For new investors, underwriting a multifamily deal can prove particularly challenging. Many people exploring an apartment investment struggle to accurately forecast a building’s stabilized operating budget. In particular, developing realistic projections of operating expenses like utilities, taxes, and insurance can be difficult. But, it doesn’t haven’t to be! In the rest of this article, we’ll provide an overview of multifamily operating expenses – and how to estimate them.
Specifically, we’ll cover the following topics:
- What are Multifamily Operating Expenses?
- Common Multifamily Operating Expenses
- Estimating Your Multifamily Property’s Operating Expenses
- Final Thoughts
What are Multifamily Operating Expenses?
Defined
Operating expenses include all those expenses incurred by a business during its normal business operations. That is, these expenses include the necessary and regular expenses that allow a business to generate income.
Applied to multifamily properties, operating expenses include all of those expenses necessary to generate regular rental income from tenants. Common multifamily operating expenses include property taxes, utilities, insurance, management fees, and miscellaneous maintenance. Each of these items is necessary for the continued operations of an apartment building.
Why Are Operating Expenses Important?
When you deduct operating expenses from a property’s revenue (i.e. tenant rents), you arrive at net operating income, or NOI. In commercial real estate, NOI drives a property’s value (NOI / capitalization rate = value). Accordingly, understanding a property’s operating expenses and, by extension, NOI, allows you to project value – critical for calculating return on investment and the allowable mortgage based on a lender’s loan-to-value requirements.
Furthermore, most commercial loans impose a minimum debt coverage ratio, calculated by dividing NOI by the principal and interest portion of a loan. Without an accurate operating expense projection, you cannot calculate debt coverage ratio.
What Items Don’t Count as Operating Expenses
Of note, operating expenses do not include mortgage loan payments (principal and interest). Rather, the principal portion of these payments hits your balance sheet by reducing the outstanding loan balance. And, the interest portion falls “below the line,” factoring into net income but not net operating income.
Capital expenditures (e.g. replacing a roof or elevator, renovating units, adding an addition, etc.) also don’t qualify as operating expenses. Instead, these items count as investments in a property. Landlords don’t deduct them from revenue to calculate NOI; they “capitalize” them to a balance sheet account, increasing the taxable basis in that property.
The Operating Expense (OpEx) Ratio
Operating expenses also help investors understand how efficiently – or inefficiently – a multifamily property generates income. Specifically, the operating expense, or OpEx, ratio equals operating expenses divided by rental revenues.
If you earn $100,000 in rents and incur $40,000 in operating expenses, you’d have an OpEx ratio of 40% ($40,000 / $100,000). Phrased differently, out of each dollar of rent you earn, you have to pay 40 cents in operating expenses, leaving you 60 cents in operating income. As a result, a higher OpEx ratio means a property generates income less efficiently, as a larger portion of every dollar must go to operating expenses.
The OpEx ratio also gives investors a convenient tool for comparing otherwise dissimilar buildings. If Apartment A has a ratio of 40% and Apartment B one of 25%, you know that – all else being equal – Apartment B generates income more efficiently than Apartment A.
Factors that can affect a property’s OpEx ratio include age and condition of the building, construction materials used, building location and climate, and tenant behavior. While ratios can vary widely, 35% to 45% serves as a common OpEx ratio range for multifamily properties.
Common Multifamily Operating Expenses
Real Estate Taxes
Real estate taxes generally comprise the largest single multifamily operating expense. Investors calculate this expense by multiplying a building’s tax-assessed value by the local tax rate, both of which are publicly available. For example, a building with a $1,000,000 tax-assessed value with a 1.2% tax rate would translate to a $12,000 annual real estate tax expense ($1,000,000 x 1.2%).
Insurance
If you purchase an apartment with a loan, the lender will require an insurance policy including both general liability and property coverage. This protects the lender’s loan collateral, that is, the building itself.
However, even if you don’t use a loan, investors should always have insurance policies on their property. Yes, these policy premiums can be expensive, but the protection they provide more than justifies the cost. Last thing you want to happen is for a building to burn down without insurance coverage.
Utilities
Taken as a group, utilities (e.g. water/sewer, electricity, gas, stormwater, etc.) often make up the largest portion of a property’s operating expenses. However, landlords can choose to pass on all or part of these expenses to tenants in the form of reimbursable utilities. This pass-through practice requires more administrative and bookkeeping support, but it can significantly reduce unpredictability caused by swings in month-to-month utility expenses.
Management Fees
Unless you plan on doing it yourself, you will need to pay a property management company to manage an apartment building. Property managers handle the leasing, rent collection, turns, and general day-to-day operations of a building. Depending on the contract, these companies either charge a flat fee or a percentage of monthly rents.
Additionally, you may need to pay an asset manager. Whereas property managers focus on property operations, asset managers focus on the accounting and finance support of your investment. This support generally includes bookkeeping, financial report preparation, investor relations, and debt service.
Maintenance
Recurring maintenance tasks also qualify as operating expenses. These items include cleaning and repairs necessary to turn units between tenants, fixing broken appliances, replacing light bulbs, and fixing common area issues, among other responsibilities.
Generally, the older the building, the larger your maintenance expense – older buildings just tend to have more issues. Additionally, high tenant turnover can drive your maintenance costs higher. Every time a tenant moves in or out, you can expect some move-related damage that must be repaired.
Replacement Reserve*
As stated, capital expenditures like replacing a roof don’t qualify as operating expenses. But, you should account for these items on a recurring basis. Accordingly, many landlords include a monthly replacement reserve operating expense that reflects money set aside each month for long-term capital expenditures. From a tax perspective, these expenses must be added back into your “below the line” income to calculate taxable income. But, accounting for replacement reserve costs on a monthly basis more accurately reflects a building’s NOI.
Estimating Your Multifamily Property’s Operating Expenses
New investors frequently struggle to accurately project multifamily operating expenses. However, the following techniques can help you develop a solid operating budget.
Technique 1: Use Historical Financials
If you’re investing in a stabilized property, the best way to project future operating expenses is to analyze prior year expenses. Particularly with utilities, prior-year financial statements can give you keen insight into trends and seasonality factors with operating expenses.
Technique 2: Public Records and Contract Quotes
Many operating expenses don’t need to be estimated at all. Instead, you can access public records and seek vendor quotes to get hard numbers. For example, property tax information is public record, letting you calculate your exact tax expense. Other items like insurance and property management expenses can be confirmed through vendor contract quotes. That is, if you want to know how much to budget for monthly management fees, get a quote from a local management company. This step, while taking some more time, eliminates uncertainty.
Technique 3: Rules of Thumb
Finally, you may need to use rules of thumb for certain operating expenses, particularly for new buildings. Speaking with established landlords in the area can help with these items. For example, say you’re building a 100-unit apartment building. Ask other multifamily landlords in the area what utility rules of thumb they use. Someone may use $50/month/unit for water expenses and $100/month/unit for electricity.
These rules of thumb give you a foundation for projecting operating expenses. Then, once you’ve stabilized the property and operated for several years, you can refine those projections with historical results.
Final Thoughts
Successful investors understand the importance of accurately estimating a multifamily property’s operating expenses. Failing to do so can result in a deal generating significantly less cash flow than projected. But, as we’ve illustrated here, developing accurate multifamily operating expense estimates isn’t an impossible task.
If you’d like to discuss different real estate investing options for your unique situation, we’d love to chat! Drop us a note, and we’ll set up a meeting to talk about available passive real estate investment opportunities.