Operating Expense

An operating expense is any recurring cost of keeping a property open and leased: taxes, insurance, management, repairs, owner-paid utilities, association dues and a replacement reserve. Operating expenses are subtracted from effective gross income to get NOI, the numerator of the cap rate.

The example property carries $16,708 a year of operating expenses against $45,600 of effective gross income, an expense ratio of about 37%. Depreciation, income tax and the principal and interest on the mortgage all sit outside operating expenses. Leaving them out is what makes the cap rate independent of how a buyer finances or files.

Every $1,000 of annual expense moves value by about $17,300 at a 5.78% cap rate. That is why a buyer should rebuild the expense list from tax bills, insurance quotes and utility records instead of accepting a seller's summary. Missing lines are the most common way a cap rate gets inflated.