Expense Ratio Drift: The Silent NOI Killer Most Operators Don't See Coming 2

Operating expenses are up. Most operators know this. What most operators don't know is exactly how much their expense growth is outpacing their revenue — and what that gap is costing them in NOI, asset value, and refinance proceeds. That gap is expense ratio drift. And it is one of the most common — and most quietly damaging — performance problems in real estate portfolios right now. In this episode, Louis walks through the mechanics of operating expense ratio drift: what it is, the four categories that drive it most in today's market, how to detect it before it compounds, and what to do about each specific driver when you find it. Covered in this episode: 

1. What operating expense ratio is, how to calculate it, and why tracking it as a trend matters more than looking at it in any single month
2. The four categories driving the most OER drift right now: insurance, property taxes, management fees and ancillary charges, and maintenance
3. Why a 5-point OER increase on a $300,000 revenue property can represent $200,000+ in lost asset value at current cap rates
4. How expense ratio drift directly impacts your refinance: why lenders use your trailing 12-month OER and what that means when you're preparing for permanent financing
5. Category-specific remediation: how to address insurance cost increases, when and how to appeal property tax assessments, how to audit management agreements, and how to separate capital items from true operating expense trends
6. How BHPA uses OER trend analysis as one of the first diagnostic steps when onboarding a new client

 Plus a data point on multifamily insurance premiums in Florida that puts the real cost of accepting renewal quotes at face value into perspective. This episode is for operators who want to protect their NOI in a market where revenue growth is limited — and for anyone approaching a refinance who wants to understand why their numbers may not be supporting the loan amount they expected.

BHPA - https://bhpropertyadvisors.com/

Transcript

SPEAKER_00 0:12

Welcome to Beyond IRR. This podcast examines real estate investments through the lens of structure, risk, and capital durability, not just headline returns. I'm your host, Louis Heiza. This podcast is sponsored by Beacon Hill Property Advisors. Let's talk about one of the most common ways a real estate portfolio loses performance without anyone noticing until the damage is already done. And it's not vacancy, it's not a bad acquisition, it's not even a rate environment problem. It is expense ratio drift, the gradual incremental increase in operating expenses relative to revenue that quietly compresses NY over time and widens the gap between projected and actual performance, and in some cases pushes a property toward its break-even point without the operator ever making a conscious decision that caused it. The reason this is so insidious is that it happens slowly. No single month looks alarming. You know, you're gonna have your ups and downs as any property does, but all in all, it's chugging along. Expenses are a little up here, insurance went up after the renewal, management company added a fee, maybe maintenance ran hot one quarter, or you had some unexpected turnovers. But each item in isolation is explainable and you know is not a systemic issue. But taken together over, let's say, 18 to 24 months, they represent a fundamental shift in the operating economies or economics of the asset. And by the time most operators recognize the problem, they're already operating with a significantly less cushion than they thought. So today I want to walk through what expense ratio drift is, how it happens, how to detect it, and what to do when you find it. So the basic framework, let's start by defining this. So your operating expense ratio uh is simply your total operating expenses divided by your gross revenue. Um, so if your property operator generates, let's say $200,000 in gross revenue annually and your operating expenses are 90,000, your operating expense ratio is 45%. Now, some people don't use gross revenue. They're going to use net revenue. So after vacancy and um, you know, bad debt write-offs and um uh any anything else, concessions, anything that saps your gross revenue and brings that down to a net number. Um, it doesn't matter which one you're using. The point is that you're consistent because you want to be tracking these over time and consist what you're really looking for is the trend. Uh that's what we're gonna be getting to in this episode. But so how you define it is is up to you, um uh whether it's gross or net. Um but the thing to be be sure you're careful of is A that you're consistent on the revenue side, of course, but also on the expense side. Be sure you're consistent there too. I've seen operators who write leasing commissions, not as an expense, but below NOI on a profit and loss statement. They add that as um, you know, down with their debt payment, their debt, um, their principal, or not principal, their interest payments or other business expenses that don't factor into NOI sit below it. That's fine. Uh, of course, so long as the IRS is cool with that. But the point is just be consistent uh however you're uh defining it. So it might help to write down how you are specifically defining it and which revenue and expense categories are gonna be included uh in both the numerator and the denominator. So once you've come across your operating expense ratio, uh the number, that's gonna be your baseline. This is the first time you're running this, and now you've got your baseline. And this should now be tracked every single month, trended over time, and compared against itself quarter over quarter and year over year. So here's what most operators do instead. They look at the absolute dollar amount of expenses each month and compare it to the budget. If expenses are $7,500 and the budget was $8,000, they check the box. Everything is fine. The problem is that a budget comparison comparison tells you nothing about the direction of travel. Your operating expense ratio at acquisition might have been 42%. And now today, maybe it's 48%. So over 24 months, your operating expenses have grown faster than your revenue in this case. That's entirely possible. And that gap represents a permanent compression in your NOI that flows directly to your DSCR, your cash flow, and refinance coverage. Now, a quick point about budgets. This this episode's not about budgets, but I do want to make a point. Um, you know, I've heard people make the case in both directions, whether budgets are good or bad. My personal view, um, instead of a budget, I call it a uh future projection or a pro forma. I need to model how I expect this property to do. This is both before acquisition, obviously, but then after acquisition. And that gives me a bench uh benchmark uh to compare actual numbers to. But the reason I don't like the term budget is because a lot of people see budget and they see license to spend money. Oh, look, my marketing budget for this year is $1,000. I've only spent $200. That means we have another $800 we can spend because our budget says $1,000. Problem with that is if you don't need to spend $1,000 because your occupancy is great or your turnover rate is low or your time on market is low, then don't spend the extra money. That goes straight to your cash flow and your DSCR. So I tend to lean away from using the term budget. Of course, you need to project future performance to compare your property to. And that's especially important if you plan on refinancing as part of the life cycle of the property. Um, then you're gonna write out a pro forma and model what you think future financial performance is gonna be. And then you're that you're gonna immediately know based on the model in whatever year you plan on refinancing, are you on track to have the DSCR and the rent roll, et cetera, that you need to make this refinance happen? And comparing your actual numbers each month to your pro forma allows you to know you're on track. But that's a it's a different, it's a mental shift from treating it as a budget. So back to expense ratio drift. That the what we've just described here of acquisition, you're at 42%, now you're up to 48%, that is expense ratio drift. And it's happening in more portfolios right now, more than operators realize, because revenue has been relatively flat in many markets, while expense categories, insurance, property taxes, manage maintenance, um, you know, labor and materials management fees have been moving steadily upward. I just saw a Cushman and Wakefield report, this is as of May 2026, uh, that revenue growth is still sluggish. It's still in that, this is nationwide, but about 1.2% annually, which is uh tiny compared to what we experienced during the COVID era. And so revenue flat, we've all experienced insurance, property taxes, maintenance materials going up. Um, most people are experiencing this drift, and you need to keep an eye on it, especially if you're expecting or planning on a refinance. So we've identified here four categories that drive this drift. Let me walk through the four expense categories that causes, that cause the most drift, and why each one is often underestimated. So, category one insurance, this is probably the most acute right now. In many markets, particularly coastal and sunbelt, insurance premiums have increased 30 to 50% over the past two years. I've experienced it in the Midwest as well. Uh insurance companies are citing hail damage and major thunderstorms as the reason insurance premiums are shooting up. So for a property that was underwritten with insurance at, you know, let's say 8% of gross revenue, that number could now be 12 or 13%. And that's four or five percentage points of expense ratio increase just from a single line item. The compounding problem is that when operators renew policies, they often accept the increase without shopping coverage. Institutional operators run a competitive bidding process at every renewal. Independent operators tend to stick with the same carrier. And in a market where premiums are moving sharply upward, that passivity is expensive. So, category two, property taxes. Assessments have been increasing in many markets as property values were marked up during the 2020, 2022 COVID era. So some markets reassess at two or at a two or three year cycle, which means operators are now receiving tax bills that reflect valuations from a market that no longer exists. The challenge is that appealing assessments takes time and money and is not guaranteed to succeed. But for properties with significant tax increases, an appeal is almost always worth it. A $5,000 annual reduction in property taxes on a property capitalized at 6.5% adds approximately $77,000 to the asset value. Category three here, management fees and ancillary charges. Management fees are typically a percentage of collected revenue. So they should, in theory, be correlated with income. But many management agreements include ancillary charges that are not percentage-based, let's say lease renewal fees, maintenance coordination fees, vacancy management fees, leasing commissions for re-rentals. As management companies have faced their own cost pressure, they have increasingly relied on these secondary revenue streams. So if you have not audited your management agreement against your actually monthly invoices in the past 12 months, there's a reasonable chance you are paying for services you either did not authorize or did not fully understand. That leads us to category four, maintenance and repairs. This is the most variable category and one of uh often the most misread. And in a given month, if maintenance runs, let's say $3,000 over budget, most operators treat it as a one-time variance. What they often miss is the underlying trend. Aging properties require more maintenance. Deferred maintenance from prior years surfaces eventually. And as labor costs have increased, the same scope of work can cost 20 or 30% more than it did just three years ago. And if you're tracking maintenance as a percentage of gross revenue, and that number is moving from, say, 8% to 11% over the last 12, uh, 12, 24 months, that's not noise. That's a structural shift in the operating cost of the asset. So this leads us to the next part here. How to detect drift before it becomes a problem? The key to catching expense ratio drift early is to track your operating expense ratio, your OER, as a primary metric, not a secondary one, and to trend it over time rather than looking at it in isolation at each month. So here is the specific process. And this is what we use at BHPA. First, pull your trailing 24 months of operating statements. For each month, calculate your OER. Total operating expenses divided by gross revenue. Plot it on a simple line chart. What you're looking for is the direction of trend line. A well-managed property should have an expense ratio that is flat to slightly declining over time as revenue grows faster than expenses. A expense ratio that's training upward, even gradually, is a signal that expense growth is outpacing revenue growth. Second, break that expense ratio analysis down by category. You want to know which specific expense lines are driving the drift. Insurance drifting up is a different problem with different solutions than maintenance drifting up. Category level visibility is essential to diagnose the drift. Third, calculate what your net operating income, your NOI, would be at your original expense ratio. So if your expense ratio has drifted from, say 43% to 48%, and your current gross revenue is $240,000, your current expenses therefore are $115,200. So at your original 43% expense ratio, the expenses would be $103,200. That drift has cost you $12,000 in annual NOI. At a six and a half cap rate, just to make sure that this point is as sobering as it should be, $12,000 in NOI represents $184,000 just over in asset value. And that is the real cost of expense ratio drift. It's not just a reduced cash flow, but meaningful value erosion. Let's turn our attention now to the refinance implication because this is on a lot of people's minds as people go into refinances, and that's looking more and more as we uh work ourselves into quarter two of 2026, like we are going to be looking at a 2026 without a rate cut. And so paying attention to refinances and how your property stacks up is uh vitally important. So this now connects directly to where a lot of operators are at the moment. Let's say you're approaching a bridge loan maturity, trying to qualify for permanent financing. Expense ratio drift compresses NOI. Compressed NOI reduces stabilized value. Reduced stabilized value reduces the loan you can support. And in a refinance, every dollar of NOI matters at a 6.5 to 7% uh X multiplier when it comes to cap rates. So if your NOI has drifted down $12,000 due to expense creep, that is $84 to $92,000 less in permanent loan proceeds, right? Assuming the loan is somewhere between seven or around 70% LTV at the current cap rates. And so if you're trying to refinance at 70% LTV, that compounds even further. So this is why operators who are preparing for a refinance should be doing an expense ratio audit 12 months out and not just looking at occupancy and rent levels, but scrutinizing every expense category to identify where costs can be reduced or contained before the lender underwrites the deal. A lender is going to use, generally speaking, your trailing 12 months of operating statements. And if your trailing 12 includes elevated insurance costs that you have since renegotiated, the lender may or may not give you credit for that improvement. But if you haven't addressed it at all, you're presenting a compressed NOI that's working against your loan amount. So here's the big question: what do you do when you find drift? Once you've identified expense ratio drift and pinpointed the categories driving it, the remediation is category specific. So for insurance, you got to shop it competitively at every renewal. Work with a commercial insurance broker who specializes in, you know, multifamily if that's where you're at, rather than a general lines agent. Increase deductibles if cash reserves can support it. That's a way to reduce your premium. Consider whether the coverage is appropriate for the current asset value. In some cases, operators are overinsured for the actual risk profile of the property. Another tidbit about insurance that I've learned, uh, I guess the hard way, it wasn't really a costly mistake at all. It doesn't pay, it doesn't really help at all to work with multiple agents. Uh, they're gonna shop your policy around to all the same carriers. And if a carrier receives multiple uh requests for bid from different agents uh for the same address, it's gonna make them annoyed. Uh, and it's gonna therefore gonna make the agent annoyed, and you're just gonna get negative feedback down and a carrier might actually just pass on it. I actually saw that once uh with one of our properties because I had multiple agents working on the same address, and they all came back to me and said, Hey, do you have someone else working on this? Because I, the care carrier said that we've already bid this. Point being, get recommendations from local operators wherever you're working for a good uh commercial insurance agent who specializes in the property type you're in and stick with that one person. And you got to stay on them, of course. Hopefully they can stay on themselves if they're a quality agent, but you want to make sure they are bidding these at every single renewal. And it's your job to make sure they are. Don't expect them to do it. So for property taxes now, appeal it if the assessment is above market value, particularly if comparable properties have lower assessed values or if the market values have declined. The appeal process varies by jurisdiction, but it's almost always worth the effort for properties with assessments that have jumped significantly in recent years. Uh, most cases when I've done appeals for various properties in different different jurisdictions, I like to, I've I've been able to find a person who specializes in doing appeals. And what they my my preferred payment method to them is they take a percentage, whether that's 20, 30, 40%, sometimes 50%, of the money they save you. So they only get paid if you uh if they are actually able to secure a reduction. That's ideal. Everybody wins in that case. Uh I would hesitate to pay someone up front to do these only because I've seen enough um vendors who don't need to be paid up front, and there is no guarantee an assessment's going to work. And so paying up front, you might it might not be worth it. Uh for management fees, audit these every invoice against the management agreement. Categorize every charge and confirm it's authorized. If you're on a percentage of collected revenue structure and the base fee is 8% or higher, consider whether the current management company is earning that fee uh given the actual performance. And renegotiation is possible, particularly if you have a multi-property relationship. I rant run a property management company as we speak. So this uh hits home to me. And while I don't want to give ammunition to my clients to reduce my fees, I think our fees are worth it and we do an excellent job. But with that said, being on this side of the table, well, I'm I you know I'm on both sides of the table, both an investor who has to hire property managers as well as running a property management company, um, renegotiation is possible, especially if performance is not up to standard. If vacancy is higher than you think it should be or higher than your research says your locality should be, uh, if turn times are taking too long, maintenance expenses are nitpicky. These are all things that you should bring up. And then finally, for your last category maintenance, distinguish between controllable recurring costs and non-recurring capital items. A roof replacement is not operating expense drift. That's a capital expense that sits on your balance sheet, not your profit and loss statement. But if your turnover costs are trending up because unit conditions are deteriorating, that is a management issue. So track turnover costs per unit as a standalone metric. That should be a separate line item uh than repairs and maintenance. You want to see what you're what you're spending on turnover and tracking that trend as well. If turnover cost, for example, is increasing, you either have a management problem, a capital maintenance problem, or both. So at BHPA, we onboard, when we onboard a new client, one of the first things we look at is the expense ratio trend over the trailing 12 months. If we see drift, which we often do, especially now, we categorize it, quantify the NOI impact, and identify the specific interventions that will have the highest return. In most cases, operators have not tracked expense ratio at all. They know their expenses are up, they attribute it to inflation and accept it. But the actual drivers, insurance, taxes, management, anciliaries, maintenance trends, are addressable when you can see them clearly. The operators who manage their expense ratios actively are the ones who protect their NOI, their DSCR, and their asset value in markets where revenue growth is limited, which we are in right now. The ones who don't are the ones who show up at a lender with a refinance request and wonder why the numbers do not support what they are expecting. So practical takeaways from this episode to apply this immediately, go calculate your expense ratio for each of the last 12 months. Trend it. Use an Excel sheet. If you see upward movement, break it down by calculations. Category. Quantify the NOI impact and identify the top one or two expense categories driving the drift and build a specific remediation plan for each. Set a target expense ratio. Know where you need to be to support your debt service at your current cap rate assumption. Manage to that target the way a business manages to a margin target, because that's exactly what this is. Expense ratio drift is not inevitable. It's just a management outcome. And in a market where revenue growth is limited, managing your expense structure is one of the highest return activities you can do. So fun fact to close out this episode in 22 and uh 23 and 24, 2023, 2024, the average multifamily property insurance premium in Florida increased by over 40%, and in some coastal markets by more than 100%. This single expense category for properties in the affected markets moved operating expense ratios by three to five percentage points in less than 24 months. At a seven cap, a five-point expense ratio increase on a property generating, let's say 300K in gross revenue represents approximately $214,000 in lost asset value. The operators who are proactively shopped coverage, increased deductibles, restructured their policies, recovered a meaningful portion of that value. The ones who accepted renewal quotes at the face value did not. Hope you guys got a lot out of this, and we'll see you next Monday. This podcast is produced by Beacon Hill Property Advisors, where we focus on bringing clarity, structure, and rigor to real estate investment analysis. If you want to evaluate deals beyond headline metrics and better understand the mechanics driving performance, you can learn more about our tools and approach at bhpropertyadvisors.com. You can also connect with us directly for demonstrations, resources, and additional insights. Until next time, analyze deeply, allocate wisely, and always go beyond IRR