Operating Expense Ratio Analysis

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Operating expense ratio analysis usually refers to investment properties, such as apartment buildings and commercial real estate. In this context, the ratio expresses operating expenses as a percentage of gross income. In the context of mutual funds, the operating expense ratio expresses certain expenses as a percentage of the fund's assets. In either case, low operating expense ratios usually mean higher profits.

Facts

According to a 2008 article on real estate software developer Investit Software's website, the operating expense ratio can be a function of potential or effective gross income. Potential gross income is the maximum income possible from an investment property, assuming 100 percent occupancy. A more realistic measure is the effective gross income, which is equal to the potential gross income minus an allowance for vacancies and bad debts.

For example, if a commercial office building has a potential gross income of $1 million and an average allowance for vacancies and bad debts of 10 percent, the effective gross income is $900,000 ($1 million multiplied by 0.9, which is 1 minus 0.10). If the operating expenses are $450,000, the operating expense ratio with respect to potential gross income is 45 percent ($450,000 divided by $1 million, the result expressed as a percentage) and with respect to effective gross income is 50 percent ($450,000 divided by $900,000, the result expressed as a percentage).

Influences

High vacancy rates and high operating expenses are two of the key reasons for high operating expense ratios. Poor managerial execution, inadequate advertising and overall economic weakness could lead to high vacancies. A white paper hosted on real estate software developer Advantage Software's website in 2000 notes that older properties tend to have higher operating expenses because of higher repair and maintenance costs. Office buildings also have higher operating expenses than apartment buildings because of greater management oversight and maintenance requirements.

Significance

Investors use the operating expense ratio to analyze and compare real estate properties. Management can analyze the ratio's historical trend and drill down into the individual components for improvements. For example, if advertising expenses are up but vacancy rates have not improved, management might consider adjusting the advertising strategy. Management could consider quality and lease rates as potential problem areas if comparable properties have lower vacancy rates.

Considerations: Mutual Fund Operating Expense Ratios

The operating expense ratio of a mutual fund is its operating expenses expressed as a percentage of its assets. Expenses include management fees, distribution and certain shareholder expenses (known as 12b-1 fees) and custodial and other administrative expenses. Brokerage costs and sales fees are not part of operating expenses. According to the Investment Company Institute's 2011 Fact Book, mutual fund fees and expenses trended down by about 50 percent from 1990 to 2010. Investor demand for funds with lower operating expenses and competition among different fund companies are some of the reasons for this decline. Operating expenses vary -- for example, stock funds usually have higher operating expenses than bond funds.

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