Operating Expense

Operating expenses are the ongoing bills of keeping a property running, separate from one-time spending on assets that last for years. For a rental it covers taxes, insurance, maintenance, reserves, management and owner-paid utilities. These come out before debt service and set how much cash flow the return is built on.

On the default deal they total about $19,070 a year, 32% of the $59,280 collected. Taxes are $6,000, insurance $2,400, and maintenance, capital reserves and management run 5%, 5% and 8% of collected rent. What remains is $40,210 of net operating income.

Mortgage principal and interest are not operating expenses, and neither is depreciation. Underestimating the true operating costs is the most common way a projected cash on cash return turns out too high. Each extra $1,000 a year of expense costs this deal about 0.7 points of return.

Further reading: Operating Expense on Wikipedia.