BiggerPockets

"But which expenses are included in the 50%?"

Everything.

"PITI for sure, but how about maintenance, vacancy allowance, property management, and capital improvement?"

Yes on all except capital improvement. I'm not exactly sure how you're defining that.

"And if the answer is that I should include all of those in the 50%, then why should it be a 50% rule? Why not an 80% rule if we've already accounted for all possible expenses? (I'm assuming the tenant pays all utilities.) I'd be perfectly happy with $200 net profit on $1,000 gross income every single time. Is the other 50% being budgeted just for unknowns and net profit, or am I missing something?"

Because this is "real" estate, not paper investments. In "real" estate, real sh*& happens. That 50% is a buffer in your immortal struggle against God and His sense of humor. Sometimes it's more than enough, sometimes it's not even nearly enough. In the wash, it averages out.

It's just a guideline, nothing more, that works in much of the country for residential and especially for most sfrs. Don't get too uptight about it.

Originally posted by Jon Holdman

Note that the P&I part of your payment is NOT part of the 50%.

Really? I thought the whole thing was a simple comparison of what goes out of pocket vs. what goes in. May not work in all areas I guess. Ah well, another example of regional differences but the same basic idea. I'm sure there's something I deal with that Jon's area has an advantage on.

Originally posted by Dave V.

Can someone give me a definitive answer on the 50% rule? I understand the concept, that your expenses should only equal 50% of your gross rent in order to get positive cashflow. But which expenses are included in the 50%?

Just to clarify. The 50% rule is an estimate of the probable overhead costs for your rental property. It is also an estimate of the most you can allocate to your debt service and your cash flow.

If 50% of the rent won't cover your debt service (principal and interest) and still give you an acceptable cash flow, then you don't even want to consider buying the property.

If the property passes this first 50% test, then you need to determine whether the other 50% of your rent is sufficient to pay all your costs of ownership and rental operation -- or, in other words, your overhead.

Start by pretending you own the property free and clear. Now, everything you spend to own and operate your rental property is included in your overhead. The overhead cost items include, but are not limited to, advertising, leasing fees, HOA fees, condo association dues, management costs, legal fees, preventive maintenance, vacancy, rent loss, contribution to a replacement reserve account,property taxes, hazard insurance, liability insurance, utilities (at least during vacancies), trash removal, snow removal, cleaning, repairs, postage and any other expense paid by the landlord/owner.

You can get a pretty good idea of the magnitude of your overhead costs with just a little homework to nail down your expected costs for some of the big ticket items like property managment, property taxes, hazard insurance, and association fees, For a single dwelling unit, use one month rent as your vacancy allowance if you are in a strong rental market. For a soft market, you may need to allow up to three months vacancy.

Dave,

Here's the definitive answer. The 50% rule says that throughout the United States, operating expenses for rentals run 45% to 50% of the gross rents. That's all!

So, as Jon and Dave T said, half (50%) of the gross rents will go to operating expenses (over time) and therefore the rest must pay your debt and any profit you have.

You should always do a good due diligence, but many of the expenses are unknowable (such as the number of evictions for a given unit in a given year, excessive damage done by tenants to a given unit in a given year, lawsuits, etc). That is why I use the 50% rule. It is the most accurate way to calculate operating expenses over a long period of time (which is what matters to your ultimate business success).

Please note that the expenses for a given unit in a given year can be higher or lower than 50%. For example, if a tenant gets mad and does $5,000 worth of damage to one of your rentals, the operating expenses for that unit will be WAY above 50% in that year. Likewise, you can have a property that requires no maintenance; has no vacancies; and basically has nothing more than the fixed expenses in a given year. The expenses in that case will be below 50% in that year. THE KEY POINT IS THAT OVER TIME, IT WILL ALL AVERAGE OUT TO 45% TO 50% OF THE GROSS RENTS!

There are a couple of additional assumptions associated with the 50% rule. One is that you are managing the property in a proper fashion. Obviously, it you screw up the management, your expenses could be much higher. Another assumption is that the rents are market rent for the property. If you buy a million dollar mansion and rent it to your favorite neice for $500 per month, obviously the 50% rule doesn't apply.

But which expenses are included in the 50%? PITI for sure, but how about maintenance, vacancy allowance, property management, and capital improvement?

Principal and interest are DEBT, not operating expenses and are not included in the 50% rule. Basically, operating expenses are everything except debt and profit. Now, from a technical standpoint capital expenses are not operating expenses, but I included them in the 50% rule because they are an expense that must be accounted for. Similarily, accountants often account for vacancies differently, but I included it in the 50% rule for simplicity.

Why not an 80% rule if we've already accounted for all possible expenses?

Because the data from hundreds of thousands of rental properties in the United States says that the operating expenses will run 45% to 50% of the gross rents - not 80%.

Good Luck,

Mike

I think sec. 8 or not your still going to have all the same expenses. My sec8 tenants pay a portion of their rent personally, so you might still have to chase the money anyway.

Dave,

Section 8 tenants are no different than other lower income tenants. Additionally, having part of the rent provided by Section 8 isn't that beneficial either. If the tenant pays any significant portion of the rent and doesn't pay, you've still lost all your profit on that property and will need to evict the deadbeat.

So, in answer to your question, whether the tenant is on Section 8 or not is totally irrelevant to the 50% rule.

Mike

Also consider the fact that Section 8 tends to take a little longer to get the tenant in the place. A regular tenant can move in as soon as the due diligence on them is done, they are approved, and they hand over the money and sign the lease. A section 8 tenant will wait as section 8 has the property inspected and they are usually a little more stringent in standards than tenants, in my experience. section 8 may take a week or 2 between inspections and reinspections before finally approving the unit.

Hamp,

Any of the apartment associations have detailed expense data. However, it's not that difficult to figure it out yourself. Make a list of ALL the expenses for property in your area and you'll see that it easily comes up to 45% to 50% of the gross rents.

If you're having trouble, post the numbers for a property in your area and we'll be glad to help.

Good Luck,

Mike

Are there any figures available for SFR's? I suspect that expenses would be more than 50% if apartments are 50%, no?

Dave,
In my experiences, SFR units have had lower OE ratios than apartments not higher. With an SFR, you do not have pools to maintain, common areas to maintain, on site maintenance, utilitie expense (except during vacancies which is extremely small figures), etc.
Therefore, on average, you should expect to have a lower OE ratio on a sfr than apart. complex.

That said, averages mean nothing and as Rich mentioned (which is very accurate) you need to calculate the numbers for your investemnt in that area. Rules or guidelines can be helpful during an analysis, but not the foundation of the decision.

As for figures for sfr's, no you will not find them. Why? Because the vast majority of sfr owners/investors do not post or publish publically their operating expenses.