Top Commercial Property Operating Expenses and How to Reduce Them

If you were given a choice between increasing operating income or reducing operating expenses, what would you choose as a commercial real estate (CRE) developer or investor?

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Increasing operating income is the obvious choice. However, increasing rent is not always an option. For one thing, you cannot raise rent in the middle of the lease term. Furthermore, if others are not raising rent, you can price yourself out of the market.

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What’s more? Decelerating business property rental rates is one of the key commercial real estate challenges that have threatened the profitability of investors. In such an environment, increasing rental rates is not even an option. 

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Therefore, while reducing commercial property operating expenses is not an easy option, it is often the most available one to increase net operating income and capitalization rate. 

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“Directing capital expenditures to areas that reduce operating costs is always important but is particularly so during inflationary periods,” according to McKinsey and Co, a global consulting firm.  

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In what follows, we will consider the major components of commercial property costs and what you can do to reduce them and increase your profits. We’ll cover: 

1. Types of commercial property operating expenses
2. Who pays commercial property operating expenses?
3. Understanding your operating expenses ratio
4. How to reduce commercial property operating expenses

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1. Types of commercial property operating expenses

Every list of operating expenses must come under one of the following six types: 

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Property taxes

Real estate taxes in the US are levied by local governments and payable by property owners. This is often a fixed-cost component of operating expenses. Only changes to the tax laws can result in an increase or decrease in property taxes. 

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Property insurance premium

The monthly premium paid to an insurer is another operating expense. Like property taxes, it is often a fixed-cost component. 

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Property maintenance costs

There are five major building systems for every commercial property: HVAC (heating, ventilation, and air conditioning), electrical, plumbing, roofing, and the structure itself. 

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The costs of maintaining and repairing these systems are an essential part of operating expenses.  

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Utilities

Utilities cover the costs of electricity, HVAC, and water, among others. These are required to keep the property up and running. 

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Property management and administration fees

If you cannot manage the property yourself, you can outsource it to property managers. They are often responsible for collecting rent, scheduling maintenance, administering lease agreements, and relating with tenants, among others. 

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Property management fees are usually calculated as a percentage of the rent collected. 

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Services

These cover the salaries paid to workers responsible for janitorial services, property security,  and landscaping, snow removal, among others. 

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There are two questions that property developers and investors usually ask concerning operating expenses. First, is advertising an operating expense? Second, is debt service an operating expense?

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To start with the first question, advertising and marketing are not included as a part of operating expenses. “Operating expenses don’t include costs like tenant improvement allowances, advertising, refinancing, and capital improvements. These can fall into non-operating expenses or capital expenses,” according to Biscred, a CRE sales and marketing enablement platform.  

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Since the goal of marketing and advertising is to get tenants in the first place, it should be included in the property costs (more like closing costs). If a property has been occupied, there is no need for ongoing marketing and advertising.

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What about debt service? 

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“Operating expenses do not include debt service, income taxes, replacement reserves, capital expenditures, or depreciation,” according to Realized 1031, a real estate fintech platform. 

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In other words, interest expenses (like depreciation) are part of non-operating expenses. 

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There is one final point to make. While repairs and maintenance costs are part of operating expenses, structural improvements, and major renovations are treated as capital expenses (Capex). Unlike operating expenses that are deducted from operating income, capital expenses are added to the value of the property. 

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2. Who pays commercial property operating expenses?

Whose responsibility is it to pay for operating expenses: the property owner or the tenant?

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It all depends on the type of commercial lease agreement. There are 8 different lease structures, according to Sharp Launch, a CRE marketing platform.  

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• Gross lease (full-service lease): Here, the tenant only pays rent. All operating expenses are the responsibility of the property owner. 

• Modified gross lease: Tenants pay base rent as well as the utilities and maintenance costs of their units. 

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Some people use base rent to refer to the fixed rent paid by the tenant and additional rent to refer to their proportionate share of the operating expenses.

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Taxes and insurance as well as common area maintenance and utilities (areas shared by all tenants) fall to the property owner.

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• Net lease: The tenants pay base rent as well as a fixed portion (or all) of the operating expenses. The percentage the tenants pay (which can be 100%) will determine what the property owner will pay.

• Single net lease: The tenants pay base rent, utilities, and a fixed portion of property taxes. The remaining portion of property taxes, property insurance, repairs, and common area utilities and maintenance costs are paid by the property owner. 

• Double net lease: In addition to base rent and utilities, the tenants pay a fixed portion of both property taxes and insurance. The property owner pays for repairs, utilities and maintenance costs of common areas, and the remaining portion of property taxes and insurance. 

• Triple net lease (NNN lease): Tenants pay base rent, utilities, and a fixed portion of property taxes, insurance, and the maintenance costs of common areas. The property owner pays for repairs and the remaining portion of property taxes, insurance, and the maintenance costs of common areas. 

• Absolute net lease: The tenants pay all the operating expenses. 

• Commercial real estate percentage lease: Tenants pay base rent and a percentage of monthly sales. On the other hand, the property owner covers all operating expenses. It is often used in shopping centers and malls. 

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In cases where tenants have to pay operating expenses, the total amount is prorated among them based on the square feet they occupy. For example, if the total rentable square footage is 50,000 and a tenant occupies 5,000 of that, that tenant’s pro-rata share (or proportionate share) will be 10%. 

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3. Understanding your operating expenses ratio

The commercial property operating expenses ratio compares the cost of operating a commercial property with the income derived from the property. 

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The formula for the operating expenses ratio is total operating expenses divided by gross operating income (the rent received from tenants). 

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Source: Wall Street Prep

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(As we saw in the previous section, what constitutes operating expenses for you (what you are responsible for) as the property owner will depend on the type of lease you have with your tenants.) 

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Why is this ratio important? 

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It is the operating expenses ratio that tells you if your property’s operating expenses are bloated and whether there is a need to cut them down. 

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You can apply the ratio in two ways: 

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First, you can compare your commercial property operating expenses ratio to that of comparable properties. The ideal ratio is between 60%-80%, according to Investopedia, but it is often better to focus on similar properties in the same state or city. 

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If your operating expenses ratio is 60%, then you are doing well according to this ideal. But what if other owners of comparable properties have a 40% operating expenses ratio? It then means that you are underperforming and leaving money on the table. 

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Second, you can target a given operating expense ratio to achieve a specific net operating income or cap rate. 

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Let’s quickly clarify some terms. 

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The net operating income is your gross operating income minus your operating expenses. 

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The cap rate is the net operating income divided by the property’s value. It is the return on real estate investment.  

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Let’s say that your current net operating income is $1,000,000 based on gross operating income of $5,000,000 and operating expenses ratio of $4,000,000. This shows that your operating expenses ratio is 80%. 

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What if you want to increase net operating income to $1,500,000 without increasing operating income (because increasing commercial property rental rates will price you out of the market)? 

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This will require you to reduce your operating expenses to $3,500,000. Said differently, your operating expenses ratio will have to fall to 70%. 

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4. How to reduce commercial property operating expenses

We have seen how to calculate commercial property operating expenses and how the operating expenses ratio can provide information about the cost efficiency of a property. 

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Once you discover that your property is not cost-efficient based on comparison with similar properties in the same state or city, there might be a need to reduce your expenses. 

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However, while a lower operating expenses ratio is desirable, you must ensure that you are not reducing the utility of the property to the occupants. Instead, you should focus on items where you can reduce costs without undermining quality. 

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Is this even possible?

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Yes. 

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Let’s consider 3 things you can do. 

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Use smart technology to reduce maintenance costs

Smart technology is one of the trends behind commercial real estate digital transformation.  

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Smart buildings use connected devices and sensors powered by IoT (Internet of Things) to collect and analyze data about major building systems and adjust how they operate. This can lead to a reduction in utility bills and maintenance costs as well as operational efficiency, according to J.P. Morgan, the global financial services provider.

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For example, water detection sensors can monitor ceilings, sinks, and pipes and alert you at the very first indication of a possible leak. Environmental sensors can use real-time weather data to precisely control your HVAC systems, thus improving efficiency and comfort. Smart technology can also provide data about water and energy usage and suggest where more efficiency can be achieved.

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“Facilities managers and property managers can use this data to reduce a building’s carbon footprint, enable predictive maintenance, and make large spaces more cost-efficient and productive,” according to Premise HQ, a digital facility management tool.  

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Deploy automation to reduce the need for manual labor

You can also use property (or lease) management software to automate tasks like tenant screening, rent collection, and maintenance requests, according to Shore Agents, a real estate virtual assistance firm. 

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This software can also store tenant info (contract agreements, contact information, expiration dates, payment due dates), notify tenants of due bills and renewals, and provide you with important financial information, according to Stratafolio, a property management software. 

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Such automation will reduce your need for manual labor, minimize errors, and help streamline your operations.

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For our purpose, such automation can eliminate the need for property managers and save you the cost of paying property management fees. 

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Improve energy efficiency to reduce maintenance costs

After talking about the need to reduce operational costs in inflationary periods (especially with decelerating rents), McKinsey and Co. identify energy efficiency as one area for cost saving. They mentioned that energy-efficient windows and HVAC controls can reduce costs as well as reduce emissions. 

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“Investing in energy-efficient upgrades and adopting sustainable practices can significantly lower utility costs, which are a substantial part of OpEx in real estate,” according to Shore Agents. “Simple actions like installing LED lighting, energy-efficient appliances, or smart thermostats can lead to substantial savings in the long run.”

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By following these three strategies, you can significantly reduce your commercial property operating expenses and increase your net operating income and cap rate. With more net operating income, you can become more confident about expanding your CRE portfolio. 

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Takeaways

• While increasing rent is the most convenient way to increase net operating income, it is not always possible to do so. 
• With decelerating rent across multiple CRE sectors (especially office buildings), developers and investors have to focus on reducing commercial property costs. 
• Property taxes, insurance, maintenance costs, property management fees, utilities, and services are the major types of commercial property operating expenses. 
• Using smart technology, automation, and improving energy efficiency can help to reduce commercial property operating expenses ratio and increase net operating income and cap rate. 

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