can someone please explain this 50% rule to me?
Member since 2008 · 155 posts · 2 votes
I have heard from people on these boards that I can expect the operating expenses of the house I purchase to rent out would be about 50% of what I can get for it monthly. I could be misunderstanding it, but how is this so?
For example: because of the tax rates here, we can expect to generally pay in rents about 1% of the home value. this includes insurances, taxes, interest, etc. SO - a working example:
If I buy a $100k house for $70k (assuming i can get in at 70% value), and I can rent at $1k a month, how would $500 of that each month go to operating expenses?
That's exactly the way it is in my area also (and in many areas of the country). Rents generally run about 1% of the home value here. However, your statement that this includes insurance, taxes, interest, etc is meaningless. There isn't necessarily any correlation between what the tenant pays in rent and what the landlord pays in insurance, taxes, interest, debt, etc. That's why the vast majority of newbies fail in this business. They take in less money than they pay out.
What you pay for a house has ABSOLUTELY NOTHING to do with the operating expenses. In your example, it would make absolutely no difference whether you paid $70,000 for the house or only $10 for the house - the operating expenses would be exactly the same! Operating expenses include everything you spend to operate the business, but do not include the mortgage (principal and interest).
The 50% rule simply reflects the fact that throughout the United States, operating expenses run 45% to 50% of the gross rents. That includes taxes, insurance, vacancies, advertising, utilities paid by the owner, management, maintenance, entity maintenance, legal fees, evictions, damage done by the tenants in excess of the security deposit, capital expenses, lawsuits, etc, etc, etc. (I could go on and on). Some of these expenses don't occur on a regular basis (such as excessive tenant damage), yet the effect on the bottom line is still profound.
What type of business are you in? Whatever it is, you should still have operating expenses and the principle is the same (although the numbers may be different).
Mike
[[[[.......dead beats that need to be formally evicted, and these properties often need complete rehab, or at least major repairs and also the fact that the units are OLD, this would really factor into higher expenses for YOU....]]]]]
This is just my own personal comment on the above: When I buy a place, I include the cost of bringing it up to my standards in the purchase price, not in my expenses (and that is the way Uncle Sam sees it, too).
Once the property is renovated and put into my stable of rental units, it is in good condition, and the expenses, as in any other unit, are almost always tenant caused. Tenant damage is independent of the age of the building.
If a landlord is experienced and has been running his business long enough to know what he is doing, his expenses might be lower or hgher than the 50%, but he is NOT coming on here asking if a building is a good purchase or not. He already knows what it will cost to run the building and how much rent he can get for it.
It's the beginners who are coming on here asking us if they should buy the $300,000 house that rents for $1200 a month. They are asking if it is a good deal, because they do not know how to tell whether they should buy it or not.
If they allow the 50% for expenses, they will not didscover that the new house is mysteriously bleeding them to death and not understand why.
My experience, over decades, is that expenses average out close to the 50%. Some years are good. I can really make a nickel scream, and I do my own management and don't get too much tenant damge. All that serves to keep expenses down.
However, some years are a real pain, with tenants moving whole herds at a time. Those years the expense of vacancies is really high. It balances out the good years that had good profits.
Or you can be going along, not having much in the line of expenses and have a tenant go off the deep end and end up with a very bad move-out that costs a bundle. That balances out with the good years to change your average costs.
Those of you who are experienced are welcome to figure out your own expenses. Those of you who are starting out, be aware that expenses will be a lot higher than you expect, and you need to budget for it.
Jason, I agree! And as PNW said, no successful investor whti 100 properties would come on this or any other forum to ask for advice about operating expenses.
EXCELLENT POST PNW!
AMEN!
Mike
That's true.
Absolutely incorrect. I usually don't answer posts that I agree with and I don't sit here all day with nothing to do answer posts. However, there are several members that I almost always agree with. For example, I could instantly tell that Tim Weineke knows what he's talking about. Would it make you feel better if every time Tim posts something, I would post "DITTO"? In addition, I try to answer as many "is this a good deal" posts as I can. I give my honest opinion on every deal and say this is a good deal whenever it is a good deal.
I did add my ditto to PNW's post a little while ago and agreed with everything he said also.
It's ironic that you say that because in another post, Nationwide just accused me of posting horror stories about my business, because I'm trying to scare off the competition. I can't win, I guess. So, on the one hand I'm posting the best case scenario and on the other hand I'm posting the worst.
This statement shows a fundamental lack of understanding of the business. Managing the property myself and doing maintenance myself doesn't reduce expenses even one penny. Someone is still getting paid for doing the maintenance and the management, however in my case that someone is me. I don't know about you, but I certainly don't work for free.
Principal and interest have nothing to do with operating expenses. Some people with only a couple of rentals can afford to lose money every month and therefore aren't forced out of business. How do you think they would do if they owned 100 rentals that were losing money each month?
The beautiful thing about the rental business is that it's survival of the fittest. You're getting ready to get into the rental business and you can use any number you like. If you believe that the operating expenses are 5%, as you (hopefully jokingly) said above, you can do so. The business will tell you whether you're right or not.
Mike
In my limited rental property experience I had NO TENANT DAMAGE other than normal wear and tear. I also had the same great tenants in the three houses the entire 5 years, so NO vacancies!
James, are these the same properties as the ones you're selling in Kansas City and Iowa?
My Advice
1. Don't use any rule of thumb.
2. Use an airtight lease with all expenses passing to tenant.
3. Rent only to credit worthy tenants who can back up the lease.
4. Be careful of the following budget busters if 1-4 fail.
A. Lack of maintenance of HVAC systems. Tenant should pay for this.
B. Leaks of the structure leading to damage and mold.
C. Legal expense in dealing with damage and bad tenants.
D. Landscape cost, especially tree trimming of large trees.
While not a comprehensive list, by controlling cost you can do better than the average of expense to income ratios for your area.
(Excuse me if it's a naive question; passing on expenses is possible here in Australia for business premises, but strictly prohibited for residential leases.)
No, you can not pass on the maintenance in most states. To determine what's legal in your state, check your tenant's landlord tenant law. Most places have habitability requirements that specifically require the OWNER to maintain the property to some standard.
In addition to the legal problem, the entire suggestion is just plain silly. Rents are set by the market. If I charged market rent and then told applicants, "by the way you also will be paying taxes, insurance, HOA, maintenance - all expenses" - I'd be out of business tomorrow because I wouldn't have any tenants!!! Sounds good in theory, but in reality it would be a disaster! This isn't a recipe for lowering expenses, it's a recipe for failure (in a hurry).
Mike
In response to the question about passing on expenses, I must admit that my experience is exclusively in commercial real estate. There is a lease referred to as a triple net lease or NNN lease. It is very common and is considered the most valuable type of lease because it protects the owner from most variable cost. If it is not legal for residential in some states, I would still recommend obtaining a copy of this type of lease and using it to modify or create a residential lease with as many of the provisions as possible.
Investors pay far more for a property with a NNN lease than they do for other leases with the same net income. Typically this type of lease will be used for companies like Walgreen's, Wal-mart and other national tenants. It can be used for single tenant or multi-tenant properties. Not every NNN lease is the same and like almost any legal document the parties can agree to a variety of changes and modifications to it, usually during the lease negotiation period.
I hope this helps you. Good luck.
Another question (along the lines of this topic) for experienced property owners...
I used the 50% rule for SFH, and I do a much more detailed analysis for any buildings over 5 units, but I'm not really sure how to evaluate expenses for 2-4 unit properties (duplexes, triplexes, quad-plexes).
I imagine there are some economies of scale for multiple units in a single building, but certainly not to the degree of an apartment building.
Do you guys use the 50% rule for 2-4 units? Or some other rule? Or do you do a more detailed (i.e., NOI and cap rate) analysis when determining if a 2-4 unit property is a good deal?
Thanks!
No that makes sense. I was going to say you got very lucky on MO tenants...lol. On that note then, with the increased price of Central Valley property, even with no tenant damage - did the increased financing payments along with taxes and the other minutae approach if not exceed 50%? I don't know the prices you bought these but I personally include mortgage payments into the expenses.
I agree completely that very few properties will fall EXACTLY at the 50% line, but that isn't what a "rule" is about. This is the 50% Rule, not the 50% Law and I think you get what I mean here. A "rule" is a unit of measure and when we refer to this, we refer to how a property's individual performance measures up against the national average. How the property falls within the "rule" gives you an idea of how strong a performer it may be. After that, it's an individual's choice whether or not to buy but they can't go into it saying that they did not have a nonbiased standard of measure at their disposal. For this same reason we don't build using cubits anymore or price the weight of goods based on how much is held in the king's hand. It's an advancement in property performance measurement. Personally I think it's a great initial analysis tool for SFR rentals when scanning dozens of properties at a time to see what you want to take a closer look at.
Tim
"NO! I bought these properties around 65% of market value (less cosmetic upgrades and some repairs) at the time. The upgrades and repairs were done at wholesale cost being a contractor. I put a bunch down and NEVER re financed. Payments were very low in comparison of rent and property taxes were based upon purchase and never re assessed while I owned the properties."
"Putting a bunch down" is also part of the expenses that needs to be averaged imho as it does mathematically skew the performance relative to the average.
"Thank you for using the term AVERAGE. What's the lowest possible figure and the highest possible figure when an AVERAGE is 50%? 1%-100%"
I don't think Mike has ever presented this an anything other than the average as well. I just know he uses it to challenge real estate MERCHANTS (not investors) who label property in their marketing as "cashflowing rental" property with total disregard to the average.
"I agree 100% if your totally new to the game and any loss what so ever would wife you out."
Careful - you had a Freudian slip there...lol.
"Personally my threshold is 35-45% as a factor."
That's fine and you take personal responsibility for the 5-15% deviation from the average. It's your choice to deviate and money can still be made but it doesn't change the average. My guess is that the money you made in speculation creates a buffer for you that most beginning investors don't have.
Tim
I would expect this owner's expenses to be well over 50%. 50% seems to be an expected case if you do things well. This owner is not doing things well.
Even though I'm in no position to buy them, I look at a lot of large multi-unit building listings. These often do have some expense information. Even though this info is suspect, its interesting reading. I've looked at more than one listing where expenses are 70%, 80% or more of the gross scheduled rents. And that's just whats reported, so you have to think that's an optimistic view.
This investor buys properties in good condition at below market cost in a high per capita income
state and area that has lower property tax and insurance rates.
Rental property business owner B:
This investor buys properties in good condition at below market cost in a high per capita income
state and area that has lower property tax and insurance rates.
I would expect this owner to land much closer to the 50% guideline.
This sounds like this person is right at 40% of gross rents. In a followup you mention he pays 4% in management expenses vs. the 10% that's included in the 50% rule of thumb. Right there he can reduce 50% to 44%.
I'm assuming, James, that in your discussion it was clear the 50% number includes vacancies and capital expenditures, even though these aren't “expenses” in an accounting sense. If the 4.5% vacancy is included in the 40%, then this person seems to be doing quite well. If the 4.5% is not included in the 40%, then, with the reduced management expenses, they're right where you would expect with the 50% rule of thumb.
Personally, I use 40% when evaluating a property. That's because I only have, for now, the one SFR. I don't expect to get to 500 or even 20 units any time soon. Plus I have a full time day job. So, for now, I'm perfectly willing to work for free to manage my rentals. If the unit will generate some positive cash flow with a 40% expenses projection, then I'm OK with that property. Note that even with these factors, it is VERY tough to find anything that works. Lots and lots of properties aren't even close to this.
I do think there are lots of people who go into this business thinking cash flow = rent – PITI. They ignore the times its vacant. They pay for maintenance and other expenses out of their own pocket. If they have a job, they can handle this. They're expecting appreciation, and over the long term, that's entirely possible. People get sold a bill of goods by this industry. At every one of our CAREI meetings, Bill Bronchick stands up and asks "who would want to buy their parent's house for what their parents paid"? You hear lots of situations where a house is worth 10x what it was worth 60 years ago. Folks just look at the numbers and think "wow, what a return". If you do the math, though, that's exactly 4% appreciation. Even low returns look impressive if given enough time.
I think there are some number of investors who buy into a negative cash flow deal based on the idea they will get appreciation over the long term. And with leverage, the appreciation will be even better. These sort of people:
Anyone who's paying 75% of rent for PITI is, at best, just breaking even. They're probably actually losing money, but doing it in such a way they don't notice. Or, they have enough other income to support their bad investment.
Since some expenses are in that PITI, and 25% is left for other expenses, they're probably working with at least 35% expenses. If they're lucky, that might work and they may make money.
If not, they will be one of those sorts that posts here every now and then. “Help! My tenant moved out with no notice and trashed the place and I can't afford the payments while its empty or to fix it up”. Or “Help! My property have been vacant three months. What do I do?” Or “Help! We bought three rentals in FL in 2004-2005. Now we can't get them rented and the loans are resetting. Will the lender be able to come after our primary residence if we just let them go to foreclosure”. I'm not at all making fun of those folks. I am point out that failures are very real, and we do hear about them here. I'm sure there are actually lots more that we don't hear about and don't make the news. I had one of my prospective tenants questioning me about my financial stability. Apparently, she was being kicked out of her place with little notice because the owner was being foreclosed on. I've heard stories like that more than once in the news. So, I think there actually are a lot of failures in the landlord business.
I think the tax advantages of real estate are way overstated. The nice thing about rental property business is that you will pay little or no income tax on the income from the rentals. You may even show a loss, though in the deals I've looked at, good deals usually show a small taxable profit. But the ability to use that loss to offset any other income is seriously limited. You certainly can't do it if you are totally passive w.r.t. the investment. Those tax shelters have been eliminated long ago. At the minimum, you have to spend the 750 hours/year, which amounts to, on average, 14.4 hours a week.
Another Freudian slip...
Too funny! Sweet typo on my part.
Ain't it the truth...lol. That's the other 50% rule.... :wink:
There are no rules that apply all the time.
I find that rules are made to be broken, you just got to find the loop hole.
I do SFR, operating expenses are limited to yearly taxes and taxes on monthly income. rents are always above market rents are almost always paid on time and I really don't care if they pay late as it means I will Make more $. Any damages that might be caused by the tennant are coverd before they move in. I haven't had a tenant do anything other than normal wear and tear since I styarted using this method.
Any rule or even LAW has it's exception or loophole
Find the hole and use it it's how Business is done.
I forgot to mention that, I always go after damages from anyone who ever does damage even though it is covered up front. If someone owes me rent I go after the back rent in court as well. Everyone knows I do this and I tell prospective tenants that I'm a nice guy but when it comes to business I'm by the book...........you pay late your served 3 day pay or quit ...........If your ever later than the 5th your gone........I always stop people in the middle of their sob stories and tell them to tell it to the next landlord they intend to have. I have a no tollerance policy and it is stated that way in my contracts....NO TOLLERANCE.........
I'm a nice guy so treat me that way and don't steal food from my familys table, I won't steal any from yours.
Cross me and be prepared for the full force of the legal system to be brought to bear on you. I'm a man of principle and will spend $500 on an attorney to get the $300 you owe me, It's nothing personal, It's business and I probably can use the write off at the end of the year.
It's really quite simple let the dog get away with peeing in the house and you will have a hard time stopping him in the future.
Ring the bell and the dog drools.................First of the month and the rents are paid
Everything is based on a conditioned response.
The difference is that I do all the conditioning not the tenants.
Brice
Really? You have no insurance expenses? No maintenance ever? Never a vacancy? No advertising? Once tenant moves out on the last day of the month and the next one moves in the next day without you touching the place? You don't pay for a CPA? You have no entities so no entity expenses, which I understand are pretty hefty in CA. That's truly astounding.
Ok, jump off a building and don't hit the ground. This kind of stuff sounds good in seminars or in a Wachowski brothers' movie but the reality is that systems have been in place to help you build wealth for centuries and it serves you best to use those systems to help you. Before I've referred to Charles Martel who ruled in the 730s-740s A.D. and inspired the feudal system off which our current system of landlording is based. There's nothing new here and the rich don't "break" rules, they just follow rich people rules.
RIDICULOUS! Here we go again with the nonsense!
No, I don't have 300 rentals and this shows your fundamental misunderstanding of the business. My eviction rate isn't based on a single day, or even a single month. It's the average of the 5 years I've been in business and all of my rentals. As I have been building my business over the past 5 years, my eviction rate has been 1% per month. If you take out the inherited tenants, it will significantly lower, I estimate .25 to .5% per month. It's that simple. If I don't have any evictions next month, would you judge that my eviction rate is ZERO? If I didn't have any evictions for 3 straight months, should we conclude that evictions don't exist and that no landlord in the country will ever have another eviction? That's just not how it works.
I have some months where I have no evictions, some months when I have 1 eviction, and then a month like last month where I ended up with three formal evictions (including one with a July 1st court date) and one informal eviction (where I basically intimidated the tenant into leaving). None of that changes the business. What matters is the big picture (the average over time) and the bottom line.
Wow! I like your math! If I was making that kind of money selling books or selling that number of books, I would sell all my rentals next month and do nothing but write. Just like the rentals, you're WAY off on the numbers (meaning not even in the ballpark). You didn't even get the price right!
That's funny. 50% expenses on my book business would be a blessing! No, that's not the right word - it would be a MIRACLE!
What you don't seem to understand is that ALL BUSINESS have operating expenses. They are different and may be of different magnitudes, but they all have expenses and they are all more than you would imagine being on the outside looking in.
I'm sorry, I can not. I am not an expert in the book business. In fact, I just consider it a hobby. What I can tell you is that the operating expenses are WAY over 50% and the sales numbers are FAR below your guestimates above. I read somewhere that the typical traditional author makes about $2 per book. Since I use an on-demand publisher, I make more than that, but it's still a BUNCH less than the sale price. The publisher charges to make the book and takes their cut; the big booksellers take a HUGE cut. There is advertising expense. Website expense. Labor in writing the book and posting, etc, etc, etc.
In my experience, NOTHING is ever as rosey as advertised!!!
Mike
Spending $500 to get $300?
It may be business, but it's not good business...
But, based on your comment about having no expenses other than taxes, I'm not quite sure I believe you have a business at all...
James,
There's something I want to go back to here for the newbies reading this that's very important. We are both in an obvious consensus that mortgage payments are to be included in the expenses in holding rental property. One thing you said though bears repeating, "I put a bunch down and NEVER re financed." I saw a lot of instances (usually Learning Annex booths) when people would sell proformas to newbies where huge downpayments were needed to make properties cashflow and their claim was that this made the property perform better. I think you and I agree on this but it bears noting (for the newbs) that when analyzing a property's cash flow performance, putting more money down on the acquisition does not improve the property's inherrent performance. Outside of some interest payments, it does not lessen expenses, it is a pre-payment of expenses.
Tim
Without speaking for Mike, I think that's what it is as well.
You bring up another interesting point - when it is time to sell the cashflowing asset. I used to believe this was "never" but a friend in New Zealand convinced me otherwise. There are times when market conditions favor selling a perfectly good cashflowing asset for a much greater return than holding it would provide. This is not all the time, but those times do come and those who are holding property that is performing well in the interim be in the best position to cash out when the time is right.
There is a wrong perception that those of us who focus on cashflowing rental property ignore or minimalize speculation, appreciation and even developing. Nothing could be further from the truth. We buy in areas that are undervalued, buy a massive discounts to create instant forced appreciation, develop some assets, use the cashflow to support holding the portfolio and acquiring more and sell when the market returns. We speculate and buy for appreciation in the midst of the landlording business but it is adhering to the core principles of the landlording/cashflow business that allow us to acquire as much as possible and stay afloat while we wait for a market recovery during which to sell and find the next area that is undervalued.
Tim
Wow! I am away for a few days since my last post and come back to find three additional pages of responses. What a hot topic again. I am glad to see that there really are others on this forum who do not agree 100% with Mike's 50% rule he made up. I was beginning to think I was alone on that.
Of all the investors who invest in residential RE across the country, none of them report their financials to anyone exept their own accountants and in their IRS tax filings. The IRS does not publish these results either as that info is privaleged and private info. So how can you claim that over the entire US, all the OE average 50%? To answer my own question, that figure you use stems from your own personal results and is your own opinion. Other investors will encounter lower expenses, others, higher, and others will hit your 50% mark. End of story.
I do not pretend that expenses do not or will not exist. I prevent them from taking effect in my business. You may argue all you want on what I do and do not have for OE, but you will be wasting all of our time as you can only assume and have your opinions.
You insist on posting my duplex unit numbers so you may critique them. The numbers posted are of the expenses I know 100% for sure that exist. I can not or will not assume that every investor will have a certain vacancy factor, ore if they will have an entity expense, or if they will have any other expenses. It will be up to each individual investor to take the cash flow show, add in any other expenses they know they will have, and reduce the listed cash flow accordingly. That is what everone in the "real world" does. I do not expect them to use your 50% rule. If they choose to, that is fine for them, that does not mean that their expenses will hit that mark just because they were to use that rule or any other rule. That is why my point is to not use rules, but evealute each investment and crunch the numbers accordingly. Your rule can not possibly work on every re investement in the US or anywhere else.
I am sure this is a little bit off-Topic. Question to James/Josh and all our BP members:
How about introducing some National Average Operating Expense report in BP? We can collect rental expense details from the investors registered in this website and request them to send us a report of average expenses in their city (every Month average). BP can process this report by writing a code that will present it in a reportable and graphical form? Does that sound like a "Good/Great" Idea?
I am just thinking out loud. Since none has it nationwide (may be worldwide), why not we START IT?
Cheers
Ram
Forgot to mention this... Rental expense average every month for the properties they own in City "XYZ".
Cheers
Ram