What Is the Operating Expense Ratio (OER)?
The Operating Expense Ratio (OER) is a simple performance metric used in real estate to show how much of a property’s income is consumed by operating costs. It is most commonly calculated as operating expenses (excluding depreciation) divided by the property’s gross operating income. Lower OERs indicate that a smaller share of revenue is being used to run the property — generally a sign of more efficient operations and higher potential profitability. (Source: Investopedia, Theresa Chiechi; AGDirect)
Key takeaways
– OER = (Operating expenses − Depreciation) ÷ Gross operating income (often effective gross income).
– OER measures expense efficiency, not market value or return on investment.
– A lower OER is better; Investopedia states a common “good” range is about 60%–80% (industry norms vary by property type).
– Use OER together with other metrics (NOI, cap rate, expense per unit/sq ft) and multi-year trends to evaluate a property. (Investopedia; AGDirect)
Formula and calculation of the Operating Expense Ratio (OER)
Standard formula:OER = (Total operating expenses − Depreciation) ÷ Gross operating income
Notes on components:
– Total operating expenses: recurring, day‑to‑day costs of running the property (management fees, maintenance, utilities, insurance, property taxes, repairs, landscaping, trash removal, legal fees related to operations, etc.).
– Depreciation: usually subtracted because it is a non‑cash accounting charge. (Some simple definitions present OER as operating expenses ÷ gross revenue; clarify which version you’re using when comparing properties.)
– Gross operating income: typically effective gross income (potential rental income minus vacancy & credit losses + other income). Using effective gross income makes OER reflect real occupancy/collection performance. (Investopedia)
What the OER can tell you
– Operational efficiency: how much of revenue is being used for routine operation and maintenance.
– Management quality: higher vacancies, poor maintenance or inefficient operations will raise OER.
– Trend detection: rising OER over multiple years signals expenses are growing faster than income — a red flag.
Limitations: OER does not reflect property market value, financing costs (debt service) or capital expenditures, and it can be affected by accounting choices (especially depreciation). Use it alongside NOI and cap rate. (Investopedia)
Step‑by‑step: How to calculate OER (practical)
1. Gather the property income statement for the period (typically annual):
– Potential rental income
– Vacancy & credit losses
– Other operating income (parking, laundry, fees)
– Operating expenses (list each category)
– Depreciation expense
2. Compute effective gross income (EGI):
EGI = Potential rental income − Vacancy & credit losses + Other income
3. Sum operating expenses (exclude mortgage payments, loan interest, principal, capital expenditures, and owner draws). Subtract depreciation if you’re using the non‑cash‑adjusted version:
Adjusted operating expenses = Total operating expenses − Depreciation
4. Apply formula:
OER = Adjusted operating expenses ÷ EGI
5. Express as a percentage and interpret relative to property type benchmarks and historical values.
Practical example
Given:
– Monthly rent collected: $65,000 → Annual gross rent = $65,000 × 12 = $780,000
– Monthly operating expenses (recurring): $50,000 → Annual operating expenses = $50,000 × 12 = $600,000
– Annual depreciation (non‑cash): $85,000
Calculation:
Adjusted operating expenses = $600,000 − $85,000 = $515,000OER = $515,000 ÷ $780,000 = 0.6603 → 66.0%
Interpretation: About two‑thirds of the property’s revenue is consumed by operating costs. That’s relatively high by many standards, so you’d investigate which expenses are driving the ratio and whether rent or occupancy can be improved. (Example based on Investopedia illustration)
OER vs. Capitalization Rate (cap rate)
– OER measures expense efficiency: what share of revenue is used to operate the property.
– Cap rate measures yield/value: net operating income (NOI) ÷ current market value (how much return the property generates relative to its price, ignoring financing).
Use both: OER helps you understand operating efficiency and potential trouble spots; cap rate tells you the return you could expect given the purchase price. OER does not address market value — cap rate does. (Investopedia)
Limitations of using the OER
– No market‑value context: OER doesn’t tell you whether you paid a fair price; it only measures ongoing operating efficiency.
– Accounting variability: depreciation methods and classification of expenses can change the ratio (so apples‑to‑apples comparisons require consistent accounting).
– Excludes capex and financing: capital improvements and debt service are not included; properties with low OERs could still be poor investments if capex needs or financing costs are high.
– One‑time items and seasonality: unusual repairs or short‑term vacancies can distort a single‑year OER — analyze multiple years. (Investopedia)
What is a good OER?
– Guideline: Investopedia cites a typical “good” range of about 60%–80%, and notes the lower the better. However, acceptable OERs vary by property type, age of the asset, geography, and property management model.
– Compare to peers: benchmark by property class (multifamily, office, retail, industrial), by submarket, and by unit or square foot. Look at 3–5 year trends rather than a single year.
What are operating expenses in real estate?
Typical operating expense categories:
– Property taxes
– Insurance (property/landlord)
– Utilities (unless tenant‑paid)
– Repairs and maintenance
– Property management fees
– Landscaping, snow removal, trash
– Advertising, leasing commissions (if recurring)
– Legal and professional fees related to operations
Excluded: mortgage payments (debt service), principal, capital expenditures (major improvements), and owner‑specific personal expenses. (Investopedia)
Practical due-diligence checklist to use OER when evaluating a property
1. Obtain 3–5 years of historical P&L statements (or pro forma + historical if available).
2. Use consistent definitions: confirm what the seller/income statement includes as operating expenses and depreciation method.
3. Normalize for one‑time items: remove irregular expenses (catastrophic repairs, owner’s discretionary expenses, nonrecurring legal settlements).
4. Calculate EGI (use effective gross income, not potential rent) to reflect vacancy/collection performance.
5. Compute OER for each year and average; also calculate per unit and per sq ft expense metrics.
6. Compare to comparable properties and market benchmarks for the same asset class and vintage.
7. Break down expense categories to identify problem areas (utilities, repairs, property taxes, management fees).
8. Evaluate sensitivity: model how OER changes with vacancy, rent increases, or expense reductions.
9. Use alongside NOI and cap rate to assess returns and value.
10. Ask for supporting invoices or contracts for large recurring costs (management, landscaping, contracts).
Ways to reduce or manage OER (practical actions)
– Reduce vacancies and improve rent collections (increase EGI).
– Negotiate service contracts and insurance.
– Implement preventive maintenance to lower large repairs.
– Optimize property management: in‑house vs. third‑party costs and performance.
– Invest selectively in improvements that enable higher rents without proportionally raising operating costs.
– Monitor utilities and implement energy efficiency measures where cost effective.
The bottom line
The Operating Expense Ratio is a straightforward, useful metric for comparing how efficiently a property is run and for spotting trends in operating costs over time. It should be calculated consistently (preferably using effective gross income and excluding depreciation) and used together with other investment metrics such as NOI and cap rate. Because OER does not reflect market value, financing, or capital needs, it is a diagnostic tool — not a standalone investment decision maker. Always normalize for accounting differences and multi‑year anomalies before drawing conclusions. (Investopedia; AGDirect)
Sources
– Investopedia, “Operating Expense Ratio (OER)” — Theresa Chiechi.
– AGDirect, “Operating Expense Ratio.”
(Continuation — expanded guide, additional examples, practical steps, and concluding summary)
Additional example — step‑by‑step (using the Investopedia numbers)
– Given (monthly):
– Rent collected (gross revenue): $65,000
– Monthly operating expenses (including taxes, utilities, maintenance, management, etc.): $50,000
– Annual depreciation: $85,000
– Convert to annual amounts:
– Annual gross revenue = $65,000 × 12 = $780,000
– Annual operating expenses = $50,000 × 12 = $600,000
– Apply the OER formula:
– OER = (Operating expenses − Depreciation) / Gross revenue
– OER = ($600,000 − $85,000) / $780,000 = $515,000 / $780,000 ≈ 0.66 → 66%
– Interpretation: Operating expenses (after removing depreciation) consume about two‑thirds of revenue; this indicates relatively high operating load and may warrant deeper due diligence on expense drivers and vacancy.
Second example — quick retail property illustration
– Given (annual):
– Gross revenue (rent + other income): $200,000
– Operating expenses (repairs, taxes, insurance, utilities, management): $60,000
– Depreciation: $10,000
– OER = ($60,000 − $10,000) / $200,000 = $50,000 / $200,000 = 0.25 → 25%
– Interpretation: Only 25% of gross revenue is consumed by recurring operating costs (excluding depreciation). This suggests high operational efficiency versus the previous example, but must be compared to similar retail assets in the same market.
Practical steps to calculate OER (checklist)
1. Gather income figures
– Start with Potential Gross Income (PGI) — total rent at full occupancy.
– Subtract vacancy & credit loss to get Effective Gross Income (EGI) — many investors use EGI or actual gross operating income for a realistic denominator.
– Include other property income (parking, laundry, fees).
2. Total operating expenses
– Include recurring, day‑to‑day costs: property management, repairs & maintenance, utilities, trash, landscaping, insurance, property taxes, marketing, legal/accounting, supplies.
– Exclude debt service (mortgage payments), capital expenditures (roof replacements, major renovations) and owner personal items.
3. Depreciation
– Determine depreciation expense for the period (depends on accounting method). Because depreciation is a non‑cash charge, many analysts subtract it when computing OER.
4. Compute OER
– Formula: OER = (Total operating expenses − Depreciation) ÷ Gross revenue (or EGI if using effective income)
– Convert all inputs to the same time basis (annual is standard).
5. Analyze and compare
– Compare OER to historical trends for the property and to benchmarks for the same property type and location.
– Run sensitivity analyses (e.g., higher vacancy, increased utility costs) to see OER movement.
Using OER in underwriting and investment decisions
– Operational efficiency gauge: OER quickly shows how much of revenue is eaten by operations. A lower OER generally signals better efficiency and more cash available for returns.
– Trend analysis: Compare year‑over‑year OERs to detect rising maintenance, management inefficiencies, or creeping expenses that outpace income growth.
– Comparative metric: Use OER to compare properties of the same type and market to spot outliers (very high or low OERs).
– Complementary metrics: Always combine OER with Net Operating Income (NOI), capitalization rate (cap rate), Debt Service Coverage Ratio (DSCR), and cash‑on‑cash return to get a full investment picture. OER doesn’t show market value or financing impact.
Sensitivity example — effect of vacancy increase
– Start with a property with PGI = $500,000, vacancy & credit loss = 5% → EGI = $475,000.
– Operating expenses = $200,000; depreciation = $20,000.
– OER = ($200,000 − $20,000) / $475,000 = $180,000 / $475,000 ≈ 37.9%
– If vacancy rises to 10% → EGI = $450,000; OER = $180,000 / $450,000 = 40%
– Result: A modest vacancy rise increased OER by ~2.1 percentage points, showing how vacancy management directly affects operational efficiency.
Ways to improve (lower) the OER — practical strategies
– Increase effective income
– Reduce vacancy: improve marketing, tenant retention, screening.
– Add revenue streams: paid parking, storage, pet fees, laundry, utility billing.
– Market re‑positioning or modest renovations to justify higher rents.
– Reduce operating expenses
– Energy efficiency upgrades (LEDs, HVAC servicing) to lower utilities.
– Preventive maintenance to reduce costly emergency repairs.
– Renegotiate service contracts (landscaping, trash, pest control) or consolidate vendors.
– Evaluate management model: in‑house vs. third‑party managers and fee structures.
– Manage tax & insurance costs
– Ensure taxes are assessed correctly; appeal overassessments.
– Shop insurance providers and adjust coverage where appropriate.
– Distinguish capex from operating expenses correctly
– Move large, non‑recurring capital costs out of operating expense lines (they still matter, but excluding them from OER gives a clearer ongoing efficiency picture).
Limitations, common pitfalls, and things to watch
– Doesn’t reflect property value or purchase price: OER is about operational efficiency, not valuation.
– Excludes financing: Debt service impacts cash flow but is not in OER.
– Depreciation variability: Different accounting/depreciation methods change the OER; depreciation is non‑cash, so subtracting it can be subjective.
– CapEx and one‑time expenses: Including big capital projects in operating expenses will distort OER; ensure consistent classification.
– Cross‑property comparisons must be apples‑to‑apples: Use the same definitions for income and expenses, same time frame, and similar property types/ages/locations.
– Benchmark ambiguity: “Good” OERs vary by property type, age, and market. Investopedia notes a commonly cited ideal range of 60%–80%, but benchmarks differ widely in practice—always rely on market comps and property‑type norms when evaluating OER (Investopedia; AGDirect).
How OER relates to other key metrics
– Cap rate = NOI / Current market value. Cap rate uses NOI (revenues less operating expenses, before debt and taxes) and relates returns to price; OER uses revenue as denominator, so it measures expense burden, not yield.
– NOI — Net Operating Income = Total revenue − operating expenses (before depreciation if you follow standard NOI definitions; clarify conventions). NOI is essential for cap rate and DSCR.
– DSCR — Debt Service Coverage Ratio = NOI / Debt service (annual mortgage payments). High OER tends to reduce NOI, weakening DSCR.
– Cash‑on‑cash return considers actual cash flow after debt service and investments — OER influences cash available for debt service and distributions.
Benchmarking and what’s “good”
– There’s no universal “good” OER that applies to all asset classes and markets.
– Investopedia reports a commonly cited ideal OER between 60% and 80% (lower is better) for general guidance, but in many markets and for many property types investors target substantially lower OERs. Always:
– Compare to recent, local property comps by asset class.
– Consider building age: older buildings often have higher operating expenses.
– Review historical OER for the same property to spot trends.
Due‑diligence checklist when using OER
– Verify revenue streams and confirm actual receipts versus potential rent rolls.
– Confirm vacancy and credit loss assumptions are realistic for the market.
– Review expense ledgers and service contracts to validate recurring costs.
– Separate recurring operating expenses from capital expenditures and one‑time items.
– Recalculate OER using standardized definitions (e.g., EGI in denominator) for comparability.
– Run sensitivity scenarios (higher/lower vacancy, unexpected repairs, utility spikes).
– Cross‑check with NOI, cap rate, and DSCR to ensure investment viability.
Final summary (conclusion)
The Operating Expense Ratio (OER) is a practical, quick indicator of how much of a property’s revenue is consumed by ongoing operations. Calculated as (total operating expenses − depreciation) divided by gross revenue (or effective gross income), OER helps investors compare operating efficiency across similar properties and track trends over time. It should never be used in isolation: OER does not account for market value, financing structure, or capital expenditures. Use OER alongside NOI, cap rate, DSCR, and cash‑flow analysis, and always benchmark against comparable assets in the same market. When OER looks high, investigate expense drivers, vacancy management, and opportunities to increase income or reduce costs. With consistent inputs and careful due diligence, OER is a valuable tool in the investor’s toolkit for assessing operational health and potential profitability of real estate investments.
Sources
– Investopedia, “Operating Expense Ratio (OER)” — Theresa Chiechi. (Investopedia discussion and formulas referenced.)
– AGDirect, “Operating Expense Ratio.” [[END]]