Rental Property Operating Expenses: How To Get It Right the First Time!
One of the common mistakes real estate agents new to real estate investing make when creating a rental property cash flow analysis (e.g. APOD) is knowing specifically which costs associated with the investment property should be classified as operating expenses, and which should not.
As a result, some costs then are either wrongly included or omitted, which in turn skews the cash flows and subsequent rates of return, and thereby creates a false financial image of the investment opportunity. And this is not good for the real estate investor who is relying on the numbers to make a prudent investment decision or for the credibility of the agent who is presenting the numbers.
Throughout my real estate career I personally encountered many agents confused by this issue asking around for clarification.
So it seemed needful to at least offer a brief explanation of what a rental property's operating expenses are, along with some examples. Hopefully it will broaden the understanding of those who are new to real estate investing and thereby help them to create more reliable rental property evaluations that can build or grow their real estate investment business.
Operating expenses are ongoing costs to maintain and keep a rental property investment in service. In other words, they're the costs that affect the day-to-day operation of the investment and are considered necessary to keep the revenue stream flowing.
Here's a brief overview of the types of costs you want to include as an operating expense, as well as those expenses that you want to exclude.
1. INCLUDE expenses like these:
- Property taxes
- Property insurance
- Water and sewer
- Garbage collection
- Property management
- Maintenance and repairs
- Pool service
Note These are legitimate operating expenses because they affect the day-to-day operation of the investment and contribute to the investor's ability to rent the units. Other examples would include costs for administrative and accounting, telephone, supplies, snow removal, janitorial service, pest control, advertising and so on.
2. EXCLUDE these expenses:
- Debt service
- Investor income taxes
- Replacement reserves
- Capital improvements
Note These are not legitimate operating expense because they are not directly related to the investment property's core operations. What the owner pays in federal income taxes, for instance, would not affect the property's ability to produce rental income.
Rule of Thumb
Since they typically represent a huge financial chunk of what real estate investors must pay to own rental property, operating expenses ultimately play a major role in the real estate investment decision primarily because they affect the net operating income and the annual cash flow—both of which in turn affect crucial rates of return investors use to make investment decisions.
So You Know
ProAPOD Agent 6 and Executive 10 real estate investing software solutions each include a form that allows you to enter a property's operating expenses in one of three ways: (1) as an actual annual dollar amount, (2) as a percentage of the gross operating income, or (3) as an annual dollar amount per unit.