REPORT #3: What is Operating Ratio?
Operating Ratio is a calculation that will tell you how efficiently or inefficiently an Apartment Complex is being operated.
Calculating the Operating Ratio is simple as long as you have all the correct figures to use. The two figures you need to calculate the ‘OR’ are the OE or Operating Expenses (TIMMUR), except your debt service/mortgage payments, and the EGI or Effective Gross Income.
In order to find the OR, you take the Operating Expenses (OE) and divide it by the Effective Gross Income (EGI). Example: OE / EGI = $57,542 / $136,291 = 42.2%. As a rule of thumb, the OR should be between 40%-50%. This will vary depending on several factors such as the age of the building, how recently it was rehabbed and the area of the country where the building is located.
We’ve found that buildings further north tend to have higher OR’s and buildings further south have lower OR’s. The more recently the building has been rehabbed or the newer it is the lower the OR will be too. Of course, that will also depend on how extensive the rehab was. If all someone did was throw on some new paint, replace an appliance and put in new carpet, your expenses will be higher. Now, if they put in all new appliances, new windows, new roof, new mechanicals (AC, boiler/chiller, elevator), new fixtures and/or new kitchens/baths, then your expenses will be lower.
How do you find out what the average OR is for the area in which you want to purchase? One way is to speak with several commercial brokers in that market that specialize in Apartments. We prefer brokers with a CCIM designation. You can find them at www.CCIM.com The second way is to speak with several Property Managers in that market. Another way is to go to the web site www.IREM.org and purchase the information from them. IREM conducts an annual survey of thousands of Apartment owners/managers nationwide and compiles a plethora of information that is extremely useful. The downside is that the report is several hundred dollars to purchase and it may not even include the market that your potential property is located in. You can also find CPM’s (Certified Property Managers) on the IREM web site that can tell you the average Operating Expenses too.
Once you know what the average Operating Ratio is in your market you can use that for comparison purposes. If the average should be between 40%-50% and you find a complex with an OR of 28%, it usually means that the seller is either hiding information or they are just very efficient. In some cases the owner maybe doing their own management and, therefore, they don’t include a management percentage which you will need to do. In other cases they literally are lying to you and trying to hide expenses which you’ll have to uncover during the due diligence phase if you get that far. We’ve seen several complexes that are over 40 years old with no recent rehab work completed where the OR was as low as 26.9% in one case and around 22% in another case.
On the other hand, if you find a complex with an OR above 50% that can mean some big bucks for you. As an example, if you find a property with an OR of 51% and the market average is 44% in that area, and, if you can get the expenses under control, then every dollar you save will literally go straight to your bottom line. However, we wouldn’t recommend buying the complex unless you can figure out why the expenses are out of whack beforehand. If you buy it first with the hope that you’ll be able to figure it out later, you may be in for a rude awakening.
Another reason I look for properties that have Operating Ratios above the market average is something called ‘Forced Appreciation’. In the example above, if I know prior to closing why the expenses are so high and know I can lower those expenses to or close to the market average, then not only does that produce more cash flow for me, but it also increases the value of the property via Forced Appreciation. Let’s say I lower the expenses by $500 per month. Number one, my NOI (Net Operating Income) will increase $6000 per year. ($500 x 12 months = $6000) That also equates to $6000 more in my pocket. Via Forced Appreciation, if my property is in an area that has an average Cap Rate of 10% and my NOI just increased by $6000, then the value of the property just went up $60,000!!! Here’s why; a $6000 increase in NOI divided by the Cap Rate of 10% equals $60,000. ($6000 / .1 or 10% = $60,000) What if my property is located in an area with a CR of 8%? $6000 divided by 8% equals $75,000. ($6000 / .08 = $75,000). That’s the power of Forced Appreciation at work. Try doing that with a Single Family Home!
Another great thing about Forced Appreciation is that it’s in effect anytime your NOI increases. What if you had a 30 unit property and increased the rent on each unit a whopping $10 per month? That would equate to an annual increase of $3600. A $3600 increase in NOI, divided by the market Cap Rate in your area, let’s say 10%, equals an increase in value of $36,000. What if your market Cap Rate is 8%? That means your equity just increased to $45,000. (30 units x $10 x 12 months = $3600 / .08 = $45,000)
I love apartment buildings!!!