Rent gets the attention. Expenses decide the outcome.
A seller’s pro forma will almost always show an expense line that is achievable in theory and optimistic in practice. Rebuilding that number from the ground up is the single most useful thing an investor can do before committing capital, because at a 5% cap rate every $10,000 of understated annual expense overstates the property’s value by roughly $200,000.
Start With the Trailing Twelve, Not the Pro Forma
Ask for the trailing twelve months of actual operating statements, ideally alongside the two prior calendar years. The pro forma describes what the seller believes the property could do. The T-12 describes what it did. Where the two diverge, the burden is on the seller to explain why.
Read the T-12 month by month rather than as an annual total. Annualised figures hide the pattern that matters — a repair line that is flat for eleven months and then spikes in month twelve usually indicates a deferred item that was finally addressed, and it tells you something the summary does not.
The Lines Most Often Understated
Property taxes. The most common and most expensive error in California underwriting. Under Proposition 13, the assessed value resets on sale — so the seller’s current tax bill, often based on a decades-old basis, tells you almost nothing about what you will pay. Model taxes on your purchase price at the local rate, not on the seller’s historical figure. On a long-held building this single correction can move NOI by tens of thousands of dollars a year.
Insurance. California premiums have moved sharply, and a policy written three years ago is not a guide to what you will be quoted. Get an actual quote during due diligence rather than escalating the seller’s number by an assumed percentage. For properties in or near wildfire-exposed areas, confirm availability before assuming price.
Management. If the seller self-manages, the operating statement may show no management fee at all. That is not a saving you inherit unless you intend to self-manage too. Add a market fee — commonly 8-10% of collected income on smaller multifamily — even if you plan to manage it yourself, so the asset is judged on its own economics.
Repairs, maintenance, and reserves. Owners nearing a sale rarely spend on the building. A suppressed repair line in the final year of ownership is a signal, not a saving. Underwrite a normalised figure and add a separate per-unit annual reserve for capital items; treating capital replacement as if it were an occasional surprise is how buyers end up funding a roof out of distributions.
Payroll. On-site staff, even part-time, carries more than wages — payroll taxes, workers’ compensation, and any unit provided rent-free all belong in the expense line.
Where the Utility Structure Changes the Answer
Establish early whether the building is master-metered or separately metered, and which utilities the owner pays. Older Southern California buildings are frequently master-metered for water and sometimes gas, which places the full cost and all future rate increases on the owner.
This is worth quantifying rather than noting. A master-metered building carrying $700 a month in owner-paid water is absorbing $8,400 a year that a separately metered comparable is not — meaningful money against the NOI of a small property. Sub-metering or a ratio utility billing arrangement can recover part of it, subject to local rules, but both take time and capital, so treat the recovery as a project rather than an assumption.
A Worked Example
Consider a 12-unit building where the seller presents $58,000 of annual operating expenses against $180,000 of effective gross income — a 32% expense ratio, which looks efficient.
Rebuilt: property taxes reassessed at the purchase price add $14,000. A current insurance quote adds $4,000. A market management fee the seller never paid adds $16,000. Normalised repairs and a $300 per-unit reserve add $9,000. The expense line becomes roughly $101,000, and the ratio moves from 32% to 56%.
NOI falls from $122,000 to about $79,000. At a 5% cap rate, that is the difference between a $2.44M valuation and a $1.58M one. The building did not change; the arithmetic did. This is illustrative rather than a rule of thumb — the point is the method, not the percentages.
Expense Ratios Are a Sense-Check, Not a Conclusion
A ratio that lands far below comparable buildings in the same submarket is a prompt to find the missing line item, not evidence of efficient operation. Age, construction type, utility structure, and whether taxes have reset all move the number legitimately. Use the ratio to decide where to look, then verify the underlying lines individually.
Questions Investors Ask About Operating Expenses
Why does the seller’s tax figure not carry over?
Because Proposition 13 ties the assessment to the last change in ownership. A building held for thirty years may be assessed at a fraction of its market value, and that assessment resets when you buy. Underwriting on the seller’s tax bill is the most reliable way to overpay for a long-held California property.
Should I include a management fee if I plan to self-manage?
Yes. Self-management substitutes your labour for a cost; it does not remove the cost from the asset. Including a market fee keeps the valuation honest, and it means the numbers still work on the day you decide to hand the property to a manager.
How much should I reserve for capital items?
It depends on the age and condition of the building rather than a fixed formula. The more useful approach is to price the actual remaining life of the roof, electrical panels, plumbing lines, and heating from the inspection report, then set the annual reserve against that schedule. A licensed contractor walking the property will give you a better number than any rule of thumb.
What if the seller will not provide a full trailing twelve?
Treat it as information in itself. Incomplete records may reflect informal bookkeeping rather than concealment, but either way you are underwriting without verification and should widen your expense assumptions accordingly. Bank statements, tax filings, and the utility provider’s own billing history can partially substitute.
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This content is for informational purposes only and does not constitute investment, legal, or tax advice. Real estate transactions and private placements involve significant risk, including potential loss of principal. Always consult qualified legal, financial, and tax professionals before making investment decisions.
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- How to Review a Multifamily Rent Roll
- Multifamily Capital-Expenditure Due Diligence
- How to Value an Apartment Building in Southern California
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