OPERATING EXPENSES are those necessary to run investment property even if it were bought without debt. The key to successfull investment often is spending money wisely for operations. Being careful, but not skimping, is the answer.
Operating Expenses may be devided into two categories. Fixed expenses do not change as the rate of occupancy changes. Variable expenses are directly related to the occupancy rate: as more people occupy and use a building, variable expenses increase.
Fixed expences include property taxes, license and permit fees, and property insurance. Variable expenses generally include utilities (such as heat, water, sewer), management fees, payroll and payroll taxes, security, landscaping, advertising, and supplies and fees for various services provided by local government or private contractors. There may be fixed component in expenses normally classified as variable - for example, a basic fixed management cost regardless of the occupancy rate.
You may compare expenses reported for the subject property to the experience of comparable properties. This information my be obtained from published reports of trade organizations and also from property managers, assessors, appraisers, and other professionals. Some items, such as property taxes and energy costs, can change substantially in a short time. You should consider the local situation and underlying economic conditions in forecasting possible trends affection expenditures. When historical costs of operation are examined, care should be taken to assure that the reporting practices have been consistent throughout the period. (For instance, in one year the owner might have paid all utilities: but in the next, a seperate metering system was installed so that tenants began to pay some).
REPLACEMENT RESERVE. Provision must be made for the replacement of short-lived items (such as carpeting, appliances, and some mechanical equipment) that wear out. These expenditures usually occure in large lump sums: a portion of the expected cost can be set aside every year to stabilize the expenses. A replacement reserve is necessary because the wearing out of short-lived assets causes a hidden loss of income. If this economic fact s not included in financial statements, the net operating income will be overstated. You should provide for a replacement reserve even though most owners do not actually set aside money for this purpose.(Note that replacement reserve is not deductable from taxable income).
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