. After you have experience in this field, you can tweak the estimate to account for local variations.
A Property tax is an annual tax levied on the property’s value. It’s simple to calculate as most municipalities publish the rules and values yearly. You should be able to forecast this value accurately, but it’s included in our formula as a convenience.
Insurance will provide financial protection for your real estate assets and personal and business protection if someone is injured on your property. Many insurance agencies will give you a price quote, so this expense is straightforward to forecast.
Maintenance costs are the unpredictable expenses required to keep your property in good condition. This will repair broken windows, missing shingles, plumbing problems, electrical issues, and most problems that tenants report. In addition, this includes the cost of refreshing the property between tenants.
The management cost is the cost you pay for someone else to manage your rental property. This is often a combination of a flat fee and a percentage of the rent. As a general rule, I recommend you manage the properties yourself until you have a lot of experience and more than 15 properties.
What are Not Operating Expenses?
When owning rental property, you will have significant cash outflow that is not classified as an operating expense. Many of these expenditures have the devasting effect of reducing your bank account balance while not being tax deductible. Others may be tax deductible but are still not classified as operating expenses. After including the actual operating cost, you need to adjust for these other items before estimating your cash flow.
That’s right. A monthly loan payment is not considered an operating expense. Generally, the interest portion of a loan is an operating expense for tax purposes. However, this article does not consider mortgage interest as an operating expense. The principal amount of your loan payment will never be an operating expense. Just think of it as trading cash for equity. For every dollar you pay in principle, you receive a dollar in equity.
If you intend to have a mortgage on your property, the debt service will be a significant cash outlay. It may be the largest cash outflow that you have each year. Be sure to adjust the cash flow estimate to include this payment.
Capital Expenses can be thought of as home improvements. This includes things like replacing the roof or the HVAC system. Generally, from a tax perspective, these large items are capitalized and depreciated over several years. These are not operating expenses, but when they are needed, they will be costly. If large items are near their end of life when purchasing the property, but sure to factor in this high cost. In some cases, I go ahead and do the replacement immediately.
Advertising and Marketing your vacant property is not considered an operating expense for the basis of this article. Many landlords only put out a sign to attract tenants, while others run a considerable advertising campaign. This expense varies based on your approach and is not a cost associated with operating the property. If you plan extensive marketing, remember to adjust your cash flow figure.
Legal fees, such as the cost of an eviction, are not considered operating expenses for this article. Hopefully, it’s not a cost you frequently encounter with your real estate business. If it is, you should work on your tenant selection criteria.
How much are Operating Expenses?
Operating expenses are directly related to the property condition and how efficiently management runs the business. Some expenses, such as property tax and insurance, are easy to estimate in the short term. On the other hand, routine maintenance costs are primarily based on how efficiently management resolves issues.
A 2015 working paper, Rental Yields and HPA: The Returns to Single Family Rentals, from UCLA Anderson School of Management, states that “on average, net yields are about 60% of gross yields”. This paper uses data from 1986 to 2014 collected by the American Housing Survey conducted by the US Census Bureau. The report concluded that the mean expense ratio is 42%3Demers/Eisfeldt Page 22 of rent. Using this paper for reference, we can estimate operating expenses at 40% of the rent and expect a profit of 60% of rent4Demers/Eisfeldt Page 4.
After scrutinizing the research paper, I analyzed my current rental portfolio of 68 single-family rentals. I performed this analysis over five years and adjusted for the properties I no longer own. I found an expense ratio of 39.97%, slightly better than the 42% in the article above. Keep in mind that my analysis was over five years, while the paper used 28 years of data. I expect my expense ratio to approach that of the research paper as the time horizon grows.
As a third method for confirming the operating expense ratio, I pulled the last year’s operating expenses from my accounting package5. In August 2021, I changed accounting packages. I don’t readily have access to 2022 and previous years combined.. The table below shows my actual operating expenses for the year 2022. This shows that I had a 45% operating expense ratio, higher than my previous five years and the number predicted from the document.
I believe the reason for this expense increase is that I had a higher-than-normal tenant turnover rate in 2022. This was a result of the expiration of the recent eviction moratorium.
|Total Operating Income||$771,783.51|
|Total Operating Expense||$349,534.49|
Real World Reality Check!
WOW! My net income for 2022 was over $400,000. This sounds impressive, but remember, this is just a calculation of operating expenses. As mentioned earlier, this doesn’t include capital expense and debt service. My capital expenses were nearly $125,000, and I paid about $276,000 in debt service. This left me with a cash flow of about $40,000 for the year, and I will owe taxes on a much larger number.
Using my data and the 2015 study by Andrew Demers and Andrea Eisfeldt, it’s safe to say that operating expenses are about 40% of the rent. This leads to a profit of about 60% of the rent. It should be stressed that this number is a rough estimate. However, due to the dynamic nature of real estate investing, it’s unlikely that we will be able to pinpoint a more accurate number. In some years, you will have many more expenses, and the costs will be lower in other years. If you stick with 40% of rental income, you should be close to the actual number over several years.
This paper fully described operating expenses and estimated what the operational expenses should average as a percent of the rent. It should be stressed that other non-operating costs are not included in this number. As mentioned above, debt service for a mortgage is not included in our operating expense ratio. In addition, capital expenditures will likely be needed over the life of the property, and they are omitted here. I used academic research and my data to determine the expense ratio estimated in his article.