The operating expenses of a multifamily property are an area of opportunity to create significant financial growth and make money in real estate.
How can this be? After all, expenses make you poorer, not richer.
Few individuals are good at managing expenses, but learning this skill can accelerate your financial growth. In my acquisition activities, I frequently encounter properties that are fat in expenses and lean on returns.
Quality, experienced management that utilize systems, bulk buying, and economies of scale can manage expenses in a way that accidental weekend managers cannot even imagine are possible. They see properties like these as real opportunities to purchase an undervalued property at a discounted rate and turn it around in a relatively short period of time.
Let’s start by first understanding the operating expenses. The categories I use are:
- Repairs and Maintenance
- Property Management
- Salaries and Wages
- Promotional / Advertising
When analyzing a property you will get the income and expense reports for the last 12 months known as the “Trailing 12” or “T-12.” You will also get the broker’s proforma. The difference between a T-12 and a proforma is like reading the same story in both non-fiction and fiction. Always look at a broker’s proforma with a jaundiced eye as it is intended to present the property in the best possible light.
On the other hand, the trailing 12 is the properties actual income and expenses for the last year. There is a loose rule in commercial multifamily real estate that says that operating expenses should cost about 50% of gross operating income. Somewhere in the range of 40% – 60% may be reasonable.
However, as the ratio of operating expenses to gross operating income decreases, the more I worry about deferred maintenance and capital needs on a property.
Conversely, as this ratio rises to 60% and above, I can’t help but wonder if the property is being mismanaged, has high vacancy / turnover, or is in a high property tax state. The owner could be paying for utilities or a multitude of other factors that need to be addressed.
Whatever the case may be, it behooves you to find out as there is opportunity in controlling operating expenses.
Take for example a property with a gross operating income of $1,000,000 and operating expenses of $650,000 (65% op-ex ratio). In this example, you purchase it at a market cap rate of 8% for $4,375,000.
Value = NOI / Cap Rate = ($1,000,000 – $650,000) / 0.08 = $4,375,000
Your management team runs a tight ship and after a year or so of management, they bring operating expenses down to $500,000 or 50% op-ex ratio. Assuming no growth in income, the property is now worth, $6,250,000.
Value = NOI / Cap Rate = ($1,000,000 – $500,000) / 0.08 = $6,250,000
The power of leverage coupled with good management shows how cutting $150,000 in annual operating expenses can create nearly $2 Million in increased value. This is just one of many reasons why I love commercial multifamily real estate investing and you should too.
To Your Wealth!
Dennis Bethel, M.D.
P.S. The best real estate investments make every dollar count by controlling operating expenses for financial growth with commercial multifamily real estate.