Operating Expenses in CRE: Control Costs & Boost NOI
Key Takeaways
- Operating expenses directly reduce your net operating income (NOI).
- Lease structure determines who pays operating expenses: triple net (NNN) leases transfer most costs to tenants, modified gross leases split expenses between landlord and tenant, and full-service leases place all OpEx on the landlord.
- Operating expenses are fully tax-deductible in the year you incur them, but misclassifying capital expenditures as OpEx inflates your NOI and can trigger IRS audit issues.
- Systematic OpEx reduction strategies can significantly improve property cash flow without sacrificing quality or tenant satisfaction.
What Are Operating Expenses in Commercial Real Estate?
Operating expenses are the recurring costs required to keep a commercial property functional and generate rental income.
Operating expenses (OpEx) are the day-to-day costs necessary to keep your asset running smoothly. Common OpEx include:
- Property management fees
- Repairs and routine maintenance
- Utilities
- Insurance
- Property taxes
- Administrative expenses
- Janitorial services
- Security
Understanding and keeping your OpEx costs under control maximizes your property value and boosts your operating cash flow. Mismanagement, on the other hand, can erode your investment returns month after month.
How do operating expenses impact NOI and property value?
Net operating income (NOI) is calculated by subtracting OpEx from your gross operating income, which means that operating expenses directly reduce your NOI. This matters because buyers and appraisers use NOI to help determine property value through cap rate.
For example, if you were to buy an office building that generates $500,000 in rental income and has $200,000 in operating expenses, your NOI is $300,000. At a 6% cap rate, your property value is $5 million. But if you add just $30,000 in OpEx, your property value drops by $500,000.
Property A: $500K income - $200K OpEx = $300K NOI ÷ 6% cap rate = $5M value
Property B: $500K income - $230K OpEx = $270K NOI ÷ 6% cap rate = $4.5M value
This is why controlling operating expenses is crucial to maximizing the value of your asset. Every dollar you cut from OpEx can have an outsized impact on your property value.
How does lease structure affect operating expenses?
Who pays operating expenses depends entirely on your lease structure. In triple net (NNN) leases, tenants pay property taxes, insurance, and maintenance on top of base rent. A triple net lease minimizes your expense exposure but typically commands lower base rents. Retail properties and single-tenant industrial buildings commonly use NNN leases.
A modified gross lease splits operating expenses between landlord and tenant. You might cover property taxes and insurance while tenants pay their proportionate share of utilities and common area maintenance (CAM) charges. CAM fees cover shared space costs like landscaping, common area utilities, or seasonal maintenance such as snow removal. Office buildings frequently use this structure.
Some gross leases include expense caps that limit annual increases to a fixed percentage. Expense caps protect tenants from volatile cost spikes but expose you to absorbing costs above the cap. Poorly structured escalations can erode your returns over time, however, so review expense escalation clauses carefully during lease negotiations.
With a full-service or gross lease you cover all operating expenses. You build these costs into higher rental rates, but you also absorb all expense volatility. If property taxes jump 15% or utility costs spike, you cannot pass those increases to tenants until lease renewal. Multifamily properties typically operate under gross lease structures.
| Lease Type | Triple Net (NNN) | Modified Gross | Full-Service (Gross) |
|---|---|---|---|
| Who Pays OpEx | Tenant pays taxes, insurance, maintenance | Split: Landlord covers base year amount, tenant pays increases above baseline | Landlord covers all operating expenses |
| Landlord Exposure | Minimal | Moderate | High |
| Base Rent | Lower | Mid-range | Higher |
| Typical Property Types | Retail, single-tenant industrial | Office buildings | Multifamily |
| Key Consideration | Requires detailed expense reconciliation | Base year calculations and expense caps are critical | Cannot pass cost increases to tenants until renewal |
How do operating expenses vary by property type?
The type of commercial property you invest in will have a significant impact on your OpEx ratios. Some of the common OpEx characteristics and cost drivers by property type include:
| Property Type | OpEx Characteristics | Key Cost Drivers |
|---|---|---|
| Industrial | Lowest operating costs per square foot | Minimal common areas, tenant-paid utilities, simple building systems |
| Retail | Moderate operating costs, highly variable by format | CAM expenses, parking lot maintenance, common area utilities |
| Office | Higher operating costs per square foot | HVAC, janitorial, common area amenities, Class A properties highest |
| Multifamily | Measured as percentage of effective gross income | Turnover costs, utilities, amenity maintenance, property management |
Building age matters significantly. A 40-year-old property will carry higher maintenance and utility costs than a five-year-old building with modern HVAC systems and energy-efficient design. Geographic location affects property taxes, insurance rates (especially in coastal flood zones), and seasonal maintenance costs.
These benchmarks help you identify whether a property's operating expenses are reasonable or inflated. When an aging property posts OpEx in line with a new building, treat it as a warning. Investigate whether maintenance has been deferred or expenses understated.
Misclassifying capital improvements as operating expenses inflates reported NOI. This distortion misleads buyers during property sales and creates audit risk with lenders and tax authorities.
What's the Difference Between OpEx and CapEx?
Operating expenses maintain current condition. Capital expenditures improve or extend asset life.
Misclassifying CapEx as OpEx makes your NOI look higher than it actually is, which can mislead buyers about your property's true value and can trigger audit issues. The distinction between CapEx and OpEx comes down to three tests:
- Does it add significant value?
- Does it extend the property's useful life beyond one year?
- Does it adapt the property to a new use?
If the answer to those questions is yes, the expense is CapEx. If the change simply maintains current operations, it's OpEx.
Patching a roof leak is OpEx. Full roof replacement is CapEx. Repainting a unit between tenants is OpEx. Gut renovations that reconfigure floor plans are CapEx. Replacing a broken door handle is OpEx. Upgrading every door in the building with a smart lock is CapEx.
Understanding how to capitalize an expense impacts your tax treatment, NOI calculations, and how lenders evaluate your property. Misclassifying expenses distorts your financial performance and can trigger audit risk.
Effective CapEx planning helps you budget for major improvements while keeping your operating expenses under control.
What Are Fixed vs. Variable Operating Costs?
Fixed costs remain constant regardless of occupancy. Variable costs fluctuate with usage and tenant activity.
Fixed operating costs stay the same no matter the occupancy rate of your property. Property taxes, insurance premiums, and base service contracts cost the same whether your building is empty or fully leased.
Variable operating expenses change based on occupancy rates, seasonal factors, and usage intensity. Utilities, janitorial services tied to occupied square footage, and CAM charges all fluctuate with tenant activity and season.
This chart outlines some common fixed and variable operating expenses:
| Fixed Operating Expenses | Variable Operating Expenses |
|---|---|
| Property taxes | Utilities (electricity, water, gas) |
| Insurance premiums | Janitorial services |
| Base management fees | Seasonal maintenance |
| Long-term service contracts | Turnover costs |
Control variable expense volatility through strategic structuring.
Variable expenses can spike at certain points throughout the year. Think snow removal during winter or air conditioning costs during the summer. Protect yourself by negotiating fixed-price service contracts where possible, passing variable costs through to tenants via CAM reconciliation, and implementing energy efficiency measures that reduce utility fluctuations.
Higher occupancy also spreads fixed costs across more tenants, which improves your occupancy cost per square foot and overall property performance.
How Do Operating Expenses Affect Taxes?
Operating expenses are fully deductible in the year you incur them, providing immediate tax benefits.
Unlike capital expenditures (CapEx), which must be depreciated over time, OpEx reduces your taxable income in the same year you pay them. If you were to buy a multifamily property and spend $100,000 on operating expenses and you're in the 35% tax bracket, you save $35,000 in taxes that year.
To qualify as deductible operating expenses, costs must meet two requirements: they must be ordinary (common and accepted in your industry) and necessary (helpful and appropriate for your business).
Avoid common tax deduction mistakes.
The most expensive mistake investors make is misclassifying capital improvements as operating expenses. Replacing an entire HVAC system is a capital expenditure that could be eligible for real estate bonus depreciation or qualified improvement property treatment. HVAC filter replacements, refrigerant recharges, and minor repairs, however, are operating expenses.
Capital improvements extend the useful life of your property or add significant value. Operating expenses maintain the property's current condition. When in doubt, consult your CPA before categorizing borderline expenses.
How Do You Benchmark Your Operating Expenses?
Benchmarks differ by property type, class, and age.
Operating expense ratios measure what percentage of your gross income goes toward OpEx. But, without benchmarking, you have no way to know if you're overpaying for operating expenses while your competitors operate more efficiently.
Some local chapters of CRE groups, such as the Building Owners and Managers Association (BOMA), publish regional operating expense reports with market-specific data. Contact your local chapter or other CRE association for benchmarking data, then focus on identifying expense categories where your property deviates significantly from the market norm.
Industrial properties typically show the lowest ratios thanks to minimal common areas and tenant-paid utilities. Retail and office properties fall in the middle range, but will vary significantly based on lease structure. NNN lease properties minimize landlord OpEx exposure, since tenants cover most costs directly.
Property class and age also matter. Class A office buildings will have higher operating expenses due to premium services and amenities. Older buildings face higher maintenance and utility costs than newer, energy-efficient properties.
Seasonal variations affect budgeting accuracy. Properties in cold climates see winter spikes in heating and snow removal costs. Coastal properties face higher insurance premiums and seasonal storm preparation expenses.
Compare your property against similar assets in your market using the same building class, age, and lease structure to identify whether your operating expenses are reasonable or inflated.
Commercial Real Estate Properties For Sale
How Can You Reduce Operating Expenses Without Sacrificing Property Quality?
Audit expenses systematically to identify waste and inefficiencies.
Start by reviewing 24 months of OpEx statements line by line, then identify whether any costs are increasing without corresponding occupancy changes. Those trends can signal opportunities to increase efficiency and bring down OpEx.
Focus on largest expense categories first. A 10% reduction in your top three expense categories delivers more savings than eliminating five smaller line items.
Negotiate better vendor contracts and service agreements.
Rebid major service contracts such as landscaping, janitorial, security, and maintenance every two to three years. Vendors are more likely to compete aggressively for multi-year contracts, and competitive bidding can significantly reduce costs without sacrificing service quality.
When possible, structure contracts with performance incentives. For example, tie management fees to occupancy or tenant turnover targets, or link HVAC maintenance contracts to energy consumption reductions. This way your vendors' interests are aligned with your bottom line.
Optimize operational practices to control variable costs.
Implement preventative maintenance schedules to catch small problems before they become expensive emergency repairs. A $200 HVAC filter replacement that prevents a $5,000 compressor failure is easy and delivers 25:1 ROI.
Adjust operational schedules to match actual usage. If no one is in your office building on weekends, reduce HVAC usage to avoid cooling or heating empty space. You can also coordinate janitorial services to minimize overtime charges. These operational tweaks require no capital investment but deliver immediate savings.
Frequently Asked Questions
What are the most effective strategies for reducing operating expenses without negatively impacting property value or tenant satisfaction?
Reduce operating costs by tightening operations rather than cutting service quality. Schedule preventative maintenance to avoid expensive failures, rebid cleaning, landscaping, and security contracts every few years to keep pricing competitive, audit utilities for errors, and limit HVAC use during vacant hours. Consolidate vendors to capture scale discounts and review insurance coverage annually to confirm rates and limits still fit the asset. Executed consistently, these steps lower expenses while protecting property performance and tenant satisfaction.
How do different lease structures affect the allocation of operating expenses between landlords and tenants in commercial real estate?
Triple Net (NNN) leases transfer most operating expenses (taxes, insurance, maintenance) to tenants, minimizing landlord expense exposure but typically commanding lower base rents. Modified Gross leases have tenants paying base rent plus their proportionate share of expense increases over a base year, creating shared responsibility. Full-Service (Gross) leases have landlords covering operating expenses, which are built into higher rental rates but expose landlords to expense volatility. The optimal structure depends on market conditions, property type, and investor risk tolerance.
What operating expense benchmarks should you use to evaluate if a commercial property is performing efficiently compared to similar properties?
Calculate your operating expense ratio (total OpEx divided by gross income) and compare it against similar properties in your market with the same lease structure, building class, and age. Local BOMA chapters publish regional operating expense reports with market-specific data. Focus on expense categories where you significantly deviate from market norms; these are your best opportunities for cost reduction.
