Confused by the terms “operating expense” and “finance expense”?

It can sound complicated. I know, because I get this exact question all the time when I’m talking to people at my Cashflow game events and when meeting with potential investors.

Let me remove the complication.

Just like the name indicates, an “operating expense” is any cost involved in running the day-to-day operations of your property. Just like any business, there are costs involved to keep things running smoothly. Remember, as a real estate entrepreneur who invests in properties for profit you are running a business.  Unless you want to run into financial difficulties, you’ll want to have all your line items in place on your income statement.  – Tweet  

I’ll get to that in a minute.

A “finance expense” on the other hand has more to do with the debt side of the equation. If you want to buy more properties you will incur more debt. That’s a given. Whether you take out a traditional loan from a bank and have to make mortgage payments every month or you raise money from private investors and will make payments to them then that is debt you are leveraging to move further toward your goals.

I explain things quickly in this short video:

 

Let’s dive deeper into operating expenses

So, what are the operating expenses you need to calculate into your expense spreadsheet every month? These are referred to as line items in your profit & loss statement or income statement. Operating expenses include:

Insurance

You absolutely need insurance to protect yourself against anything that could possibly happen on your properties. You will need to insure each property separately. Of course, there are different types of insurance and it’s best to speak with your friendly insurance professional to get the best type and rate for your needs. Even during the rehab process you should have a special type of insurance in place, because you never know what can happen.

For example, a good friend who is also a real estate investor was rehabbing a property. Fortunately for him he had the right insurance to cover that property at that stage, because his property was broken into and vandalized during the rehab. Because he had insurance he actually walked out ahead of his costs on that one! He finished the rehab and rented out the property. No harm; no foul!

As you can see, all the way through the process, it’s best to have insurance in place.  It is an operating expense. Whether you use it or not, get insurance! Then you and your business is covered.  – Tweet  

Maintenance and repairs

As a real estate entrepreneur who buys properties, let me tell you that you can expect to have maintenance and repair costs. Sometimes they are pretty big, too. (That’s why you want to put money aside every month in a reserve account… also known as “reserves.”) Expect the unexpected. Be prepared. If the roof leaks, fix it. That’s an operating expense. If a tenant damages your property and refuses to pay for it, that becomes a matter for the courts, but in the meantime you will pay to have repairs done. That’s an operating expense. If a pipe ruptures or your property has sewage issues, that’s a costly repair, but you have to do it if you intend to continue operating your business. Ask me about pipe problems. I could write a short book on the subject!

Taxes

You might think this would fall on the side of finance expenses, but you’d be wrong. Taxes are indeed an operating expense, because to continue operating your business requires you to pay taxes. I’m not a tax professional, so if you have questions about taxes, seek out the appropriate professional.

Travel and related

For me, this is a big expense a couple of times a year. Because I am a long-distance investor who lives and works in Barcelona while investing in properties in the U.S. that means I have travel expenses. If I have to stay at a hotel or short-term rental while I’m walking properties to buy or handling things at my existing properties, guess what? That is an operating expense, meals included. Again, this is something about which you should consult your tax professional. In the meantime, save all your receipts and categorize them as travel-related expenses. Be honest. It has to be related to your business!

Professional and legal

There are expenses that you will need to keep your business on track and moving forward the right way. Any professionals you have to hire to help you operate your business, including your tax professional, attorneys and related legal professionals, and other human beings that require a professional certification to do what they do. For me, that means having a legal team in Barcelona and one in the U.S. That way my transactions run smoothly. I talk about this in my eBook. If you haven’t downloaded it yet, go here:


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Employees

These people help you run the property, and without them you wouldn’t be able to do as well as you would when you have them in place.  – Tweet   For example, your property management team. For me, my property management people are the best! I love these people because they handle things for me in the U.S. while I am in Barcelona. You have to admit, if I didn’t have people to help me manage my properties, it would be an awfully long commute for me to do what they do myself! If you live in the area where your properties are located, you may want to start out managing things yourself. That way you can see what a pain it can be! Eventually you will want to put property management in place so your stress levels can decrease. After all, there’s a lot to manage in a property. For example, collecting rents and making sure units are ready for new tenants, alerting the team that there is a repair or maintenance task that needs to be done, advertising open units, etc. That stuff can steal your sleep. Why not let an experienced property manager take these tasks off your plate? Paying that person becomes an operating expense, so it is tax-deductible. (Again, consult your tax professional.)

But what about finance expenses?

Simply, the biggest finance expense (also called “financial expenses”) is your debt service (a.k.a., mortgage). You will find this line item under the Net Operating Income.

If you have payments to investor backers in your property, that is a finance expense. You will either pay your investors monthly or quarterly over a term of a few years. All of this depends on your agreement with them. If you want to learn more about negotiating terms, click this link:

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In short, when paying a loan related to your properties, whether that’s mortgage or private lender, you are leveraging that debt to secure more properties. What I mean by that is that maybe you will take out a bank loan to buy your first rental property. Great! As you pay down that loan you are also earning cashflow month after month after month. If you put that money to the side, you are saving toward buying your next property.

If you secure private money, the same rule applies. Except in this case, you don’t have to wait to buy another property. You can find other private investors to back property after property. Besides, the bank will only give you so many loans. At about the third bank loan you can begin to look like a big risk to them. That’s because traditional bankers look at things traditionally. Maybe no one taught them about creative acquisition strategies or the benefits of private lending.

Well, I hope this article helps you understand the differences between operating expenses and finance expenses. Here is where I would normally leave you with a question, but I’ll give you a pass this time.

If you still have questions, I’d be happy to go further with you in this topic. I’m just a phone call away!

Schedule your time with me here:

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You can also check out my latest podcasts and collaborations here keeponcashflow.com/podcasts/