Which Rental Property Expenses Are Really Considered Operating Expenses?
It’s not uncommon for anyone just getting started with rental property to be unsure about which expenses should be included as an operating expense in a real estate analysis and which should not.
It’s not rocket science (by any measure). Nonetheless, not unlike most real estate investing nuances, the ability to properly identify a rental property's operating expenses can be a bit confusing to a novice who has never created a real estate analysis. Hey, we’ve all been there.
In this article we will discuss operating expenses in order for you to understand which rental property expenses they are and what they are not. Hopefully it will benefit your next real estate analysis. Anyway, that's the objective.
Operating expenses consist of those expenditures an investor must make on a timely basis in order to maintain and keep a rental property investment in service.
In other words, operating expenses are costs associated with the rental property that must be paid to keep the property in operation and free from interruption.
The sample APOD (annual property operating data) provided below illustrates how operating expenses are typically listed when conducting a real estate analysis for a rental property.
Expenditures to Exclude
There are three expenditures commonly mistaken by novices as operating expenses that incorrectly get listed in their real estate analysis.
The first is the mortgage payment (or debt service). Debt service is later deducted from the net operating income to calculate cash flow before taxes (CFBT) and therefore comes into play in a real estate analysis, but it is not an operating expense.
The second are any capitalized improvements made to the property. These are defined as expenditures that will lengthen the life of an improvement, so it feels like a repair that belongs with the operating expenses, but the tax code states that these types of improvements (i.e., a new roof or exterior paint) must be depreciated over a number of years and cannot be deducted in full for the year it was expended (as with operating expenses).
The third is the investor’s personal income tax payment. Though certainly crucial to computing the investor’s rate of return and profitability, you must not mistake income tax as an expense required to keep the investment maintained or in service and therefore must not be treated as an operating expense.
Expenditures to Include
Okay, let’s move on by considering what operating expenses are typically included in a real estate analysis. They are listed according to one of the following categories just to help you understand the general concept and not intended to offer either an exhaustive or strict interpretation.
This includes the operating expenses associated with routine maintenance and repair costs to the exterior and interior of the rental property.
- broken (or missing) electrical covers
- faulty door locks or knobs
- cracked (or defective) windows
- torn (or tattered) window screens
- malfunctioning stoves, refrigerators, or washer/dryer units
- busted (or misplaced) baseboards
- limited repairs to the roof or siding
- pool cleaning and maintenance
- landscaping and parking lot maintenance
Any property manager, of course, can list dozens more, but you get the idea. You have to make expenditures for a regiment of repairs that keep the rental property adequately maintained and in good working condition.
This differs from repairs and maintenance in that these are the operating expenses necessary to keep the day-to-day activities of the rental property running and uninterrupted. A broken window will not impact the entire rental property if repair is postponed, for instance, whereas these are operating expenses that require regular and timely attention to avoid problems likely to impact the entire property.
- trash removal
- real estate taxes
- insurance (fire and liability)
- water & sewer
Most real estate requires management in one form or the other whether professional management is utilized or the investor does the management. Therefore the costs associated with such tasks as keeping the property space occupied, structures and grounds properly maintained, and supervision of the employees must be included as an operating expense in your real estate analysis.
Reserves for Replacement (optional)
This is not a true operating expense and cannot be deducted under federal tax code until they are incurred and paid. It is optional, therefore, whether you want to include an allocation of reserves for replacements in your real estate analysis but in a planning sense it is a proper allocation of cash flow because it enables investors to make annual allowances for anticipated future expenses.
About the Author
James Kobzeff is a real estate professional and the owner/developer of ProAPOD - leading real estate investment software solutions since 2000. Create cash flow, rates of return, and profitability analysis on rental property at your fingertips in minutes!
ProAPOD also provides an online real estate calculator that enables you to learn dozens of real estate definitions and formulas as you calculate. You save 64%. Learn more at real estate calculator
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