Day 56: The Self Storage 50% Operating Expense Rule: Is It a Myth or Reality?

Howdy folks, day 56 of the Storage 100 series. I'm Joe Downs with the Storage Moguls Mastermind, and today we're tackling one of the biggest myths in self-storage underwriting. Today, the 30% operating expense myth. This myth is dangerous because it gives you a false sense of security about a property's profitability. You hear this rule everywhere, but it's often a massive oversimplification. That can lead to bad deals, could lead to you really overpaying for deals and really not appreciating what the true expenses of a deal are the way you are going to operate them. So the reality is operating expenses are highly variable and depend on the facility size and location and how you operate it. So relying on low blanket percentage numbers, especially when they come from the sellers or the brokers, means you're not doing the necessary deep dive into the financials. We need to move past this myth and create a rule of thumb that's actually beneficial. So we can understand the actual line items that drive profitability, and we have to understand it. I should say, if you don't know the true operating cost, you can't accurately calculate your net operating income. So let's break down what this rule of thumb is actually, and why it can be useful. So for the rule of thumb, I'd highly suggest using the 40% rule, which is. In the, with the type of facilities that we were talking about buying here, I think, I think the 40% rule makes the most sense. And it's just a quick and dirty metric that says operating expenses should be equal to somewhere between 35% and 45% of your gross revenue. So it's a, it's a common shortcut used by, you know, the better brokers and inexperienced investors for fast, or even experienced investors for fast surface level analysis. Just to get just to cut through it, just to see if this deal is worth looking at further. It's meant to be a rough screening tool, but don't get caught treating it as gospel. All right? Taking shortcuts in due diligence is a bad idea. The problem is that the actual expense ratio for well-run facilities can be lower or much higher. So a small unmanned facility might run at 35%, while a large fully staffed facility in a high tax area could hit up to 60%. So if you assume 30% when the real number is 45, let's say you've You just grossly inflated your projected NOI, and that'll cost you a lot of money because you'll unknowingly overpay for the facility that actually doesn't operate as efficiently or inexpensively as the way you underwrote it. So you must always verify actual expenses during due diligence, not just rely on any average. The 40% rule is just— that's a good number to tell you whether it's not— it's worth it to keep going. It's just a starting point, not a substitute for detailed financial analysis. All right. So what exactly are we including when we talk about operating expenses? I don't truly understand a facility's performance. You got to know what the expenses— what expenses actually count toward the operating total. So operating expenses are the necessary recurring costs required to keep the facility running day to day. So this would include property taxes, which are often the single largest expense and they're non-negotiable. Insurance, utilities like electricity, water, payroll costs for managers and staff are included. Repairs and maintenance are critical. This covers everything from fixing a leaky faucet to replacing a broken gate. Management fees, whether they're paid to a third party or they're allocated internally, they're also an operating cost. And then finally, marketing and administrative costs like office supplies and software subscriptions. Mark— I said marketing. Yeah, that rounds out the list. So these are the items that directly reduce your gross income to arrive at your net operating income. But just as important as what counts is knowing what you should explicitly exclude from this calculation. So understanding what doesn't count as an operating expense, I guess, is where many new investors make critical mistakes. So the biggest exclusion, of course, is debt service. Your mortgage payments are financing costs, not an operating cost. NOI is calculated before debt service, so including it artificially lowers your apparent profitability. CapEx, or capital expenditures, are also excluded because they're a one-time major improvement. Maybe it's a new roof or a new gate or a new, you know, you paved the driveway. These are not recurring operational costs, even though you have to budget for them separately. They don't, they don't factor into the actual daily operation of the facility. And then there's depreciation, which is purely an accounting entry for tax purposes. It's not a cash leaving. It's not an expense of cash leaving your actual bank account. Same with owner distributions. Unless you're actively paying yourself as the manager and that's how you're making the distribution, then that's not an operating expense. That's profit. So keeping these items separate to ensure you are calculating a true and accurate net operating income is, is very important. All right, let's talk about why sellers often try to blur these lines and hide these expenses. You sometimes find sellers hiding expenses for one simple reason: lower expenses means a higher NOI, which translates directly to a higher asking price and valuation. So this is core motivation behind the, the, you know, I've seen the 28-30% expense trap one we often see in offering memorandums. By presenting artificially low expenses, they inflate the property's value based on the capitalization rate. Common tactics is simply missing line items, like not including a realistic budget for repairs and marketing, or, uh, they might also underreport costs showing a low utility bill because they haven't been running the, the lights or AC properly. You have to scrutinize every expense and compare it to industry averages and your own pro forma. Never take the seller's expense report at face value. Always verify and normalize the numbers. This is why due diligence is so critical. If you're verifying the true cost of operating the business, then you'll get it right. If you just take their numbers, the seller's numbers, you could be in for a world of hurt. All right, let's take a look at the specific example of this tactic, the infamous 28% expense trap. So classic move where a seller presents a wildly low expense ratio to inflate the net operating income. They'll claim expenses are only 28% of revenue. Makes the deal look much more profitable on paper, but maybe they conveniently left out some or all of the big 3, like property taxes, insurance, and professional management costs. When you plug in those actual numbers for those missing items, that 28% expense ratio skyrockets. In this example, the actual operating expenses jumped to 52%. And that difference completely changes the valuation and the cash flow of the property. So never trust a low expense ratio without digging into the details yourself. So how do we avoid this trap and verify the true cost of the operating facility? Well, key to due diligence is verifying every single number the seller gives you. So you need to ask for the trailing 12, which The T12, which is the trailing 12 months report showing the last year of income and expenses. Don't just accept the seller's P&L statement. You have to make sure it matches their tax returns. If the numbers don't align, you know the seller's using 2 different sets of books, and that's a massive, massive, massive red flag. Always ask for receipts for any major expenses, especially repairs, utilities, CapEx. This helps you catch any one-time costs that the seller might try to hide or misrepresent as well. And then finally, compare the reported expenses to industry benchmarks, which typically fall between that 35% and 45%. If the seller's number is outside the range, you need to know exactly why. But what if the expenses are legitimately below that 40% benchmark? Well, a low expense ratio can be a good thing, but it's often a sign of a hidden problem you need to uncover. If the expenses are below 40%, you need to ask if the facility is brand new and hasn't had any major repairs yet. A new facility won't have the deferred maintenance costs that you'll eventually face. Another common reason is the current owner self-manages the property, saving on management fees. But remember, you're an investor, not a property manager, so you need to factor in professional management costs. Low property taxes can also artificially depress the expense ratio, but be careful. If the property's selling for a much higher price, a tax reassessment is coming. It might already be automatic, and your taxes will jump significantly. You must underwrite the deal using the pro forma expenses you will actually incur, not the seller's historical numbers. All right, let's look at how the 40% rule helps us quickly reevaluate a deal. So the 40% rule is your quick and dirty sanity check to see if a deal is worth pursuing. So let's take this scenario with $100,000 in gross revenue, which is a nice round number for Easy math. The seller claims a 28% expense ratio, which leaves a very attractive $72,000 in net operating income. Well, that high NOI leads to a high valuation, which is exactly what the seller wants. Now, if you apply the 40% rule, just assume 40% of the gross revenue will go towards operating expenses. That instantly drops your net operating income down to $60,000. This conservative estimate gives you a realistic baseline for what that property will actually generate under professional management. If the deal still makes sense at the 40% NOI, meaning the seller's asking price, you got a strong potential investment. This rule protects you from overpaying based on the seller's manipulated expense fixture figures. All right. And if you just apply a simple 10 cap to those 2 numbers in the seller's 28% expense ratio example, that's $72,000 at a 10 cap would lead to a $720,000 purchase price. Whereas using the 40% rule, it would look more like a $600,000 purchase price. So you can see that just that difference there is pretty huge. So if you can negotiate the— if you can help the seller understand that you would be operating at more like a 40% expense ratio and you can negotiate it down to $600,000, then that deal might work. All right, we've covered a lot of ground here on expenses and how they tie into Our NOI and valuation. So let's wrap up with a final request because up next is day 57, and we're going to do— to dive deep into deal breakers that should make you walk away immediately. So if you found this information on the 40% rule and expense verification helpful, please hit that like button. Subscribe to the Storage Moguls Mastermind channel so you don't miss any of the remaining days in the Storage 100 series. We are, of course, committed to giving you the tools to underwrite the deals like a professional. And lastly, share this video with someone who's currently looking at a self-storage deal with suspiciously low expenses. They'll thank you later.