In our post regarding Net Operating Income (linked here), we noted that actual expenses vary wildly from what you find on listing fliers. In this quick post, we want to cover expense categories and how they are typically calculated. For this purpose, we will use apartments as the property type since it has the most consistent and number of categories.
First, you have fixed expenses. These are typically all utilities (water, sewer, electric, gas, and garbage) along with property taxes, insurance, and landscaping. These expenses do not fall under a normal percentage calculation or per unit calculation. We at CLG typically look at the historical utilities and lump those together into a per unit expense based on looking at the historical figures coupled with the listing flier (for sale properties). Real estate brokers and investors typically take utilities and use the per unit figure as that can be compared to similar
properties in the immediate market. There are times when that figure seems unusually large relative to the market leading to a quick water leak test. In most of those cases, a leak is found! Property taxes can be another tricky category to analyze. While they are fixed, their calculation varies from state to state based most of the time on a new purchase price.
There’s no sense using an old tax rate if the new one will be double once a sale closes. This is a very important question to ask the listing and selling real estate brokers as it will effect your bottom line net income. Insurance is another fixed expense, but one that is good to review on a per unit basis. For example, if the rates in the area are $400 per unit annually, and the flier has $200 as an estimate, you need to ask questions about how they arrived at that figure. The reverse can also be true. Finally in the fixed group, landscaping varies wildly from property to property. Our suggestion is to generally rely on the listing flier until you have a chance to physically look at the property to determine whether or not the figure seems reasonable.
Second, you have variable per unit expenses. These typically are maintenance, turnover and capital repairs (or replacement reserves). You will still at times come across listing fliers using a percentage of income expense for these categories. However, in our opinion, that isn’t applicable on the theory that a new sink or cabinet costs the same whether it’s in a $2,000/month unit or a $1,000/month unit. The key is the unit, not the rent. That said, there are variations between properties. As an example, a newer property will have lower maintenance and capital repair expenses. Another would be a property made up of mostly singles and one-bedroom units will typically have higher turnover expenses as tenants stay in those units for shorter terms than larger, more family oriented 2- and 3-bedroom units. These estimates are going to admittedly be a bit subjective. However, using basic figures going into a transaction based on the market and property type will get you a lot closer to a supportable net income you can rely on.
Third, and last, you have percentage expenses. There is only one expense item we ever use in this category: property management. This is an area you do need to rely on local real estate brokers generally for advice on market norms. However, based on our experience of the years, you can use the following as a gauge. For apartments less than 20-25 units, we use 6% (which is based on our home market here in Portland). From 25-75 units, we use 8.5%. The change is due to the need for having some onsite management in addition to the offsite property manager. And 75+ units, we generally suggest 10-12% as you need even more onsite help. For commercial property (office, retail, etc.) we generally suggest 4%. That seems to be the norm in most places around the country. That figure can be higher depending on the complexity of the leases for a particular property and responsibilities of the landlord (more on that in another paper).
Overall, properly determining expenses is the best predictor of true net income for a property. The key is knowing what to look for and what the local expenses tend to run. Once you have both of those elements in place, the rest is just a matter of inserting numbers into your projection. If you would like a generic projection spreadsheet we use at CLG, please feel free to reach out. We would be happy to provide our spreadsheet.
