50% rule: How much vacancy factored in?

Question

Hi all,

When analyzing a deal quickly before going into the actual numbers, the 50% rule is a good starting point. My question is, how much of a vacancy factor is allocated in this 50%? 10%? More? How would you approach it if the current complex is 40% vacant? Thanks.

Jason Varney · Answer

Thanks guys

Jason Varney · Answer

Thanks all. I am only using the 50% rule as a quick glance to see if its something id be interested in looking into further. If it comes to fruition, a full due diligence will be in order but for now, its something that passed along my desk and I'm just giving it a quick review to see if its worth it. Its in a decent area so I don't think the vacancy is due to the neighborhood or rents being too high, but more of a mismanagement situation. Thanks for all the input.

Shaun Reilly · Answer

@Bryan Hancock hits on a great point here.

Way too many people start talking about the 50% rule as too much of a holy grail.  Even the fact we are going down this rabbit hole of breaking it down to some extent is evidence of that.

the 50% rule should be a quick and dirty screen to decide if it is worth doing more due diligence on a deal.  It isn't the only criteria used to evaluate something.

Quick example.  Say I'm looking at a 3 family that is more or less move in ready (To avoid the hassle of adding rehab costs as a evaluation factor) and has two 3BR units and one 2BR with market rents of $800 x 2 and $650 for a total of $2,250/month or $27,000 annual.  Using the 50% rule my expected NOI would be $13,500 and if I required a 10% Cap then I'd want to pay at most $135,000 for it.  If it was being offered at $150K or less I would do a full evaluation on it without hesitation but if it was at $220K I would not bother as NOI would need to be greater than 80% gross rental income to justify that price.

Bryan Hancock · Answer

The "market rent" should drive your 50% rule of thumb calculation.  So if the economic vacancy rate (including skips, etc.) is 40% the rent is probably too high and thus you'd need to drop the rent to have a good calibration point.

The 50% rule of thumb is far oversold on BP and is not the end-all-be-all.  Use actual numbers and interview local property managers to get a better sense of what the market will support.  Some areas will always have high vacancy and are really just poor investments.

Joel Owens · Answer

Vacancy varies by area.

10% is kind if a safe hedge that banks go by. Some operators keep at 15% and some have zero.

The biggest question is why is vacancy at 40%?? If it's just deferred management, bad operator, etc. I can fix those things.

If it's in a crummy location even if I make it new there is not much value there for me.

The rehabbed units will get thrashed again with rough tenants and the nice tenants will not want to live in that area.

Adam Johns · Answer

If I could go back and edit I would, but my reply was too long ago.

I don't know where I got the 10% of the 50% rule is vacancy, I think that's just the number I see used alot when people are breaking down their NOI. Either way, it doesn't change the rest of my answer.

Shaun Reilly · Answer

I don't think I have ever seen a specific breakdown for how to allocate different things in the 50% rule.

In fact I think it is supposed to be vague since some things like taxes and insurance will vary a lot based on location and there isn't really anything you can do about that.

The one thing I do hear sometimes is if you are going to self manage, and you don't care about getting paid to do it, people will use 40% for the rule of thumb.

Remember that if the property isn't a true money pit you should beat this most years.  It is supposed to factor in major repairs and capital expenses.  If you own a place for 15 years there is a good chance you will need to do the roof at some point and probably replace a furnace/boiler as well, and probably some other bigger repairs.  So maybe 13 of those years you might be at like 30-35% but then the 2 years you do those projects you suck up all your cash flow for 2-3 years on each and it evens out to more like 50%.

Adam Johns · Answer

@Jason Varney Your post really caught my eye because I had a good friend in high school whose name was Jason Varney. But onto answer your question.

The 50% rule is usually used for residential properties, and it typically factors about 10% vacancy, but there is also a "cushion" built into the 50% rule.

As for how I would approach this; I'm assuming this is a commercial property (and I'm guessing it is, since I can't figure out how to get 40% vacancy out of less than 5 units), then you'll have to actually figure out the NOI. I would use the average vacancy over the last year and present those numbers with the offer. If you think that there is something you can change quickly to get that vacancy rate down (deferred maintenance, better marketing, etc) than you have a lot of room to add value quickly. If you're wrong, and the vacancy stays around 40%, than your offer should be one where you still make money and the deal makes sense.

50% rule: How much vacancy factored in?

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