Operating Expense Ratio

The ratio of Operating Expenses to Effective Gross Revenue. The Operating Expense ratio is a metric used in real estate underwriting to understand what proportion of gross revenue is used to cover the expenses necessary to operate the property. The amount leftover, after paying the operating expenses, is the Net Operating Income.

Operating Expenses ÷ Effective Gross Revenue

Putting ‘Operating Expense Ratio’ in Context

Gulfstream Capital Partners, a real estate private equity firm, recently acquired Cypress Grove Marketplace, a 75,000-square-foot grocery-anchored retail center in Tampa, Florida. The property, anchored by a regional grocery chain, includes 15 additional in-line tenants, such as a fitness studio, a nail salon, a pizzeria, and a local bank branch. Gulfstream Capital acquired the center for $23 million, reflecting a 6.75% cap rate on its current Net Operating Income (NOI).

Understanding the Operating Expense Ratio

As part of its due diligence, Gulfstream Capital analyzed the Operating Expense Ratio (OER) to evaluate the efficiency of the property’s operations. The OER measures the proportion of effective gross revenue used to cover operating expenses and is calculated as:

Operating Expense Ratio (OER) = Operating Expenses ÷ Effective Gross Revenue

Here’s how the numbers break down for Cypress Grove Marketplace:

• Effective Gross Revenue (EGR):
  • Base Rent Revenue: $1,125,000 annually
  • Tenant Reimbursements (e.g., CAM, insurance, taxes): $375,000 annually
  • Other Revenue (e.g., percentage rents, parking): $50,000 annually
  • Total EGR: $1,125,000 + $375,000 + $50,000 = $1,550,000
• Operating Expenses:
  • CAM Expenses: $300,000 annually
  • Property Taxes: $150,000 annually
  • Insurance: $30,000 annually
  • Other Expenses (e.g., maintenance, management): $70,000 annually
  • Total Operating Expenses: $300,000 + $150,000 + $30,000 + $70,000 = $550,000
• Operating Expense Ratio (OER): $550,000 ÷ $1,550,000 = 35.5%

Insights from the Operating Expense Ratio

An OER of 35.5% suggests that 35.5% of the center’s gross revenue is used to cover operating expenses. This ratio is well within the typical range for similar retail properties (30-40%). The remaining 64.5% of the EGR contributes to the Net Operating Income (NOI), ensuring healthy cash flow for Gulfstream Capital and its investors.

Application of the Term

The Operating Expense Ratio is a critical metric in Gulfstream Capital’s underwriting process, as it helps assess the property’s operational efficiency. A low OER relative to market benchmarks indicates that Cypress Grove Marketplace is being operated efficiently, which enhances its investment appeal. By closely monitoring and potentially optimizing operating expenses, Gulfstream Capital aims to maintain or improve the property’s NOI and overall financial performance.