Revenue assumptions get most of the attention, but operating expenses kill more deals than revenue projections do. A 10% miss on expenses isn't "10% less NOI" — because expenses are leveraged by the capitalization rate, a 10% expense miss on a 6% cap deal translates to roughly a 3-4% hit to property value. On a $5M deal, that's $150,000-$200,000 of value erased.

This lesson walks through how to build a realistic expense side that won't embarrass you at closing.

The standard expense categories

Every operating statement groups expenses the same way. Learn this structure once and you'll recognize it on every deal you look at.

Fixed expenses (don't change much year-over-year)

Property taxes — often the largest single line
Insurance — property + liability + umbrella
Management fees — typically 3-5% of EGI

Variable expenses (track occupancy, weather, usage)

Utilities — water, sewer, electric, gas (landlord-paid portions)
Repairs & maintenance — plumbing, electrical, HVAC, general upkeep
Landscaping / grounds
Trash / recycling
Pest control
Snow removal (northern markets only)
Cleaning / janitorial (common areas, office)
Security
Turnover costs — paint, carpet, flooring between tenants

Administrative

Legal — evictions, lease enforcement
Accounting — bookkeeping, tax prep
Marketing / advertising — leasing costs
Office supplies / admin
Payroll (on-site staff — only applies to larger properties)

Reserves

Replacement reserves — a budget for future capital expenses (roofs, HVAC, parking lot)

The sum of all these is Total Operating Expenses. Subtract from EGI to get NOI.

Which expenses stay above the NOI line?

This is where pro formas get fudged. The rule: anything required to operate the property goes above NOI. Anything that's a capital improvement or owner-discretion goes below.

Above NOI (operating expenses):

Everything in the list above
Routine repairs and maintenance
Landlord-paid utilities
Standard management fees

Below NOI (capital and discretionary):

Tenant improvements (TIs) at lease-up
Leasing commissions
Major renovations (roof replacement, HVAC replacement, repaving)
Interest expense (financing, not operating)
Depreciation (accounting, not cash)
Owner's personal expenses inappropriately run through the property

Common seller trick: treating a roof repair as "capital" when it's really ongoing maintenance, or treating leasing commissions as "below NOI" when they're a recurring cost of operating a multi-tenant building. When comparing properties, normalize — move leasing costs and reserves above the NOI line so all deals are compared apples-to-apples.

Getting accurate Year-1 expenses

Three sources, in order of reliability:

1. The trailing 12-month operating statement (T-12)

The actual expenses the property ran over the last 12 months. This is your best data — real bills, real checks written. Review every line for one-time items that need to be normalized out (a $30K roof repair from a storm, a $15K legal bill from an eviction) and for recurring items that might not be in the T-12 (the seller was self-managing and didn't pay management fees, but you will).

2. Appraisal market expense comps

Appraisers survey comparable properties and publish average expense ratios. Use these to sanity-check the T-12. If the T-12 shows 28% expense ratio but appraisal comps show 38%, something is under-reported.

3. Industry benchmarks (IREM, NAA, BOMA)

Published per-unit and per-square-foot expense benchmarks. Less granular than a T-12 but useful when you have no property-specific data.

Expense growth rates

Not every expense grows at the same rate. Treating them all as "3% inflation" is lazy and wrong.

| Category | Typical growth rate | Why | |---|---|---| | Property taxes | 2-4% | Assessed value adjustments, millage changes. In Florida, Save-Our-Homes caps apply only to homesteads — commercial has no cap. | | Insurance | 5-15%+ | Running way above inflation — coastal Florida insurance is doubling every 3-5 years | | Utilities | 3-5% | Tracks energy costs | | Repairs & maintenance | 3-4% | Roughly tracks inflation but trending up with labor costs | | Management fees | Tracks EGI | As a % of EGI, grows as revenue grows | | Landscaping / services | 3-4% | Labor-driven | | Payroll | 3-5% | Wage inflation | | Reserves | 3% | Usually modeled flat or with inflation |

Insurance is the biggest trap in 2024-2026. If you're underwriting a Florida coastal property and assuming 3% insurance growth, you're going to miss badly. Use 10-15% for coastal Florida and 5-8% for inland. Pull actual insurance quotes before closing, not after.

Property taxes at acquisition

Here's a mistake that burns new investors: property taxes will reset when you buy the property. The seller's current tax bill reflects an assessed value that may be years out of date. When you buy, the county reassesses based on your purchase price.

In Florida (and most states), this means your Year-1 property tax bill will be dramatically higher than the seller's.

Example. A $4M multifamily property:

Seller's current assessed value: $2.5M (stale assessment)
Seller's property tax: $2.5M × 2% millage = $50,000/year
Your purchase price: $4.0M
Your Year-1 tax bill: $4.0M × 2% = $80,000/year

That's $30,000 of extra expense that wasn't on the seller's T-12. At a 6% cap rate, $30,000 of expense erases $500,000 of property value. Always re-estimate property taxes at your purchase price using the current millage rate — and factor in the timing lag (your bill might not reset until the following tax year, so there might be 6-18 months of partial savings).

In Florida specifically, call the county appraiser's office and ask for the projected reassessment. Or use the simple formula: your purchase price × the current millage rate (check the TRIM notice or the tax collector's website for the rate).

Management fees — don't skip them

If the seller was self-managing, the T-12 won't show a management fee. But you (probably) won't self-manage, so you need to add a management fee into your pro forma:

| Asset type | Management fee (% of EGI) | |---|---| | Multifamily 20–100 units | 4–6% | | Multifamily 100+ units | 3–4% | | Retail strip center | 4–5% | | Office | 3–4% | | NNN single tenant | 1–2% (mostly administrative) |

Also add the cost of a property-management software subscription ($50-200/month), occasional professional services, and on-site labor if applicable.

Rule of thumb: if the seller didn't show a management fee, add 4% of EGI to your pro forma. If the seller showed 2%, bump it to 4%.

Replacement reserves — the line sellers love to skip

Every property wears out. Roofs need replacing, HVAC systems die, parking lots need repaving, water heaters fail. Over a 20-year holding period, these capital costs add up to real money — typically $200-500/unit/year for multifamily, $0.15-0.30/sq ft for retail.

Institutional investors always book a replacement reserve as an above-NOI expense. Individual sellers almost never do — they treat these as one-time events below NOI. The result: the seller's NOI looks higher, but the long-run cash flow to the owner is the same.

Benchmarks for replacement reserves:

| Property type | Reserve budget | |---|---| | Multifamily (stabilized) | $250-400 per unit per year | | Multifamily (older Class C) | $400-600 per unit per year | | Retail strip | $0.15-0.25 per SF per year | | NNN single tenant | Minimal — tenant responsible for most items | | Office | $0.25-0.50 per SF per year | | Industrial / warehouse | $0.10-0.20 per SF per year |

Always include reserves. Lenders (especially agency lenders on multifamily) will require them anyway — typically $250-300/unit — and will escrow the money monthly.

A clean expense section

Here's what a well-built expense section looks like, with mixed growth rates:

                                Year 1      Year 2      Year 3      Year 4      Year 5
Property taxes  (3% growth)     80,000     82,400      84,872      87,418      90,041
Insurance       (10% growth)    18,000     19,800      21,780      23,958      26,354
Management fee  (4% of EGI)     13,444     14,093      14,755      15,430      15,893
Repairs & Maint (3.5% growth)   28,000     28,980      29,994      31,044      32,130
Utilities       (4% growth)     15,000     15,600      16,224      16,873      17,548
Landscaping     (3% growth)      6,000      6,180       6,365       6,556       6,753
Trash           (3% growth)      4,500      4,635       4,774       4,917       5,065
Pest control    (3% growth)      2,400      2,472       2,546       2,623       2,701
Legal/Accounting (3% growth)     3,000      3,090       3,183       3,278       3,377
Payroll         (3.5% growth)   12,000     12,420      12,855      13,305      13,771
Reserves        (3% growth)      6,000      6,180       6,365       6,556       6,753

Total OpEx                     188,344    195,850     203,713     211,958     220,386
EGI                            336,096    352,327     368,874     385,751     397,322
NOI                            147,752    156,477     165,161     173,793     176,936

Every line has its own growth rate. Insurance runs at 10%, property taxes at 3%, payroll at 3.5%, reserves at 3%. This gives you a realistic expense trajectory — not the "all expenses grow at 3%" fantasy.

The expense ratio sanity check

After you build the expense section, calculate the expense ratio (OpEx ÷ EGI) and check it against industry norms:

| Asset class | Typical expense ratio | |---|---| | Class A multifamily | 30-40% | | Class B multifamily | 40-50% | | Class C multifamily | 45-55% | | Stabilized retail (NNN) | 15-25% (net of recoveries) | | Stabilized retail (gross) | 35-45% | | Office | 35-50% | | NNN single tenant | 2-5% (nearly all recovered) | | Industrial / warehouse | 15-25% | | Self-storage | 35-45% |

If your pro forma shows a Class C multifamily at 35% expense ratio, something is wrong — probably management fees or reserves are missing. Back into the right ratio and figure out which line is off.

What to take away

Expenses are as important as revenue — a 10% miss on expenses hurts value as much as a 10% miss on revenue
Use the T-12 as your starting point, then normalize for one-time items and add missing lines (management, reserves)
Growth rates are NOT uniform — insurance is running 10%+, taxes 3-4%, management tracks EGI
Reset property taxes at your purchase price, not the seller's stale assessed value
Always include a replacement reserve even if the seller didn't
Sanity-check the expense ratio against industry norms

Next lesson: building the loan amortization schedule — monthly P&I calculations, DSCR compliance, and how to handle balloon payments at loan maturity.

Modeling Operating Expenses — Line by Line