Understanding the profitability of a potential investment property and how much positive cash flow it’s likely to generate is key to generating real estate investment revenue. And one of the most significant factors to consider is the operating expenses.
What’s most important to remember is that while many expenses are associated with purchasing and running a rental home, including mortgage and interest costs, insurance, property taxes, home inspection costs, closing costs, and more, not all these expenses fall under operating expenses. Here’s what to consider:
What are the operating expenses of a rental home?
Operating expenses are regular or semi-regular expenses necessary for the upkeep of a rental home to keep it functioning smoothly. As the name suggests, the operating expenses of your rental home are any expenses that keep it operational and in good condition but do not increase its property value. For this reason, mortgage payments aren’t considered operating expenses and must be tracked differently in your cash flow analysis.
Here are some of the most common operating expenses when running a single-family home or a multifamily unit.
Marketing and advertising
If you’ve marketed your property to attract renters through print or online ads, the expenses will count as operating expenses. Similarly, running a website, blog, or YouTube channel to promote your rental business is an operating expense.
Property taxes
Sometimes, property taxes are included in your mortgage payment. If this is the case, calculate the part of your monthly payment that goes towards taxes and include that in your operating expenditures calculation.
Insurance
Like property taxes, insurance premiums can be included in the mortgage payment. To estimate your operating expenses accurately, you’ll need to break them out as a deductible operating expense for your tax return.
Maintenance and repairs
Minor repairs can include anything from fixing leaking pipes to painting walls. However, it’s important to note that only minor repairs are considered operating expenses since major renovations are depreciable for tax purposes and, therefore, not included in this calculation.
Utilities and trash collection
Any utilities paid for by the landlord, such as water and sewer, are operating expenses, as are municipal charges, such as trash collection.
Landscaping, pool care, and snow removal
All these expenses are usually the landlord’s cost to bear and, as such, are included in the operating expenses calculation. Seasonal pest control for termites, ants, and spiders should also be factored into this number.
Property management fees
You’ll include those fees as operating costs if you’re using a property manager for a single property or your entire rental property business. A property manager may do tenant screening, which involves a background and credit check of all prospective tenants and rent collection.
Any professional fees paid out to accountants, financial planners, or attorneys regarding rental property management are operating expenses for the rental.
HOA fees
HOA or Homeowners Association fees are a common single family rental expense that can vary based on the specifications of your property. These are not fixed costs, however, and can increase over time.
Which costs are not considered operating expenses?
The rule of thumb is that if a cost is necessary for the day-to-day functioning of a property and its core operation, it will be considered an operating cost. However, if an expense doesn’t directly impact the property’s ability to produce a rental income, it is not considered an operating expense. Examples of regular and recurring costs that are not operating expenses include:
Mortgage payments
The monthly principal and interest payments you make towards a mortgage are called debt service and are not included in your operating expenses calculation. While your monthly mortgage payment directly impacts your cash flow, it’s a means of financing a property and has no bearing on its day-to-day operation. Similarly, any refinancing costs incurred due to changes in lenders or mortgage terms are not considered operating expenses.
Capital expenses
Suppose you’re undertaking major repairs, renovations, or repairs on a property, such as installing a new roof, replacing the HVAC system, or adding a new wall. In that case, these are considered capital expenses and are not included in the operating expenses. This is because upgrades of this type typically allow a landlord to charge a higher rent and are, therefore, considered material changes in the property, not day-to-day expenses necessary for keeping it running.
Income taxes
While property taxes are included in the operating costs, investor income taxes are not. Your income tax is calculated on the profit and cash flow you receive from your rental property business, and, again, since this has no direct relation to the property’s ability to run smoothly, it is not considered an operating expense.
Depreciation
As an owner of a residential investment property, the IRS allows you to claim an annual depreciation expense for the wear and tear of the property. This is over 27.5 years for a residential property. While depreciation is a deductible cost and allows you to reduce your taxable income, it doesn’t impact the property’s ability to generate this income, so it’s not counted as an operational expense.
Estimating rental property operating expenses
Many metrics and rules of thumb can be used to evaluate a property for investment purposes. We recommend using a combination of different methods, so you feel comfortable and confident in your purchase and can predict the potential cash flow as accurately as possible. Here are a few ways to look at operating expenses, specifically how they impact a rental unit’s profit potential.
The 50% rule
As a quick back-of-the-envelope calculation, the 50% rule is a preferred rule of thumb. According to the 50% rule, a property’s operating expenses will likely equal half its gross annual rental income. So, if your property generates an annual rental income of $20,000 after considering vacancy rates, you can expect your operating expenses to be roughly $10,000 for that year. Of course, your operating expenses will vary depending on several factors.
Operating expense ratio (OER)
Another way to approach this is by calculating the operating expense ratio or OER. The OER allows you to calculate how efficiently a property runs on a day-to-day basis by comparing the cost of running the property with the income it generates.
Operating expense ratio = total operating expenses / effective gross income
The OER can reveal high maintenance costs and low-income issues. Ideally, you’ll want your property to have an OER between 60 and 80%. The lower this ratio, the more efficient your rental property.
Net operating income
The net operating income, or NOI, is frequently used to calculate the profitability of a rental property by subtracting all operating expenses from the total revenue generated by the property. The NOI is a helpful metric for calculating the cap rate or the property’s rate of return.
The bottom line
Whether you’re a first-time landlord or an experienced rental real estate investor, understanding operating expenses and how to calculate them will be key in determining the profitability of your rental properties and your overall rental home business. Plus, operating costs are included in many other metrics that can help give an overview of how a rental property is performing.
Interested in real estate investing but still waiting to purchase your first rental property? Arrived can help. Through our platform, you can purchase shares of rental properties for as little as $100 and start building a portfolio — and a rental income — today.
The opinions expressed in this article are for general informational purposes only and are not intended to provide specific advice or recommendations for any individual or on any specific security or investment product. The views reflected in the commentary are subject to change at any time without notice. View Arrived’s disclaimers.
