Expense Growth Assumptions

Operating expenses grow faster than nominal inflation, driven by property taxes and insurance rising 4–5% annually while maintenance and utilities grow 2–3%. A 3% overall operating expense growth assumption is too low; 4–5% is more realistic.

Key takeaways

• Property tax growth: 3–5% annually (varies by jurisdiction, but rarely stays flat)
• Insurance growth: 4–7% annually (driven by claims inflation, natural disaster risk repricing)
• Maintenance and repairs: 2–4% annually, with lumpy capital needs (roof, parking lot) every 5–10 years
• Overall operating expense growth of 4–5% is conservative and realistic for a ten-year pro forma
• Underestimating expense growth is the second-most-common underwriting error (after overestimating rent growth)

Why expenses grow faster than inflation

Operating expenses are labor-intensive and capital-intensive. Property tax bases grow with property values and assessment cycles. Insurance risk premiums rise faster than general inflation. Maintenance costs rise not only from inflation but from aging assets and deferred maintenance.

General inflation (CPI) averages 2.5–3% long-term. Operating expense growth typically runs 3.5–5%, creating a "squeeze" on net operating income if rents only grow 3%. Over ten years, this matters enormously.

Property tax growth (4% annually)

Property taxes are the largest single operating expense in most U.S. real estate markets. They have three components:

1. Assessment increase: As property values rise, assessed value rises. If a property appreciates 3% annually, assessment base grows 2–3%. Assessors lag market by 1–2 years, so assessment growth lags actual appreciation.

2. Tax rate increase: Many jurisdictions raise millage rates to fund schools, infrastructure. This is not automatic, but it happens in many high-growth metro areas every 3–5 years.

3. Expansion of tax base: New development, infill projects, and rezoning can cause reassessment.

Real-world example: a $1,000,000 property in a 1.2% tax rate jurisdiction (fairly high, typical of northern states) pays $12,000 annually. If the property appreciates 3% annually and tax rates stay flat, year-10 assessed value is ~$1,343,000, and year-10 property tax is $16,116. Annual growth: 3.7%.

But if the jurisdiction raises rates by 0.05% in year 5 (not uncommon), year-10 tax might be $17,500, or 4.5% annual growth.

In low-tax states (Texas, Florida, Nevada: 0.7–0.9% rates), property tax growth is slower but follows the same pattern. In high-tax states (New York, New Jersey, Illinois: 1.5–2.2% rates), property tax growth is faster in absolute dollars.

Assumption: 3.5–4% annual property tax growth is conservative.

Insurance growth (5–6% annually)

Insurance is the second-largest expense and has grown faster than general inflation for two decades. Several factors:

1. Claims inflation: Labor costs, materials, and replacement costs rise 4–5% annually.

2. Risk repricing: As natural disaster frequency increases (hurricanes, wildfires, hail) or as individual properties generate claims, insurers raise rates to offset expected losses.

3. Construction cost escalation: Building replacement cost indices rise 4–6% annually, directly driving property insurance premiums.

4. Deductible exhaustion: Properties with frequent small claims see rate increases at renewal.

Real-world example: a 100-unit apartment building in the Midwest might have $8,000 annual property insurance in 2020. By 2025, the same coverage is $10,500 (32% increase, or 5.7% CAGR). By 2030, it's $13,000 (another 4.8% CAGR).

Assumption: 5–6% annual insurance growth is realistic; 4% is slightly optimistic.

Maintenance and repairs (3–4% annually, with lumpy capital)

This is where many underwriters go wrong. They assume maintenance costs are a fixed percentage of income (say, 7% of gross receipts) and model that percentage flat. In reality, maintenance costs grow with the age of the building and with wage/material inflation.

Maintenance has two components:

1. Recurring maintenance: HVAC filters, landscaping, pest control, minor repairs. These grow 3–4% annually with wage inflation and material costs.

2. Capital improvements: Roof replacement (every 20–25 years), parking lot resealing (every 8–10 years), boiler/HVAC replacement (15–20 years), unit renovations, exterior paint. These are lumpy and large.

A ten-year pro forma should budget for at least one major capital project. A 50-unit apartment building typically has $500–1,000 per unit in capital reserves over ten years, or $25,000–50,000 total.

If you skip capital reserves in the pro forma, you're understating expense growth.

Assumption: 3–4% annual maintenance growth, plus $500–1,000 per unit in reserves.

Utilities (2–3% annually, owner-paid)

If the property owner pays utilities (common in older apartment buildings, less so in newer ones), budget 2–3% annual growth. Some of this is price inflation; some is usage increases as the building ages and systems become less efficient. Newer buildings with sub-metered or tenant-paid utilities have zero expense growth here.

Assumption: 2–3% if owner-paid, 0% if tenant-paid.

Management fees (3–5% annually)

Professional management companies charge 4–8% of gross collected income (GCI), and these fees grow with income. If rents grow 3%, management fees grow 3%. Some building managers raise rates independently (1–2% annually) on top of income-based growth.

Assumption: 3–4% annual management fee growth (captures both income growth and rate increases).

Combining all components: building the expense forecast

Here's the discipline:

1. Year 1: Break down expenses into components:

   • Property tax: $X
   • Insurance: $Y
   • Maintenance + capital reserves: $Z
   • Management: $W
   • Utilities (if owner-paid): $V
   • Other (landscaping, legal, HOA, etc.): $U
   • Total: $X + $Y + $Z + $W + $V + $U

2. Years 2–10: Apply component-specific growth rates:

   • Property tax: 4% annually
   • Insurance: 5% annually
   • Maintenance: 3% annually (plus lumpy capital in years 5 and 10)
   • Management: 3% annually (grows with income)
   • Utilities: 2% annually
   • Other: 3% annually

This is more accurate than applying a blanket 3% or 4% growth rate to all expenses. Some pieces grow 5–6% (insurance, property tax); others grow 2–3% (utilities, maintenance).

Real-world example: building a ten-year expense forecast

Year 1 expenses (100-unit multifamily):

• Property tax: $16,000 (at 1.6% of $1,000,000 assumed value)
• Insurance: $8,000
• Maintenance and reserves: $12,000
• Management (at 5% of $120,000 GCI): $6,000
• Utilities (owner-paid): $8,000
• Other (landscaping, legal): $4,000
• Total year 1: $54,000

Year 5 expenses:

• Property tax: $16,000 × (1.04^4) = $18,735
• Insurance: $8,000 × (1.05^4) = $9,730
• Maintenance: $12,000 × (1.03^4) = $13,497
• Management: $6,000 × (1.03^4) = $6,749 (or slightly more if income-based and rents grew 3%)
• Utilities: $8,000 × (1.02^4) = $8,659
• Other: $4,000 × (1.03^4) = $4,499
• Total year 5: $61,869

Year 10 expenses:

• Property tax: $16,000 × (1.04^9) = $22,822
• Insurance: $8,000 × (1.05^9) = $12,365
• Maintenance: $12,000 × (1.03^9) = $15,649 (plus $15,000 capital project in year 10)
• Management: $6,000 × (1.03^9) = $7,816 (or higher if income-based)
• Utilities: $8,000 × (1.02^9) = $9,517
• Other: $4,000 × (1.03^9) = $5,216
• Total year 10 recurring: $73,385 (plus $15,000 capital = $88,385)

The ten-year cumulative operating expense burden is roughly $650,000 (sum of years 1–9 recurring plus year 10). If you underestimated and used 3% flat growth, you might have forecasted $600,000, missing $50,000 in cumulative expenses. On a thin-margin deal, that's the difference between viability and negative cash flow in years 8–10.

Expense growth outpacing rent growth: the margin squeeze

Here's the dynamics:

• Year 1: Rents $120,000, Expenses $54,000, NOI $66,000 (55% margin)
• Year 5: Rents grow 3% to $139,000, Expenses grow 5% (blended rate from components) to $69,000, NOI $70,000 (50% margin)
• Year 10: Rents grow 3% to $161,000, Expenses grow 5% to $88,000, NOI $73,000 (45% margin)

NOI is growing (rents up 35% over ten years) but margin is shrinking (55% to 45%). This is normal, but many underwriters don't see it in the annual dollars and get surprised that "NOI growth is slowing" even though rents are growing.

The lesson: stress-test expense assumptions. If you assume 4% expense growth but the blended calculation shows 5%, you're overstating NOI by $20,000–30,000 over the period. That's a real gap.

Expense growth in distressed markets

In markets with rent stagnation (zero rent growth), expense growth becomes especially pernicious. If rents are flat but expenses grow 4% annually, NOI declines 4% annually—a death spiral for holding period returns.

This happened to many office properties post-COVID: rents fell or stayed flat, but operating expenses continued rising. Owners faced the choice to cut services (lower occupancy), refinance at lower NOI, or sell.

For deals in potentially stressed markets, assume 0% rent growth and 5% expense growth in the downside scenario. If the deal survives, it's viable.

Documenting and stress-testing expense assumptions

The pro forma should show:

1. Year-1 baseline expenses (broken down by category)
2. Growth rate applied to each category (property tax 4%, insurance 5%, etc.)
3. Year-10 expense projection
4. Sensitivity: what if property tax grows 5% (not 4%), or insurance 6%?

If a 1% increase in property tax growth rate tanks the deal's IRR by 2–3 points, you're concentrated on tax assumption. That's a risk factor.

Comparison flowchart

Related concepts

• The Pro Forma Spreadsheet
• Net Operating Income (NOI)

Next

The pro forma model is built; now you need to decide when you'll sell. That requires the exit cap rate assumption—the single most impactful number in your ten-year projection.