Operating Expenses - Part 1

This week I want to teach you about the different expenses you'll have with your commercial properties. They are common expenses, but what you may not be aware of is how these expenses can affect the value of your commercial property unlike a Single Family Home. If you look at the chart below, you'll see the first 3 Income items I've taught you about over the last few weeks. I taught you that SGI or Scheduled Gross Income assumes that all of your units are fully occupied and that everyone is paying full market rent, on time, every month. Then, you subtract out your Vacancy which can be either Physical or Economic. I highly recommend you look at the Economic Vacancy as it will always be higher. In addition to that, you then add in Other Income for things like Late Fees, Pet Deposits, Laundry, Vending Machines, Parking, Storage and even Utility Reimbursement (aka RUBBS). After you subtract your Vacancy from your SGI and add in your Other Income, you're left with Effective Gross Income (EGI). Once you know your income you then subtract your Operating Expenses and that's the lesson in this post.

If you look at the spreadsheet below, you'll notice that I've added another layer called Operating Expenses. There's an acronym you should utilize whenever you look at the P&L of a prospective property you're considering purchasing. That acronym is TIMMUR. TIMMUR stands for the 6 main Operating Expense categories that you'll have to account for on every property. After you subtract TIMMUR from your EGI you're left with Net Operating Income (NOI). I'll teach you about that in another week or so. In the meantime, take a look at the spreadsheet below and I'll meet you on the other side.


Scheduled Gross Income

-Vacancy

+Other Income

=Effective Gross Income (EGI)

-Operating Expenses (TIMMUR)

=Net Operating Income (NOI)


Expenses can be summarized within 6 major categories which are; Taxes, Insurance, Management, Maintenance, Utilities and Repairs (TIMMUR). Within each of these major categories there are subcategories, but I will only be referring to the major categories in this lesson. Depending on the age, quality of the complex and when the last rehab was completed, the expenses will generally range from about 40%-50% of the EGI. For a complex which is considered 'All Bills Paid' (see utilities paragraph below) the expenses will generally range from 50%-60% of the EGI.

The reason you want to remember the acronym TIMMUR is because it's a fast way to remind yourself what to look for in the Seller's numbers to make sure all expenses have been included in the calculations. Let's take a look at the first 3 items under TIMMUR this week and we'll look at the last 3 next week.

Taxes are the property taxes associated with the complex. The amount as a percentage of Effective Gross Income (EGI) can vary widely depending on the state in which the property is located and the value of the property. The seller can provide you with the amount of property tax they've paid during a calendar year. You may also be able to determine the amount through on-line resources such as accessing your county Tax Assessors web site. You can even have your Title Company supply this information to you once your contract is accepted and you start due-diligence prior to closing.

One thing you need to be careful about is if and when a reassessment from the sale will occur and how it will affect the property tax for this property. I would highly recommend that when you get to your due-diligence phase prior to closing, you get an estimate of what the taxes will be based on the new purchase price of the complex and use that figure in your calculations. It's not uncommon to have a complex that was purchased quite a few years earlier being taxed at a greatly reduced rate. When you purchase the complex, many states will reassess the property and start charging you based on the new value and you could find yourself in sticker shock. Always get an up to date estimate prior to closing from the tax assessor's office if possible.

Insurance is pretty obvious too. This amount will vary depending on the insurer, the state the property is located in, the type and classification of the property, your experience with this type of property, how many other units your insurer is already covering for you and the type of coverage you need. Make sure you get a good policy from a reputable company. Many times your best source is to stick with the company that is currently insuring the complex. They know the building and its history. They know whether or not any claims have been filed against the property. Always get 3 estimates anyway, including one from the current provider. Providers other than the current insurer still have access to a database that will inform them of any current or prior claims against the property or policy. The nice part about a good policy is that if something does happen to the complex, it will pay you the lost rental income while the repairs are being completed along with possibly helping the displaced tenants find alternative accommodations. Ask the agent for detailed information about the policy's coverage.

Management is the person or company that will manage your tenants. I know they are called Property Managers, but the reality is that 80% of what they do is managing the tenants. I highly recommend you use a third party company to manage your tenants and not do it yourself. Why would you want to anyway? If you purchase the property the right way, you would have already calculated in the cost of management and the complex should support itself. If it doesn't, I suggest you find another property. If the only way the property will cash flow the way you need it too is for you to manage the property yourself, go find another property. There are plenty of them out there.

Don't always go with the company that charges the least amount. Check around. Ask for references from other owners, RE brokers or even your finance company. Good or bad, the word does spread in a community as to who to use, and more importantly, who not to use. Management fees are determined by the size of the complex and competition in a given area. On a 30 unit complex you could pay in the range of 5%-8% of the monthly rents. For a 100+ unit complex it may drop to 3-5%. Make sure the fee is based on the 'Collected Rent' and not the 'Scheduled Rent". This gives the Property Manager an incentive to collect the rent. If they don't collect it, they don't get paid.

That's it for this week. I'll finish up Expenses (TIMMUR) next week.