What are the most important expenses to include in a commercial property budget?

1 Operating expenses

Operating expenses are the costs of running and maintaining the property, such as utilities, repairs, maintenance, insurance, property taxes, and management fees. These expenses are usually paid by the owner, but some may be passed on to the tenants through leases or service charges. Operating expenses affect your net operating income (NOI), which is the difference between your rental income and your operating expenses. NOI is a key indicator of your property's profitability and value, so you should aim to keep your operating expenses as low as possible without compromising the quality and safety of your property.

2 Capital expenditures

Capital expenditures (CapEx) are the costs of improving or replacing major components of the property, such as roofs, elevators, HVAC systems, or parking lots. These expenses are usually not recurring, but they can have a significant impact on your cash flow and property value. CapEx can enhance the functionality, appearance, and marketability of your property, as well as extend its useful life and reduce future maintenance costs. However, CapEx also requires a large upfront investment, which may reduce your cash-on-cash return (CoC), which is the ratio of your annual cash flow to your initial equity investment. Therefore, you should plan your CapEx carefully, and allocate sufficient reserves for them in your budget.

3 Debt service

Debt service is the amount of money you need to pay back your mortgage or other loans that you used to finance your property acquisition or improvement. Debt service consists of principal and interest payments, which are usually fixed and predictable. Debt service affects your cash flow available for distribution (CFAD), which is the amount of money left after paying your operating expenses, CapEx, and debt service. CFAD is the money that you can use to pay yourself or your investors, or to reinvest in your property or other opportunities. Debt service also affects your debt service coverage ratio (DSCR), which is the ratio of your NOI to your debt service. DSCR measures your ability to repay your debt obligations, and lenders usually require a minimum DSCR of 1.2 or higher to approve or refinance your loan.

4 Vacancy and credit losses

Vacancy and credit losses are the amounts of money that you lose due to vacant units or non-paying tenants in your property. Vacancy and credit losses reduce your gross potential income (GPI), which is the amount of money that you could earn if your property was fully occupied and all tenants paid their rent on time. Vacancy and credit losses depend on the market demand, the quality and location of your property, the type and terms of your leases, and your tenant screening and retention strategies. Vacancy and credit losses affect your effective gross income (EGI), which is the amount of money that you actually earn from your property after deducting vacancy and credit losses from your GPI. EGI is the basis for calculating your NOI and your property value, so you should aim to minimize your vacancy and credit losses as much as possible.