The Operating Expense Ratio

In my experience it is the size of a loan that the borrower can obtain that is usually more of a sticking point than the rate or the loan fee. Now that you all know that loan sizes are gen­erally limited by the debt service coverage ratio (i.e., cash flow) rather than the LTV, the operating expense figure that the lender uses in his calculations is critical.

Whereas operating expense ratios are helpful in evaluating Multi-family properties, they are not as useful for commercial or industrial properties. This is because those spaces can be rented on a triple net basis, a net basis, or a full service basis.

Let’s suppose you have a commercial property with gross leases and the following Operating Statement: [Click here to view a PDF of the statement]

The operating expense ratio is defined as follows:
Operating Expense Ratio = Total Operating Expenses
______________________________EGI
or in our example,
Operating Expense Ratio = $159,311 = 44.7%
_______________________$356,670

Appraisers and professional property managers often keep track of the operating expenses of the buildings they appraise or manage, and publish their results. For example, the National Association of Realtors publishes the results of their surveys annually in several hardbound books including Income and Expenses Analysis – Apartments and Income and Expense Analysis – Office Buildings.

Lenders have access to these types of publications and therefore are reluctant to accept at face value operating expenses supplied by the borrower when their operating expense ratios are less than those experienced by similar buildings in the area.

It might be possible to operate an apartment building or commercial building with gross leases IN THE SHORT RUN at an operating expense ratio of less than 30%. However, in the LONG RUN the end result will be a seriously deteriorated building. It might be possible to get an operating expense ratio as low as 28% accepted on a very new building if it had fewer than 10 or so units, and if it had no pool and very little landscaping, and if you had 2 to 3 years of authentic source documents to back up your claim. But in general, it is difficult to get operating expense ratios on apartments of less than 30% accepted.

The following are factors that will influence the lender to use a higher operating expense ratio:

1. Lack of individual metering or utilities
2. Swimming pool
3. Elevator
4. Extensive landscaping
5. Low income area and/or tenants
6. Presence of families with children

In general, larger projects will require a larger required operating ratio. Large projects usually entail extensive recreational facilities and pools, and often require a full time on-site management team.

So after you are done putting together the operating statement with the information from the borrower double check the operating expense ratio to see if it will meet what most lenders are looking for.