Investors diversify their portfolios to ensure their investments are safe. This process involves selecting and investing in several asset classes. Usually, investors prefer two types of assets. These include stock and debt. Both of these come with specific benefits. However, they are riskier investments as they increase the portfolio risks. Investors also prefer alternative investments. These include various asset classes.
Real estate is one of the most viable investment options for most investors. It is straightforward to understand and invest in those assets. However, they come with their own set of rules and benefits. When choosing them, investors must know the returns related to real estate. Consequently, they must study the income and expenses for these investments.
Income and expenses in real estate are similar to other companies. However, they may include different items compared to the former. One of the most crucial areas in real estate investing is operating expenses. These expenses differ for properties from traditional companies and businesses. Before discussing that, it is critical to understand what operating expenses are.
What is an Operating Expense?
An operating expense is a cost that companies bear due to their normal business operations. These costs appear in the income statements under a separate section. Usually, operating expenses include various types of costs associated with operations. These may include rent, equipment, inventory costs, payroll, insurance, marketing, selling, etc. These costs are crucial in generating revenues, although they may decrease profits.
Operating expenses are inevitable costs for a company. These occur due to operations daily. Usually, operating expenses differ from one company to another. However, companies in the same industry will have similar costs under this head. As stated above, operating expenses in real estate are significantly different from those in other sectors. Companies must separate these costs from non-operating expenses.
Some operating expenses may relate to activity levels. Essentially, those costs are variable and increase as the production levels rise. On the other hand, they will be lower for companies with lower activity. On top of that, operating expenses also include fixed costs. These costs will stay the same regardless of activity levels. In some cases, operating expenses also consist of semi-fixed and stepped-fixed costs.
Operating expenses also appear under the abbreviation OPEX. These do not fall under the cost of goods sold. However, they may consist of direct costs incurred in producing goods or services. On top of that, operating expenses do not include factory overheads that contribute to those items. Nonetheless, these expenses are crucial. Operating expenses may also appear as Selling, General, and Administrative (SG&A) expenses.
Overall, operating expenses are costs incurred due to operations. These costs decrease profits. However, they are crucial to generating revenues. Companies include operating expenses on the income statement as a separate item. They also provide a breakdown of these costs in the notes to the financial statements. Similarly, operating expenses are crucial in calculating operating profits.
What are Operating Expenses in Real Estate?
Operating expenses in real estate are crucial costs in maintaining the property. On top of that, it includes the costs necessary to manage the underlying property. Usually, these costs are similar across various real estate. However, they may differ from one area to another. Some of the most prevalent items for operating expenses in real estate include the following.
Marketing and advertising
Running a property also requires marketing and advertising costs. These costs occur when owners promote their property for rent or sale. Usually, these costs are crucial in generating income. If landlords do not market their property, they may not find suitable buyers or tenants. Marketing and advertising expenses are deductible items from revenues under operating expenses.
Usually, taxes fall under non-operating expenses for most companies. These costs relate to the business as a whole and not to the underlying product. Similarly, they depend on profits. However, the same does not apply to real estate. Property taxes are prevalent in various jurisdictions. Landlords pay these taxes as a part of their operations. Therefore, property taxes fall under operating expenses in real estate.
Insurance is an operating expense in other companies. In real estate, they get the same treatment. These costs include the annual insurance premium paid for the property. Sometimes, they may be escrowed and a part of mortgage payments. Landlords can report these under operating expenses. Insurance expenses are a part of the operations for real estate.
Utilities are operating expenses in real estate. Landlords report these as a part of those expenses in the income statement. Usually, utility expenses relate to tenants or occupants. In those cases, these expenses are not deductible or included under operating expenses in real estate. If a landlord pays them, they will appear in the income statement.
Maintenance and repairs
Real estate includes property and land. Landlords must maintain these assets in good condition to attract buyers or tenants. Similarly, they must conduct repair work if needed. In those cases, they must include these costs under operating expenses in real estate. However, they cannot deduct significant items like renovation from that amount. Capital expenditure items do not appear under operating expenses in real estate.
Management and administration
Companies maintain a management and administration team to overlook their operations. On top of that, they take care of any administrative work related to operations. In real estate, the same applies. Landlords may employ workers to perform these tasks. Any costs incurred for those workers fall under operating expenses in real estate. Usually, it includes salaries or fees paid to individuals.
What is not a part of Operating Expenses in Real Estate?
Some items may appear in operating expenses for other businesses. However, these items do not apply to real estate. Usually, these items relate to the underlying property directly. Companies must report them as the cost of sales or property. Therefore, they cannot classify those expenses as operating expenses in real estate. Usually, these include two prevalent items as follows.
Operating expenses in real estate do not contain mortgage-related expenses. Usually, this amount relates to financing activities. In some cases, they may also constitute a direct cost to the real estate. For real estate, it consists of principal and interest payments. Therefore, companies do not include them as a part of operating expenses. Even for tax purposes, mortgages do not become a part of those expenses.
Depreciation on real estate does not become a part of operating expenses. For other companies, any depreciated amount may go under the cost of sales or operating expenses. However, these items become a part of the former for real estate companies. Since depreciation relates directly to the underlying property, classifying them as operating expenses is not applicable.
What is the Operating Expense Ratio?
The operating expense ratio applies to real estate like for other companies. Most companies calculate this ratio as follows.
Operating Expense Ratio (OER) = (Total operating expenses – Depreciation) / Gross Revenues
However, the operating expense ratio formula in real estate may differ. As mentioned above, operating expenses in real estate do not include depreciation. So, deducting this item does not apply to this formula. Other than that, the total operating expenses in real estate will consist of the items listed above. Overall, the formula for the operating expense ratio in real estate is as follows.
Operating Expense Ratio (OER) = Total operating expenses / Gross Revenues
Operating expenses include any costs incurred to perform or conduct business operations. These costs differ from one industry to another. Therefore, the operating expenses in real estate may vary from other companies. Usually, it includes items such as marketing and advertising, property taxes, utilities, insurance, etc. Operating expenses in real estate do not consist of mortgage or depreciation costs.