When reviewing a deal it is important to properly estimate the operating expenses of the income property- if you underestimate the expenses you may pay way too much for the building, or the building might negative cash flow!
A good rule of thumb for operating expenses is 40% of Gross Income. Having property management versus no property management will change the expenses by 5%-8% and is one of the bigger expenses. I would be very suspicious of 20% or less operating expense buildings- chances are they are leaving somethings out.
There are 3 different sets of numbers for Operating expenses: the seller’s numbers, the listing brokers numbers, and the buyer’s numbers.
The seller’s numbers will be understated (I have never seen an accurate seller accounting!). The seller has incentive to report lower expenses because this will raise the net operating income of the building and increase the cap rate/ price. The seller may tell you that they didn’t spend money on property management or that they spent very little over the past year on maintenance. Some expenses may be missing altogether from their accounting, such as pest control or reserves.
Verify all operating expenses during the due diligence period.
Listing Brokers play ‘with the numbers’ to make the property look like a better investment. They may use “Market” Rents instead of actual rents, current annual property tax instead of the property tax based on the new purchase price, or understate expenses or omit expenses.
Buyers, do your homework.
Operating Expenses do not include Capital Improvements and Mortgage.
Operating Expense Catagories:
-Property Management (On site & Off site)
-Cleaning Service (if Applicable)
-Pool Service (if Applicable)
-Elevator Service (if Applicable)
-Sprinkler Systems (if Applicable)
-Phone Service (if Applicable)
-Intercom Service (if Applicable)
-Payroll (if Applicable)