Real Estate Operating Basics: Income, Expenses, and Simple Performance Measures

Property Economics for Rentals: The Big Picture

Operating a rental property is mostly about managing a simple equation: income you can realistically collect minus ongoing costs to keep the property producing that income. The goal is to understand what the property can earn under normal conditions, what it costs to run, and how to summarize performance in a few practical measures.

Key Income Terms (From “Could Earn” to “Actually Earns”)

1) Gross Potential Rent (GPR)

Gross Potential Rent is the rent the property would collect if every rentable unit/space were occupied and everyone paid the full contracted rent for the entire period.

• Think of GPR as “100% occupancy, 100% collection.”
• For a small multifamily: add up monthly rents for all units and multiply by 12.

Example: 4 units at $1,500/month each → GPR = 4 × 1,500 × 12 = $72,000/year.

2) Vacancy and Credit Loss

Real life includes move-outs, lease-up time, and occasional non-payment. These are commonly grouped as vacancy and credit loss.

• Vacancy: empty units or unleased space.
• Credit loss: leased but not fully collected (late payments, write-offs).

Practical note: Many owners estimate vacancy as a percentage of GPR (for example, 5%–10%), then refine it using actual rent rolls and local leasing conditions.

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3) Effective Gross Income (EGI)

Effective Gross Income is what you expect to actually bring in after vacancy/credit loss, plus any other recurring income.

EGI = GPR − Vacancy/Credit Loss + Other Income

Other income examples: parking fees, laundry income, pet rent, storage fees, application fees (if recurring/consistent), RUBS utility reimbursements.

Example: GPR $72,000; vacancy 6% ($4,320); other income $1,200 → EGI = 72,000 − 4,320 + 1,200 = $68,880.

Operating Expenses: What It Costs to Run the Property

4) Operating Expenses (OpEx)

Operating expenses are the ongoing costs required to keep the property functioning and rentable. They are not about improving the property; they are about operating it.

Common operating expense categories include:

• Property taxes
• Insurance
• Utilities (owner-paid water/sewer, common electric, gas, trash)
• Repairs & maintenance (plumbing fixes, turnover repairs, minor replacements)
• Property management fees (third-party or an imputed cost if self-managing for analysis)
• Landscaping/snow removal
• Pest control
• HOA/COA dues (if applicable)
• Administrative (bank fees, leasing costs, software, postage)

Step-by-step: building a simple OpEx estimate

1. Start with fixed items: taxes, insurance, HOA (use actual bills/quotes).
2. Add contract services: landscaping, trash, pest control (use vendor quotes).
3. Estimate variable items: utilities and repairs/maintenance (use trailing 12 months if available; otherwise use conservative placeholders).
4. Include management: even if you self-manage, include a market-rate fee for apples-to-apples comparisons.

What Operating Expenses Typically Do NOT Include

Two items commonly confused with operating expenses are:

• Debt service (mortgage principal and interest): this is a financing cost, not an operating cost. Two owners can have the same building and same operations but different loans.
• Capital improvements (CapEx): larger, longer-life replacements or upgrades (roof replacement, major HVAC replacement, parking lot resurfacing, full unit renovations). These are investments into the asset, not routine operations.

Why this distinction matters: It keeps operating performance comparable across different financing choices and different renovation strategies.

5) Reserves (Reserve for Replacement) Concept

Reserves are a budgeting concept: setting aside money each year for future capital items that will eventually need replacement. Reserves are often shown as a line item in underwriting even though they are not a bill you pay monthly like utilities.

• Example reserve items: roof, exterior paint, appliances, flooring, HVAC, parking surfaces.
• Reserves help avoid “surprise” capital events turning into emergency borrowing.

Simple approach: Use a per-unit or per-square-foot annual reserve assumption (for example, $250–$400 per unit per year for smaller properties, adjusted for age/condition), then refine after inspections and maintenance history.

NOI: The Core Operating Result

6) Net Operating Income (NOI)

NOI summarizes the property’s operating performance before financing and before capital improvements.

NOI = EGI − Operating Expenses

Sometimes you’ll see a “NOI after reserves” or “Adjusted NOI”:

NOI (after reserves) = NOI − Reserves

Example continuing from above: EGI $68,880; OpEx $28,000 → NOI = 68,880 − 28,000 = $40,880. If reserves are $1,600/year, NOI after reserves = $39,280.

Simple Performance Measures You Can Use Quickly

1) Rent per Square Foot (Rent/SF)

Rent per square foot helps compare rents across different unit sizes or properties.

Rent/SF = Monthly Rent ÷ Unit Size (SF)

Example: $1,800/month for 900 SF → $1,800 ÷ 900 = $2.00/SF per month.

Practical use: If one unit feels “under-rented,” Rent/SF helps you compare it to similar units and identify whether the issue is pricing, unit condition, or amenities.

2) Price per Square Foot (Price/SF)

Price per square foot is a rough way to compare purchase prices across properties of similar type and quality.

Price/SF = Purchase Price ÷ Building Size (SF)

Example: $1,200,000 purchase price for 6,000 SF → $200/SF.

Caution: Price/SF can mislead when properties have different layouts, different amounts of common area, different land value components, or very different expense structures. Use it as a quick screen, not a final decision tool.

3) Cap Rate Intuition (NOI Yield)

Cap rate is a simple ratio that links a property’s NOI to its price/value. It is often interpreted as an unlevered “yield” based on current NOI.

Cap Rate = NOI ÷ Price

Example: NOI $40,880 and price $800,000 → cap rate = 40,880 ÷ 800,000 = 5.11%.

How to think about it:

• Higher cap rate usually means a lower price relative to NOI (often more perceived risk, more management intensity, weaker location, or more uncertainty).
• Lower cap rate usually means a higher price relative to NOI (often more perceived stability, stronger location, newer asset, or stronger demand).

Important: Cap rate uses NOI, so it ignores financing. Two buyers can have the same cap rate but very different cash flow depending on their loans.

4) Cash Flow Concept (After Debt Service)

Cash flow is what’s left after paying operating expenses and the mortgage payment (and often reserves, depending on how you track it).

Cash Flow (before taxes) ≈ NOI − Debt Service − (Reserves, if not already included)

Example: NOI $40,880; annual debt service $34,000 → cash flow before reserves ≈ $6,880. If reserves are $1,600, cash flow after reserves ≈ $5,280.

Practical use: Cash flow is sensitive to interest rates and loan terms. A property can have a solid NOI but weak cash flow if the financing is expensive.

5) Breakeven Occupancy

Breakeven occupancy estimates how full the property must be to cover operating expenses and debt service.

A simple version uses gross potential income as the denominator:

Breakeven Occupancy ≈ (Operating Expenses + Debt Service) ÷ GPR

Example: OpEx $28,000; debt service $34,000; GPR $72,000 → breakeven occupancy ≈ (28,000 + 34,000) ÷ 72,000 = 86.1%.

Interpretation: If typical occupancy in your area is around 92% and your breakeven is 86%, you have some cushion. If your breakeven is 95%, small leasing problems can quickly create negative cash flow.

Mini-Case: Read a Simple Income/Expense Statement and Spot the Drivers

Scenario

You are reviewing a 6-unit building. Each unit is currently rented at $1,400/month. The seller provides the following annual operating statement (simplified):

Step-by-step interpretation

1. Verify the income math: GPR is consistent (6 × 1,400 × 12). Vacancy is applied as a percentage of GPR. Other income is modest and plausible.
2. Check expense reasonableness: Compare big categories as a share of EGI. Here, OpEx is $43,344 on EGI $95,544 → about 45%. That might be normal or high depending on utilities, age, and local taxes.
3. Compute a couple quick metrics:
   • NOI margin = NOI ÷ EGI = 52,200 ÷ 95,544 ≈ 54.6%.
   • If the asking price is $1,050,000, cap rate ≈ 52,200 ÷ 1,050,000 = 4.97%.

Top drivers to investigate (what could move NOI the most)

• Vacancy assumption (7%): Is it based on actual history or a generic estimate? Ask for a rent roll and trailing 12-month collections. A change from 7% to 4% increases EGI by about $3,024/year.
• Property taxes ($14,500): Will taxes reset after sale? If reassessment is likely, model a higher tax bill. Taxes are often one of the largest and least flexible expenses.
• Utilities ($6,600): Are tenants paying any utilities? If owner-paid, check for leaks, inefficient fixtures, or opportunities for submetering/RUBS where legal and practical.
• Repairs & maintenance ($7,800): Is this “normal” upkeep or is it temporarily low because the seller deferred work? Cross-check with inspection findings and work orders.
• Management fee (8% of EGI): Confirm what’s included (leasing fees? renewal fees?). If you plan to self-manage, still keep a management cost in analysis to reflect true operating economics.
• Reserves not shown: Add a reserve line (for example, $300/unit/year → $1,800/year) and see how it affects cash flow planning.
• Rent level ($1,400/unit): Compare to market rent for similar units. If market is $1,500, the upside is meaningful; if market is $1,350, the current rent may be above market and at risk on turnover.