Operating Expense Ratio

Operating Expense Ratio (OER)

Definition

The operating expense ratio (OER) measures how much it costs to operate a real estate property relative to the income it generates. It helps investors evaluate operational efficiency and compare similar properties.

Formula

Commonly used formula:
OER = (Operating Expenses − Depreciation) / Gross Operating Income

Note: Some practitioners omit depreciation (a non-cash item) and use:
OER = Operating Expenses / Effective Gross Income

Be consistent with the definition you use when comparing properties.

How to calculate (step-by-step)

1. Determine gross operating income (use effective rental income = potential rental income − vacancy and credit losses).
2. Sum recurring operating expenses (property management, utilities, maintenance, insurance, property taxes, landscaping, trash removal, legal fees, etc.).
3. Subtract depreciation if you are excluding it.
4. Divide expenses (or expenses minus depreciation) by gross operating income and express as a percentage.

Example:
– Monthly rent income: $65,000 → annual = $65,000 × 12 = $780,000
– Monthly operating expenses: $50,000 → annual = $50,000 × 12 = $600,000
– Annual depreciation: $85,000
OER = (600,000 − 85,000) / 780,000 = 515,000 / 780,000 ≈ 66%

This means operating expenses consume about two-thirds of the property’s revenue.

What OER tells you

• A lower OER indicates more efficient operations and better potential profitability.
• Tracking OER over time reveals trends—rising OERs suggest expenses are growing faster than income.
• Using effective gross income (accounting for vacancies) gives a realistic picture of management effectiveness.

What’s included and excluded

Included:
– Property management fees
– Utilities
– Maintenance and repairs
– Landscaping, trash removal
– Insurance (property and landlord)
– Property taxes
– Routine legal or administrative fees

Excluded:
– Debt service (mortgage payments)
– Capital improvements and major renovations
– Personal property or one-time extraordinary expenses
– (Often) Depreciation, because it’s a non-cash accounting item

OER vs. Capitalization Rate (Cap Rate)

• OER measures operating efficiency (expenses relative to income).
• Cap rate measures expected rate of return based on net operating income and property value:
  Cap rate = Net Operating Income / Current Market Value
• Use OER to assess operational performance and cap rate to estimate return and compare value. Both metrics together give a fuller investment picture.

Limitations

• OER does not reflect property value or purchase price—only operational efficiency.
• Depreciation methods vary; excluding or manipulating depreciation can change the OER.
• Comparing OERs is meaningful only among similar property types and markets.

Benchmarks and guidance

• Typical “good” OERs often fall between 60% and 80%; lower is preferable.
• Always compare properties within the same segment (multifamily vs. retail) and the same market.
• Combine OER with other metrics (cap rate, cash-on-cash return, vacancy trends) before making investment decisions.

Practical tips

• Use effective gross income (not potential income) to include realistic vacancy rates.
• Monitor expense categories individually to identify cost drivers (e.g., utilities, maintenance).
• Verify accounting conventions (especially depreciation) when comparing OERs across properties.

Bottom line

The operating expense ratio is a straightforward metric for evaluating how much of a property’s income is consumed by ongoing operations. It’s a useful tool for spotting efficiency issues and comparing similar properties, but it should be used alongside valuation and return metrics to make fully informed investment decisions.