Property Management: Controlling Controllable Expenses

What is a controllable expense?

A controllable expense is one that provides proactive property management an opportunity to generate meaningful financial impact. 

In this definition, many will then consider “every expense” as a controllable expense.  That is too far-reaching.  While you can bid insurance and challenge real estate taxes, these expenses remain firmly fixed based on factors out of the control of property ownership or property management.  Does that leave everything else? No. We still have to narrow the scope to items that can a material impact on NOI.

What are Operating Expenses in Real Estate?

Operating expenses definition: the costs of running and maintaining the building, including insurance premiums, legal fees, utilities, property taxes, repair costs, and janitorial fees.  -Investopedia

In running the business of rental property, operating expenses represent any expenditure necessary to keep and maintain the company flowing revenue. Said another way; its the money you must spend to make money.  For example, you can’t produce quality cookies without using real butter. Many have tried, and they have all failed.  A cookie without butter is a fake cookie, and everybody knows it.

Try operating a rental property without common-area lighting, or doors that open and close and lock.  Go ahead – don’t pay real estate taxes.  These are all necessary components of operating a successful rental property.  Sure, you can get away with deferring maintenance for a season, but it always catches up.  How? Not so much as in presentation or functionality – it takes time for that to occur.  The real hurt is in reputation and going-forward revenue.  Once you are known as a landlord that skimps on the basics, word will spread, and it is hard as hell to reverse it.

A family with a successful restaurant in a small seaside town was ready to retire and sold to the business to a cost-conscious new owner.  The first thing the new owner did was to cut the portion size and raise prices. The business was a goner within months.

controllable expenses several hundred dollar bills

 

Seek a Meaningful Financial Impact from Controllable Expenses

We want our efforts to control controllable expenses to have a meaningful financial impact—disregard prejudiced assumptions such as eliminating property management.  Removing property management is a pipe dream as there is no such thing as an asset that manages itself – and self-insurance (for deep-pocketed owners only – period).

Note the wording, controlling controllable expenses.  Too often, there is a focus on eliminating costs detrimental to real estate operations under the guise of preventing expenses.  When reviewing “broken” properties, I’m willing to try anything to assist in a turnaround.  What I mean by this is have a willingness to seek solutions outside of the norm.

When people pro-forma, or estimate the projected financials of a real estate deal, the operating expenses are typically 35 to 80 percent of the gross operating income (GOI), depending on the type of rental property. Zillow

You are not helping a struggling asset by eliminating landscaping as this will only harm leasing efforts when, at some point, property presentation is affected. However, consider reducing mowing (grass cutting) from four times each month to a ten-day schedule and replacing high maintenance plantings with drought-resistant varietals.  Sure, you can cut grass just once a month, but the negatives outweigh the brief dip in the expenditure.  How many leases lost in the interim?

See this article on Tips for Controlling your Insurance Cost from the National Real Estate Insurance Group.

While it is great to get a “quick hit” in cost savings, the real savings come from affecting recurring costs in controllable operating expenses in real estate.  Here are some examples:

  • Install energy savings devices inside units and in common areas.
  • Focus on renewals for the distinct purpose of reducing turnover.
  • Service common area plant and equipment; upgrade HVAC compressors and thermostats.
  • Replace carpet (a five-year CAPEX) with long-lasting flooring (a 20-year item) at equal costs.
  • Cross-train maintenance staff for better maintenance call coverage

Fixed Versus Variable Expenses

Let’s go a little deeper into defining controllable expenses by segregating expenditures as fixed and variable.

Fixed expenses are those necessary to operations; utilities, public safety, real estate taxes, insurance (again), and property management.  The definition is self-explanatory; the removal or non-payment of a fixed expense is detrimental to the ongoing operations of the business.

  • Non-payment of taxes creates a lien and the potential loss of the entire asset.
  • Non-payment of insurance will allow your lender to force-place coverage at an egregiously expensive rate.
  • Letting go of professional property management creates chaos because a rental property does not manage itself – it never has and never will.

Variable expense savings come in two categories: one-time cuts and ongoing savings.  The unique cuts get the headlines, but reductions to current costs are the real stars.  I wish I could attribute this statement:

“Variable expenses are where your profit margins go to die.”

It’s telling that too often; operators will affix a great value to having slashed a fixed expense to the bone and never review spending on cleaning supplies, office supplies, and travel.  There are many moving pieces here.  Just like a tune-up on a car; you can’t just replace half the spark plugs or half the motor oil when doing an oil change.

Think micro and macro.  Think short-term and long-term.

  • Removal of an unnecessary fenceline is proper. Removal of trees that require forever-annual maintenance is excellent.
  • Tightening up processes in tenant selection seems to increase processing costs. However, better selection criteria reduce evictions.  Better methods, good.  Fewer evictions because of better tenant selection, great.
  • Review all marketing and advertising spend.  Keep what works and eliminate everything else. Then monitor ongoing results. We are all creatures of habit.  It happens all the time that small management companies pay for telephone lines across their portfolio versus having a single phoneline bank.  The cost difference is more than measurable, with no change in services delivered.

operating expenses in real estate credit vards in wallet

 

Make Changes to Controllable Expenses Worth Doing

How do you decide which items to focus on in terms of controlling expenses?  Start with your most significant dollar outflows and look at cutting these as a percentage of X.  Consider contracting fixed-rate pricing on such items as lawn care, painting and, a fixed-rate service call for repairs for consistent needs like HVAC and plumbing.  On all of these items, based on the dollar volume your asset generates – you should never be paying retail price points for service on the property.

 

Select a meaningful dollar amount in terms of savings, an annual target, an amount that makes the time required to obtain the savings a worthy cost/benefit endeavor.  Savings of $10,000 from a $50,000 line item far outweighs $1,000 from $5,000.

Example: A fixed-priced contract to paint all units at a set price regardless of size (1, 2, 3 bedrooms) with built-in year-over-year savings over the prior year for this expenditure.  Remember also that some “single cuts” have multiple-year effects in terms of cost savings. Insulation, for example, is a one-time expense providing multiple years of savings.

Variable expenses include maintenance and make-ready as these costs “vary” depending on need (and age of the asset, and quality of construction and ownership and management methodology).

Controllable operating expenses in real estate are a necessary component of running the business of rental property, and they will never be zero dollars. Consider reducing costs predominantly in areas that avoid any negative impact on public safety or revenue generation.  All other regions of controlling controllable expenses should be open for discussion.  Negotiate a discount with local service providers based on being a consistent customer.  Make them your “exclusive” service provider in exchange for preferential rates.

John Wilhoit is the author of the best selling book on rent roll analysis: How to Read and Rent Roll. See also the companion guide to measuring the quality of rental income: Rent Roll Triangle.  Find JW’s Podcast here.

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