If you’re investing in a business, there are few factors more important than the operating margin. It’s a huge part of deciding whether a company is running efficiently and whether it’s worth investing in them. In terms of real estate, operating margin is important because it tells you how much you can expect to earn from a property each month.
But what is operating margin, exactly? In this guide, we’ll explore what it is, the difference between gross margin vs. operating margin, and the basic operating margin formula used to calculate it.
What Is Operating Margin?
An operating margin, sometimes called an operating profit margin, or return on sales (ROS), measures how efficiently a business is in turning sales into profits. In a nutshell, the operating margin is the income minus the expenses. This isn’t the same as profit, since some non-operating expenses, such as interest payments, don’t count as operating costs. Still, the operating margin is a prime example of a company’s health. The larger the margin and the more consistent it is, the easier it is to obtain loans.
Another important thing to remember is that some revenues don’t count as operating revenues. For example, Berkshire-Hathaway is a holding company that owns shares in other companies. Berkshire-Hathaway has zero operating revenue but earns money from investments instead. But companies like this are an outlier; outside the financial industry, most businesses earn the bulk of their income from their core business operations.
Gross Margin vs. Operating Margin
Gross margin and operating margin have a lot in common. Both numbers measure a company’s efficiency. Both numbers are better the higher they are. And you can compare both between similar businesses, but not between businesses in different industries. That said, there are important differences between gross margin vs. operating margin that are worth remembering.
To begin with, operating costs are the easiest costs to control. It’s easier to adjust staffing, for example, than it is to change the cost of production in a factory. On the other hand, many of the expenses in a company’s gross margin are difficult or impossible to control. If you can’t control a given expense, like your raw materials, how is that number even relevant to how well your company is being run? Because of this, the operating margin is usually a better gauge of upper management.
For that reason, operating margin is the criteria more commonly used by investors. If you’re looking at two similar companies, and one has a much higher operating margin, chances are good that it’s the better-run company. All other things being equal, it’s going to be more successful. That said, gross margin has its place. In manufacturing in particular, it’s a good measure of how well a company is managing its raw materials.
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How to Calculate Operating Income to Identify Operating Margin
Figuring out a company’s operating margin is fairly straightforward – you need to know their net income, net expenses, and how the money is being earned or spent. From there, you need to figure out the operating income. Here’s how to calculate operating margin once you know those numbers.
Calculate Total Revenue: This is all money earned from a business, but not from investments. For example, an apartment complex might charge rent, parking fees, and additional fees for pets. The sum of all these earnings would be the total revenue.
Calculate Operating Expenses: This is all of the expenses incurred in running the business. For an apartment complex, this would include maintenance, property taxes, marketing, insurance, and management fees. Add that all up, and you have the operating expenses.
Subtract Expenses from Total Revenue: Now, subtract your expenses from the revenue. What you have left is the operating income. Now, all you need to do is calculate your operating margin.
Operating Margin Formula & Example
To find the operating margin, you simply divide the operating income by the total revenue, like so:
Operating Margin = Operating Income/Total Revenue
For example, you own an apartment complex that earns $100,000 per month in total revenue, with $40,000 per month in expenses and an operating income of $60,000. You would divide $60,000 by $100,000 and get a result of 0.6. Based on that information, a potential investor would know that the operating margin is 60%. In other words, for every dollar you spend running the property, you earn $0.60.
Importance of Understanding Operating Margins
There are many benefits to understanding how operating margins work. By knowing how to calculate them, you can identify underperforming properties, which represent an opportunity for investment.
What Operating Margins Can Indicate
Operating margins can help you determine several things about a given property or business. Here are a few things a savvy investor can identify just by knowing a property’s operating margins:
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Durability: The higher the operating margin, the better the property is set up to withstand downturns in the real estate market.
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Investability: A higher operating margin makes it easier to get loans and attract other investors.
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Sufficiency: A higher margin demonstrates that the property earns enough to cover its own expenses.
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Context: By looking at operating margins over several years, you can see if there’s an upward or downward trend in performance.
Limitations of Operating Margins
We’ve talked a lot about all the things an operating margin is good for. But what isn’t it good for? To begin with, operating margins are only useful for comparing businesses of a similar size within a particular industry. For example, you wouldn’t compare a mom-and-pop hardware store with Amazon, nor would you compare a large, urban high-rise apartment building with a suburban, single-family rental home. The companies are wildly different, so there’s no apples-to-apples comparison.
Companies with different tax rates can also be difficult to compare – for example, buildings in the same general area but in a different tax district. For this reason, many analysts will ignore taxes to compare the two businesses. They do this by eliminating the effects of earnings before interest, taxes, depreciation, and amortization (EBITDA). EBITDA can also be used as a proxy for cash flow, although it has some significant drawbacks.
How to Improve a Property’s Operating Profit Margins
So, how do you improve the operating profit margins on a given property? Here are a few tried and true methods.
Calculate the Property’s Cap Rate
The capitalization rate, or “cap” rate, is the ratio of a property’s operating income to its value. To determine this, first calculate the net operating income as described above: subtract the operating expenses from the income. Then, divide the property’s current market value by the operating income.
In our example above, the apartment complex earned $60,000 per year in income. Let’s say that property is worth $1 million. In that case, we would divide $60,000/$1,000,000 = 0.06. This equates to a cap rate of 6%. Knowing the cap rate gives you a good idea of how long a prospective investment will take to pay for itself. For example, with a cap rate of 10%, the property will take about ten years to earn back what you invested in it.
Remember that a higher cap rate doesn’t always mean a property will be a better investment. Often, older properties will have a very high cap rate but will require major renovations in the near future. This means you’ll soon need to invest a lot of money in your property – unless you want tenants to start moving out.
Pay Attention to Taxes
For many property owners, property taxes are the number one expense. Add in income tax, payroll tax, and other miscellaneous taxes, and taxes are a major factor on your business ledger. And the more you’re paying, the more your taxes will impact your operating margin.
A good accountant is worth their weight in gold and can give you all kinds of advice to lower your tax bill. For example, if you structure your business as an LLC, they qualify as a pass-through organization for tax purposes. This means the tax rate is lower, and you can deduct 20% of your business income right off the bat. If you’re neglecting your taxes, you’re leaving money on the table.
Optimize Operations with Excellent Property Management
The primary way to improve a property’s operating margin is to invest in better management. For example, take a look at your maintenance and groundskeeping. Are the units in good condition? Is the property clean and well-landscaped? If not, you’re not able to command as much rent as you’d otherwise be able to. You might have to spend some money up front to bring the property up to standard, but that investment can pay off in spades. Along the same lines, do you have a lot of empty units? In that case, some local advertising may help. Even the best apartments won’t rent if nobody knows they exist.
One way to do this is to contract with a property management company. These companies are particularly helpful if you own a lot of out-of-state properties. If you can’t be there yourself, the next best thing is to have someone you trust on site. Another advantage of a property management company is that you don’t have to be a full-time landlord. You don’t even have to know anything about being a landlord. All you need is the savviness to make the right investments.
Manage Personal Expenses Carefully
One last thing to remember in any line of business is to be careful about personal expenses. This is particularly true when you run your own business and have control of the purse strings. Yes, you’re a real estate investor; you’ve made it, you’re a high roller. But it’s a lot easier to spend money than it is to earn it, and a lot of people fall into the trap of tapping their business for personal expenses. It can be tempting to fund your new in-ground pool by mortgaging a rental property, or buy a fancy car and write it off as a business expense. But these kinds of decisions can quickly ruin your business.
There’s a time and a place for personal expenses. If you’re going to a real estate conference, by all means, bill your room and your rental car to the company. But if you’re taking your family to Disney World, use your personal credit card instead.
Summary
Clearly, operating margin is an important number for any real estate investor, and indeed for business investors in general. By knowing how to calculate and interpret it, you can gain insight into a property’s durability, investability, sufficiency, and performance.
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