How to Examine Expense Ratios to Uncover Possible Problems Before You Purchase a Rental Property

Close examination of operating expense ratios can alert you to possible problems existing with the rental property you are considering to purchase.

To begin with, let me briefly explain what operating expenses are and how operating expense ratios are computed.

Operating Expenses

Operating expenses are costs an owner incurs to keep a property in service such as property tax, insurance, repairs and maintenance, utilities and so on.

Operating Expense Ratios

Operating expense ratio is the ratio of individual operating expenses to the gross operating income essentially showing you how big a bite each operating expense partially takes from the gross operating income.

Formula: Expense Ratio = Operating Expense / Gross Operating Income

Sample Scenario

Say you’re examining a marketing package or annual property operating data (APOD) for a rental property of interest. You already compiled enough data on similar other rental properties to have developed reasonable ratio expectations. Now you want to examine the subject property's operating expense ratios to see whether they are in line with your expectations.

Significant differences in the ratios you expect to find with those actually presented, of course, could signal a possible problem area. So you definitely would want to pay close attention and maybe request more information.

Here’s just a sampling.

1) Property Taxes - This might be a clue that the subject property’s data or the county tax assessor’s data is faulty. Request the tax statements, and maybe meet with the tax assessor to become reasonably assured that nothing hidden or misconstrued might be lurking in the background.

2) Insurance - A higher-than-norm insurance cost ratio should prompt you to have someone from your insurance company do a field inspection and advise you whether there are violations or other issues with the property that might affect insurability.

3) Electricity – This could be the result of separate metering or (more or less) lighting of common areas. If the subject property were not separately metered, would you, as the new owner, be compelled by local codes or ordinances to install them? If electricity is non-existent in the subject property’s operating expenses, you would want to know why.

4) Heating – If the ratio for this operating expense is higher than you would expect, it could indicate a faulty heating system. Is it possible for you to affordably correct the deficiencies and cut costs? In any case, always verify heating and other utility costs by contacting the utility providers directly, and always conduct a careful inspection of the property.

5) Repairs and Maintenance - Whereas a higher-than-norm ratio could spell “money pit” (or perhaps indicate some recent remodeling or updating), a lower-than-norm ratio might mean the owner neglected caring for the property, perhaps shaved costs by doing the work himself, or maybe the property simply didn’t require much maintenance this year. Whatever the reason, as you approach repairs and maintenance costs, remember to ask yourself, “Yes, but what will I pay when I own this property?”

6) Property Management - A lower-than-norm (or non-existent) ratio might mean that the seller acted as the property manager. But this might apply to you, so be sure to include some rate for property management in any event.

7) Miscellaneous- There are a host of expenses typically applied to miscellaneous operating expenses such as licenses, permits, subscriptions, general administration, and legal fees. A lower-tan-norm (or non-existent) ratio might indicate that the seller is hiding something. Be sure to make your offer subject to your approval of the seller's IRS Schedule E for the past three years just to be sure you know the facts (you should ask for this, regardless).

You get the idea. Examine each of the operating expense ratios looking for notable disparity between rental properties you consider purchasing and what is reasonably expected. And when discovered ask plenty of questions before you consider investing in the property any further.

Create a Modified APOD

Okay, now reconstruct the APOD using income and expense projections you feel confident in and see whether the subject rental property makes sense as an investment based upon the numbers you deem reasonable.

Here’s to your real estate investing success.

James Kobzeff is a real estate professional and owner/developer of ProAPOD Real Estate Investment Software. A series of rental property analysis software solutions for anyone engaged in real estate investing.