Commercial Loans Blog

Commercial Loans and the Operating Expense Ratio

Posted by George Blackburne on Mon, Apr 27, 2020

Loan on apartment buildingIn negotiating an income property loan, the size of loan the borrower can obtain is usually more of a sticking point than the rate or the loan fee.  

Since income property loan sizes are generally limited by the debt service coverage ratio (i.e., cash flow), rather than the loan-to-value ratio, the operating expense figure that the lender uses in his calculations is critical.

 

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Suppose a property has the following Pro Forma Operating Statement:

ABC APARTMENTS
1234 MAIN STREET
SAN JOSE, CALIFORNIA

PRO FORMA OPERATING STATEMENT

Income:

Gross Scheduled Rents $100,000
Less 5% Vacancy & Collection Loss 5,000

Effective Gross Income: $ 95,000

Less Operating Expenses:

Real Estate Taxes $12,500
Insurance 2,550
Repairs & Maintenance 5,890
Utilities 7,345
Management 4,865
Fees & Licenses 987
Painting & Decorating 3,986
Reserves for Replacement 1,900

Total Operating Expenses: 40,023

Net Operating Income: $54,977

 

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Then we hereby define the Operating Expense Ratio as follows:

Operating Expense Ratio = Total Operating Expenses divided by
the Effective Gross Income

Using our example above:

Operating Expense Ratio = $40,023 ÷ $95,000 = 42.1%

Appraisers and professional property managers often keep track of the operating expenses of the buildings they appraise or manage, and they 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.

 

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Lenders have access to these type of publications, and they 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.

While it might be possible to operate an apartment building IN THE SHORT RUN at an operating expense ratio of less than 30 to 45%, in the LONG RUN, the end result will be a seriously deteriorated building.

It might be possible to get a lender to accept an operating expense ratio as low as 28% 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 authentic source documents to back up your claim. But in general, lenders will very seldom accept an operating expense ratio on apartments of less than 30 to 35%, and have been often known to use 40 to 45%.

 

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

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

The larger the project, the larger the required operating ratio.  Large projects usually entail extensive recreational facilities and pools, and they often require full-time on-site management teams.

 

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Operating expense ratios are not as useful in evaluating most commercial or industrial properties.  The reason why is because the space can be rented on a triple net basis, a net basis, or a full service basis.

Certain commercial properties, however, have surprisingly predictable operating expense ratios"

  1. Self storage facilities:  25%
  2. Mobile home parks:  25%
  3. Non-flagged hotels and motels:  50%
  4. Flagged hotels:  60%
  5. Residential care homes:  85%  (food, nurses, etc.)

 

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Topics: operating expense ratio

Operating Expense Ratio I

Posted by George Blackburne on Mon, Mar 26, 2012

The Operating Expense Ratio is used by commercial mortgage underwriters to catch commercial borrowers who are trying to cheat.  The Operating Expense Ratio is defined as the Projected Operating Expenses divided by the Effective Gross Income (the Gross Income minus a 5% Reserve for Vacancy & Collection Loss), the result multiplied by 100%.

Operating Expense Ratio = (Projected Operating Expenses / Effective Gross Income) x 100%

 

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Example:  Suppose an apartment building owner is trying to refinance his 64-unit project.  His Projected Operating Expenses for next year, including a 6% off-site property management factor*, is $248,064 per year.  His Projected Gross Income is $1,000 per unit per month, or $64,000 per month.  Assuming a 5% Reserve for Vacancy and Collection Loss, his Effective Gross Income per month is $60,800 (95% of $64,000).  If we anualize that number, we get $729,600.  Therefore:

Operating Expense Ratio = (Operating Expenses / Effective Gross Income) x 100%

Operating Expense Ratio = ($248,064 / $729,600) x 100%

Operating Expense Ratio = 34.0%

*  Even if he manages the property himself, the owner has to figure in the cost of an outside management comapany because if the bank forecloses, the bank certainly isn't going to manage the property itself.

If this ratio is too low, according to industry standards, the commercial lender will simply disregard the projected operating expenses provided by the borrower or broker and use an assumption instead.  This assumption is usually punitive and often kills the deal.

 

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When most commercial mortgage borrowers apply for a new commercial loan, the single most important term in their minds is the loan amount.  Most commercial mortgage borrowers want the largest commercial loan possible.  If a commercial mortgage borrower is buying a property for, say, $1,000,000; he'll usually want to be able to borrow at least $750,000.  This way he only has to put down $250,000 (25% of the $1MM purchase price).

In real life, most commercial mortgage borrowers will choose a $750,000 loan at 5.75% over a $690,000 loan at just 5.0%.  It's the loan size, not the interest rate, that is usually the most important commercial loan term.

The problem, however, is that the commercial loan size is limited by the debt service coverage ratio.  You'll recall that the debt service coverage ratio is defined as the net operating income (NOI) divided by the debt service (annual principal and interest payments on the proposed loan).     Most commercial lenders today require a debt service coverage ratio of at least 1.25.

The higher the NOI, the larger the commercial loan for which the borrower can qualify, given a particular debt service coverage ratio.

Borrowers and brokers therefore have a large incentive to make the projected expenses on their operating statements look as low as possible.  After all, the lower the projected expenses, the higher the NOI appears.  The higher the NOI appears, the larger the commercial loan for which the borrower can qualify.

Commercial lenders therefore must be very suspicious of the projected operating expenses provided by either the borrower or mortgage broker.  The projected operating expenses are often understated or fudged.

So how can a commercial lender check to see if the projected operating expenses are reasonable or understated?  Commercial lenders use the Operating Expense Ratio to check to see if the projected operating expenses are reasonable.

So what are these industry standards for the Operating Expense Ratio?  We will cover them in our next blog article, Operating Expense Ratio II - What Ratios Will Commercial Lenders Believe.

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Topics: operating expense ratio