Making a profitable cash flow is likely one of your most sought-after reasons for owning a rental property. But achieving highly profitable income on your rental property ultimately comes down to understanding both your income and operating expenses. When your revenue exceeds your property’s operating expenses, you achieve a positive cash flow – or profit.
Estimating your income is fairly simple, but what happens if you don’t accurately calculate your rental property expenses? You experience negative cash flow – or to put it bluntly, lose money.
That’s why it’s important to understand your rental property’s operating expenses. In this article we’ll discuss:
- What an operating expense is;
- How expenses are included as operating expenses;
- Which expenses are excluded from operating expenses;
- How you can accurately calculate your property’s operating expenses and achieve a positive cash flow.
What is an Operating Expense?
Operating expenses are ongoing costs needed to maintain and operate your rental property on a day-to-day basis. Think of it this way: without paying operating expenses, you cannot perform activities needed to manage your property and generate revenue. Activities like investing or marketing are not included as operating activities, because they are not essential in operating your property. In real estate, an operating expense is the “recurring cost to maintain a rental property in good condition.”
What is Included in Rental Property Operating Expenses?
Let’s say you’re a landlord or property manager looking to make some profit. You don’t want to be caught off guard by any unexpected operating expenses on your property. What are the costs you should consider?
In general, operating expenses include:
Maintenance will include costs like lawn care, cleaning, or other expenses to keep your property in good condition. You will also want to factor in costs for repairs, like fixing a leaking pipe or installing a new dishwasher. Unfortunately, maintenance and repairs costs vary greatly depending on property conditions and who your tenants are. Generally, you can estimate yearly maintenance and repair costs as 1% of the property’s value. For example, if your property’s value is $150,000, your repair cost will be $1,500 annually or $125 monthly.
Insurance is required by law for rental property owners. Insurance is considered an operating cost even though it is often escrowed and paid through your mortgage. You can get an estimate on your insurance premium by contacting your insurance agent.
Property taxes are found by contacting your county assessor for the current rate. Property taxes are also expenses, though they are paid through your mortgage.
HOA fees (homeowner’s association fees) are expenses to help the community maintain properties, amenities, and common areas within that association. HOA fees are subject to change. You can contact a listing agent or property manager to learn what fees apply to your rental property.
Property Management Fees apply when you use a property manager for your rental. These fees vary based on your property manager but are typically anywhere from 10 to 40% of your gross income.
Utilities paid by the landlord – like water, sewage, or trash – are considered operational expenses in small multifamily properties.
These are the primary costs you should consider when calculating your operating costs. Additional costs may include:
- Accounting and legal fees
- Trash collection
- Landscape and pool care
- Pest removal
- Snow removal
- Internet upgrades and maintenance
What is NOT Included in Rental Property Operating Expenses?
It can be just as important to know what expenses should not be included in your operating expenses. That way you can accurately estimate your ROI. Remember, non-operating expenses are not directly related to your property’s operations.
Non-operating costs occur outside of everyday business activities and relate to financing or investing activities. Non-operating expenses include mortgage payments, capital expenses, investment income tax, and depreciation because they don’t directly affect your ability to produce income.
How to Estimate Rental Property Expenses
Now you know what expenses to include as rental property operating expenses. How does this compare to your property income?
Most investors use the Operating Expense Ratio, or OER, to compare costs of operating a property to the income generated. You can calculate the OER by taking the property’s operating expense and dividing it by the gross income.
For example, suppose your property’s potential rental income is $75,000, and the operating expenses are $45,000. Because 45,000 ÷ 75,000 = .6, then your OER is 60%.
Ideally, an OER between 60% and 80% is best. If your OER is on the lower end of this range, that means you are spending less money on expenses. If it is higher, you are spending more.
OERs can vary per property, but look for red flags if it’s drastically outside this range. Are your operating expenses too low because of a miscalculation? Is your income too high because you are over-charging your renters? Let your OER be a guide for determining your cash flow.
Final Thoughts on Rental Property Operating Expenses
Understanding your rental property’s expenses can help you cash out on the hard work you put in every day. The more accurate your calculated operating expense is, the greater your chance is of generating a healthy income.
While you can calculate these totals on your own, it’s good to get help from an expert. That way you can ensure you are getting the best return on your investment. We can provide the help you need to get the paycheck you want. Reach out to our team at Blackarc Investments!