In the property investment or during the company’s operating expenses the measurement and estimation of cost is the foremost priority of a capitalist. The purchase plan of properties requires good financial analysis. To measure these expenses an effective approach is used which is known as the operating expense ratio. In this article, you will get a closer insight into operating expense ratio meaning, importance, how to calculate operating expense ratio and its limitations.
Table of contents
What is the Operating Expense Ratio?
Operating expense ratio (OER) also termed as operating cost ratio is an evaluation of the cost to operate a property in comparison to earning brought in by the property. OER is mostly used to compare the cost of related properties.
It enables the property owner to perform a reality check regarding its own operations, to analyze if his operating ratios are compatible with other properties in the local property sector. Only distribution and administration costs are included in OER, it does not involve taxes and financial expenses.
Important of Operating Expense Ratio
Operating expenses are the price correlated with running a corporate major operation on regular basis. Therefore, when minimal corporate expenses are, it is more beneficial for the company. Company management can take some actions for cost reduction.
The most important factor included in the operating expense ratio is being the best indicator of the effectiveness level of property management. It reflects the property income percentage that is utilized in the paying of maintenance and operational expenses. In commercial property analysis, it provides great insight to investors to make the right investment decisions.
The ratios are used in real estate to compare the properties. It is an efficient method for property investors to compare expenses such as taxes, gross income, repair & maintenance, accounting fees, attorney fees, advertising, utilities, and insurance, etc. Involving vacancies in OER provide helps in improving property management. Lower OER properties are more profitable for the capitalists it depicts property is expertly managed.
Moreover, the operating expense ratio helps in indicating possible problems that may occur, e.g. utility bills enhancing sustainability, thus investors can resolve this issue more rapidly & secure the profitability level. A property investor should analyze the utilities, operating income, and maintenance charges that can discourage him from buying a specific property. Knowledge of OER enables the entrepreneur or business entities to develop a pro forma assessment of future expenses and income for the new venture.
Operating Expense Ratio VS Operating Ratio
The operating expense ratio is a financial ratio method of quantifying the expense of operating a property while compared with income brought. It is the most popular technique used in the real estate industry. OER is the expense connected with the maintenance and operation of the property.
Operating ratio refers to a method that represents the company’s management efficiency by comparing the overall company operating expense (OPEX) to net sales. The operating ratio indicates how efficient firm management is at controlling cost during generating sales and revenues.
A decreasing operating ratio is a more positive sign for the companies. It is calculated OR = Operating Expense + Goods Sold Cost / Net Sales. It is an excellent technique to evaluate a firm level of efficiency and performance. The one disadvantage of OR is that it does not involve the debt.
How to Calculate Operating Expense Ratio?
Financial world is based on several tools to calculate the expenses; operating expense ratio (OER) is one of the efficient techniques preferred by financial experts. It is simple and easy to calculate the operating expense ratio. It is measured by dividing all operating expenses subtracting depreciation by operating income.
The operating expense ratio formula is as;
OER = (Overall operating expense – Depreciation) / Gross Revenue
To evaluate the OER of a property, firstly you are required to know the operating cost. This involves all costs and fees experienced as the normal expense of conducting business. Then determine the depreciation expense, the calculation of depreciation may vary depending upon the accounting method applied.
The measurement of OER for multiple years would help the capitalist to notice operating expense property trends in the market. If a property’s charges enhance annually at a higher rate than income then operating expenses also increase annually. Thus, it is then possible the investing party may lose more capital the longer they hold on to the property.
Example and Analysis
Let’s consider a capitalist A owns a flat with multiple rooms and gets $85,000 monthly net. The monthly operating expresses such as taxes, utilities, and mortgage paid by the investor are $40,000. The $75,000 depreciation of property is also expected this year.
Thus, we can calculate the yearly operating expense ratio as follow:
OER = (Overall operating expense – Depreciation) / Gross Revenue
Operating expense ratio = [($40,000 x 12) – 75,000] / 85,000 x 12
The answer would be 39% which concludes the operating expense consumes roughly one-third of revenues produced by this property.
Limitation of Operating Expense Ratio
Overall OER is beneficial for the companies and property investors but it has three drawbacks for the property investors.
- The market worth of property is not included in it, at the time of sale & purchase the investor does not know about the relative value of the property. It only shows the efficiency of happening operations. Therefore, the operating expense ratio must be utilized with concurrence with something such as the capitalization rate when estimating a property investment.
- The second limitation is depreciation can be measured in multiple ways; the operating expense ratio can be gamed through utilizing a more beneficial procedure of accounting for depreciation.
- A higher percentage operating expense ratio is unfavorable for investor profitableness.
Conclusion
Operating expense ratio (OER) is the percentage between operating cost & potential net income. It is one of the best financial tools to compare analog property expenses. OER helps in evaluating the operating cost in the business and most importantly in the property sector. In order to build multiyear proforma measuring OER identify the trends in the operating expenses comparative to income,
