Operating Expense Ratio

Operating Expense Ratio (OER) in Commercial Mortgages

The Operating Expense Ratio (OER) is a critical financial metric used by real estate investors and commercial lenders to evaluate the operational efficiency of an income-producing property. It measures the cost of operating a property relative to the income it generates, providing a clear picture of how much of the gross income is consumed by day-to-day expenses.

The formula for calculating the OER is:

OER = Total Operating Expenses / Effective Gross Income

Components of the Calculation

• Total Operating Expenses: these include the costs necessary to maintain the property and keep it competitive in the market. Common examples are property taxes, insurance, utilities, property management fees, repairs, maintenance, and landscaping. It is important to note that operating expenses do not include mortgage payments (debt service), depreciation, or major capital expenditures.
• Effective Gross Income (EGI): This is the total potential income the property can generate (Gross Potential Rent) plus other income sources like parking or laundry fees, minus an allowance for vacancy and credit losses.

The Importance of OER in Commercial Mortgage Underwriting

In the context of a commercial mortgage, lenders use the OER as a primary tool for risk assessment and underwriting. Because the OER directly impacts the Net Operating Income (NOI), it determines the property's ability to "carry" a loan. Lenders look at this ratio for several key reasons:

• Benchmarking Performance: Lenders compare a property’s OER against industry standards for similar asset classes (such as multi-family, industrial, or retail) within the same geographic market. If a property's OER is significantly higher than its peers, it may indicate management inefficiencies or hidden physical problems with the building.
• Assessing Cash Flow Stability: A stable or low OER suggests that the property is well-managed and has a healthy "cushion" to cover the debt service coverage ratio (DSCR). If operating expenses are too high, there is less remaining cash flow to pay the mortgage, increasing the risk of default.
• Verifying Expense Estimates: During the loan application process, borrowers provide pro forma statements. Lenders use historical OER data to verify if the borrower’s projected expenses are realistic. If a borrower projects an OER of 25% for a property type that typically operates at 40%, the lender will likely adjust the numbers to be more conservative.

Interpreting the Ratio

A lower OER generally indicates a more efficient and profitable property. For instance, an OER of 35% means that 35 cents of every dollar earned is spent on operations, leaving 65 cents for debt service and profit. Conversely, a high OER indicates that the property is expensive to run, which can be a red flag for commercial lenders unless there is a clear plan for capital improvements that will lower future costs or increase rents significantly.