Validate the 50% rule

Validate the 50% rule

Will BarnardPro Member
Moderator
Developer · Santa Clarita, CA · Member since 2008 · 15k+ posts · 10k+ votes

It has been agressively stated here on BP that operating expenses average 50% of gross rents. I have posted many times that while that may be true with some properties, it is not accurate or appropriate to use this percentage on all properties (speaking of residential 1-4 units only).

I have stated that when you have gross rents of $400-$700 monthly, it will most likely average out to be in the ballpark of 50%, but as rents increase to amounts above $1000 per month, the ratio or percentage decreases due to a variety of factors (which will not be explained here).

The purpose of this post is to get some viable data from many individuals who have rental units with monthly rental rates in excess of $1,000 (per door) and have at least 3 years of financials. So, if you have property which fits this criteria, Please respond here with the following: (Take all the years you have owned the property(ies) and combine all the amounts listed below, then divide by the number of years to get an accurate annual average):

Gross rents
Actual annual operating expense figures (fixed expenses - taxes, insurance, PM, utilities, etc.)
operating expense reserves (items which do not occur regularly such as repairs, maintenance, vacancy, damage, advertising, legal, etc.) Please include what you have personally experienced with your properties only!
Then list your capital expense reserves (although this is not actually an operating expense, accounting wise, for avoidance of arguments sake, let's include it)
Finally, we can now arrive at your NOI, so post that as well.

Note: If you have multiple properties, combine all the figures as one and note how many properties (actual doors) the figures represent. Once we have had at least 100 doors represented by many posters, I will compile the numbers and see what operating expense ratio was averaged. If we get a rapid number of posts which quickly total more than 100 doors, we can move the figure up to 200 or more before I compile the numbers. The more data entered, the more accurate the average should be. Let's have some fun with this! :lol:

I will post updates here on the figures as we get enough to compile.

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Real Estate Investor · the villages, FL · Member since 2008 · 5k+ posts · 3k+ votes
17y

Merry Christmas to all!! I'm in Cancun and this is not what I wanted to be doing this morning, but I disagee with using this 50% as a catch all %.
Here are 2 things I've found in owning oVER than 1000 residences for rent.
1. There is a distinct difference between low price and higher priced rentals. As rent goes up , % goes down,,period
2. If you own in TX and rent for $1000 per month, JUST your taxes may be 25% per month of your rent, while other states might be 4% per month. (MS)
There are other items that cause a big difference, i.e. age of property, and condition of property. If you stick with newer properties, the % will be less than 50%, imo.
The 50% is ok as a general thing, especially for newbies as a starting point, but there are so many other conditions that will affect the %.

p.s. I currently have 11 properties at $975 or higher. All are less than 5 years old and my % is CONSIDERABLY less than the 50%, fwiw.

See this reply in the discussion

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  • Real Estate Investor · OH · Member since 2008 · 4k+ posts · 1k+ votes
    17y

    As we have seen here MANY times before, having people combine all their expenses is pointless, because most people don't even know what the expenses are. If you really want to do this, people need to list all the individual expenses, so we can see what they are ommitting or considering "off budget".

    At any rate, if anyone is going to post, please post all the individual expenses so that we can ensure everything is included.

    Mike

  • Real Estate Investor · OH · Member since 2008 · 1k+ posts · 86 votes
    17y

    Do you really think you are going to get many investors who are getting 1000 bucks per unit? I would think that most of us fall between the $400 to $800 per unit range.

  • Manhattan, NY · Member since 2008 · 801 posts · 61 votes
    17y
    Originally posted by MikeOH:
    As we have seen here MANY times before, having people combine all their expenses is pointless, because most people don't even know what the expenses are. If you really want to do this, people need to list all the individual expenses, so we can see what they are ommitting or considering "off budget".

    At any rate, if anyone is going to post, please post all the individual expenses so that we can ensure everything is included.

    Mike


    Mike, I absolutely agree with you on this. Wow, wait a minute, is THAT a sign of the end times? We actually agree on something?

    Actually, I agree with Mike more than it appears.

    In a bigger sense this is a waste of time because no matter what data is posted here it is not verified and cannot be reliably verified.

    So, if it all tracks to approximately the 50% mark, so what? If it doesn't, so what?

    I continually have discussions about what is and is not included in the "expense" numbers. People don't understand it because they don't understand business. They don't get why property taxes and insurance are part of the expense numbers but principal and interest aren't even though interest is a deductible expense for taxes.

    The thing is I have seen enough data from enough sources to feel secure in using the 50% as a RULE OF THUMB.

    You are correct when you say with higher rents the numbers adjust somewhat but not enough to be significant when looking at the bigger picture.

    Obviously, any investor is free to use any number they are comfortable using. But, for me and many like me, 50% is the MINIMUM number I will use to analyze the deal.

  • Joshua D.Pro Member
    BiggerPockets Founder · HI · Member since 2008 · 16k+ posts · 5k+ votes
    17y

    I think Taz said it best that the 50% "rule" is a great "rule of thumb." We certainly have members who push this rule because if you were to follow it, you'd practically be guaranteed a strong cash-flowing property.

    It is not the motto of BiggerPockets, and is not the only "rule" that members here promote to one another.

    I'm one who says it is better to be conservative then to be sorry, and if the 50% rule helps teach newbies to be cautious, then I think it is the greatest thing ever conceptualized. Too many people are out there screaming how little money you need to make money in real estate and how easy it is to find turn-key or cash-flow properties. This rule focuses on the expenses, which most newbies simply ignore for the most part. That makes the rule a beautiful thing in my book.

  • Real Estate Investor · OH · Member since 2008 · 4k+ posts · 1k+ votes
    17y


    EXACTLY! Furthermore, the 50% Rule includes a couple of things that are not consistent with a strict accounting perspective. The two big things that are included that many accountants wouldn't consider operating expenses are Capital Expenses (not technically an operating expense) and vacancy allowance. I included them in the 50% Rule to make this simple and easy to understand for new investors.



    Josh, I would just like to point out that the 50% Rule reflects the average expenses, not the max. Therefore, it is not a conservative number, it's just the average. Moreover, expenses can be a LOT higher than 50% in any given year due to a big capital expense, damage done by tenants, evictions, excessive vacancy, etc, etc, etc. It is a good rule over the long term and over a large number of units (which is what's important to operate a business), but you can still lose your butt in the short term on any given property in any given year even if you use the 50% rule.

    Mike

  • Will BarnardPro Member
    Moderator
    OP
    Developer · Santa Clarita, CA · Member since 2008 · 15k+ posts · 10k+ votes
    17y

    Thanks to all who contributed to the cause of the thread which was 0.
    It appears that there are certain individuals who are not interested in the posted experiment. Fine. I won't waste any more of my time as it appears that many seem to be threatened by the possibility of being wrong.

    The thread was not created with intent to discuss, prove, or disprove a 50% oe rule, only to gather some info from many investors here on BP. It is obvious that some of you will not allow that. Too bad.

  • Commercial Real Estate Agent · Boston, MA · Member since 2008 · 114 posts · 15 votes
    17y

    I don't think the people posting on the discussion set out to waste your time, nationwide. All I can offer is my thoughts as an outside observer.

    It seems to me that you and MikeOH are in an ongoing battle on the site about this 50% rule and you don't want to let it go. It seems that you're unhappy that people haven't posted anything to validate your view on the topic in this discussion. You seem to have posted the topic today, a holiday for many people, but don't have the patience to see how the thread advances without complaining about the few who have commented already.

    It would appear that you have a successful business model, so why does it matter?

    If people here don't agree with you, who cares? Why not just move on and worry about other topics? You're making money despite other people's view of this 50% things, right?

    Don't start attacking me here for my comments either please. I'm just another members who is tired of everyone trying to prove one another wrong. People seem to be interested in talking about the topic. Why chastise them?

    Its Christmas.

    Can't we just agree that we're going to disagree and move on with out lives?

    :roll:

  • Lender · Phoenix, AZ · Member since 2008 · 351 posts · 40 votes
    17y

    I will be the first to say I love the 50% rule as a newbie. I would look at many properties and thought I would cash flow easy, mortgage was at 750 I could rent for 900. Then I learned... and boy is that a good thing I now understand things WILL go wrong and its much better to use the tenants money for those problems than mine. Like Josh said I would rather be safe and conservative than sorry.

    Does it make it harder to find properties, yes it does. Does it make it easier to have a smooth running business, yes it does. Ill take the small problems of finding properties and having a cash flowing business over finding tons of properties THAT I AM PAYING to keep.

  • Real Estate Investor · the villages, FL · Member since 2008 · 5k+ posts · 3k+ votes
    17y

    Merry Christmas to all!! I'm in Cancun and this is not what I wanted to be doing this morning, but I disagee with using this 50% as a catch all %.
    Here are 2 things I've found in owning oVER than 1000 residences for rent.
    1. There is a distinct difference between low price and higher priced rentals. As rent goes up , % goes down,,period
    2. If you own in TX and rent for $1000 per month, JUST your taxes may be 25% per month of your rent, while other states might be 4% per month. (MS)
    There are other items that cause a big difference, i.e. age of property, and condition of property. If you stick with newer properties, the % will be less than 50%, imo.
    The 50% is ok as a general thing, especially for newbies as a starting point, but there are so many other conditions that will affect the %.

    p.s. I currently have 11 properties at $975 or higher. All are less than 5 years old and my % is CONSIDERABLY less than the 50%, fwiw.

  • Real Estate Investor · North Carolina · Member since 2008 · 1k+ posts · 483 votes
    17y

    In my experience collage rentals are one subset where higher rents do not necessarily mean a lower percentage of expenses -- especially when I factor in my time as manager/parent/nanny/counselor/evil landlord.....

  • Real Estate Investor · OH · Member since 2008 · 4k+ posts · 1k+ votes
    17y

    Merry Christmas!

    Post the numbers!

    Mike

  • Real Estate Investor · CA · Member since 2008 · 20 posts · 4 votes
    17y

    I own a number of single family homes (over 20) in the greater Phoenix market. I also have over 25 years experience analyzing income and expense statements for commercial and multi-family properties. Although I'm not willing to disclose specific numbers, I think my experience qualifies me to comment on this controversy.

    Most of my rents are over $1,000. Taxes have averaged about one percent of value over 12 years, although with the downturn in the market and despite the Maricopa County Assessor's proactive effort to reduce assessed values, they were a significantly higher percentage of value for 2008. All of my properties are single family residences, and they range in age from 5 to 45 years. The vast majority are three and four bedrooms, with a couple of 2 bedrooms.

    I can tell you that over this sample and over 12 years, the expenses, including the vacancy and collection loss and the capital improvements, have run around 50 percent of scheduled gross. However, most of the properties are managed, so about 7 percent goes to management. If I had managed everything myself, the expenses over the 12 years would have been a lower percentage of the SGI.

    In addition, expenses have risen faster than rents (MikeOH is the only person I can recall who has pointed out this dirty little secret of real estate investing) so I expect to be over 50 percent for the next few years until rents start to rise again. Twelve years ago, in the halcyon, pre-California invasion days, the expenses were somewhat lower as a percentage of SGI.

    In my experience, the biggest factor that should be considered in the expense analysis of a single family home is the rent differences among various parts of the country. A furnace costs the same pretty much anywhere. So do roofs and water heaters. Taxes can also vary widely as has been pointed out. There will be variations in the overall expense percentage to apply and an investor should carefully analyze the numbers before buying anything.. The 50 percent rule is an excellent starting point and should be used by a new investor to temper his or her enthusiasm and to question any sales pitch or pro forma operating expense analysis provided by the seller.

    With regard to Rich Weese's comments, in the Phoenix market there is a big trade-off for buying new/newer homes over older, well-located homes. Newer homes are found on the outskirts of the area. As lots of inexperienced investors have found out, rents are lower, vacancy is much higher, HOA's are mandatory and expensive, and tax rates are higher because there is no infrastructure. Those folks have lost over 60 percent of the value of their properties in many cases. Even at current prices, I'm not convinced these properties would cash flow at current rents, given current vacancy and operating expenses. When looking at new and newer homes, an investor should analyze the trade-offs in their specific market.

    I don't have an axe to grind or any reason to distort the numbers. It sounds like Nationwidepi specializes in marketing investments to folks with good jobs who want to diversify their investments away from the stock market. These folks do not want management intensive properties, and are willing to sacrifice current cash flow for long term appreciation. If he is buying and recommending new properties in strong rental areas, his current expenses may well be lower than 50 percent. Long term, however, the expenses will trend much higher. MikeOH, on the other hand, is running a rental business that must cash flow to support him and his family. His expenses will differ, but they will be very tightly controlled. If he experiences 50 percent expenses, then an investor that wants to follow his business model should listen up.

    I won't ask either person to post their numbers because I'm not willing to do so. I will just wish them both (and everyone else) a merry Christmas and better investment performance in 2009.

  • Manhattan, NY · Member since 2008 · 801 posts · 61 votes
    17y
    Originally posted by nationwidepi:
    Thanks to all who contributed to the cause of the thread which was 0.
    It appears that there are certain individuals who are not interested in the posted experiment. Fine. I won't waste any more of my time as it appears that many seem to be threatened by the possibility of being wrong.
    You are right. I absolutely should not have stepped in and took a whiz on your thread.

    It is always slow between Christmas and New Years and I have an intern who works on our research team who could use some extra money. I am going to send her an email to see if she is interested in compiling this data from the data we have. I will provide summary results here with a link to the detailed report.

    Here is what I propose.

    First, a description of what is included in the operating expense numbers for analysis and what is not.

    Then, I will get them to summarize it by rent amount for inclusion here. The following buckets will be used.
    < $700
    $701 - $1000
    $101 - $1500
    > $1500

    The detailed report may have more granularity in the rent amounts.

    The detailed report will also report based on state, major metropolitan area and age of property. It may even include some other break outs depending upon how easy it is to get corollary data for things like income in the area, educations levels, etc. All of that is available but I am going to limit her to 40 research hours so that may or may not come together in that time frame.

    It is what it is. Understand though, our business model values cash flow higher than anticipated appreciation.

    Now, here is what I ask of you, nationwidepi. First, at least provide the same data in summary form for your holdings. Second, either point me to the thread where you have explained your business model or explain it here. What is the driving factor in how you expect to make money? What things are you willing to trade off to obtain your primary metric?

    For example, my partners and I value cash flow OVER expected appreciation. We will readily accept little or no appreciation if the cash flow or the potential to build higher cash flows exist in the deal. This means when we buy, it is at a steep discount.

    The title you chose says otherwise.

  • Los Angeles, CA · Member since 2008 · 557 posts · 70 votes
    17y

    These are the threads that help make this site rock. The contrarian views provide an education that is valuable, and cannot be found in any book. I wish I had some value to add on this specific thread, but not yet.

    Either way:
    Happy Holidays!

  • Joshua D.Pro Member
    BiggerPockets Founder · HI · Member since 2008 · 16k+ posts · 5k+ votes
    17y
    Originally posted by Matty M:
    These are the threads that help make this site rock. The contrarian views provide an education that is valuable, and cannot be found in any book.


    I agree 100%
  • Real Estate Investor · OH · Member since 2008 · 4k+ posts · 1k+ votes
    17y

    Taz, if you're doing this for the purpose of comparing it to the 50% rule, it is important that you include the vacancy expense and the capital expenses. That will require a little extra effort, because vacancy usually isn't calculated as an "expense".

    I'm looking forward to seeing the data!

    Mike

  • Developer · Garland, TX · Member since 2008 · 8k+ posts · 4k+ votes
    17y

    Question on the 50% rule: Is CapEx inluded? I see some posts that indicate it is and others that say it includes OpEx only. I see this as a big variable, as some properties need no CapEx and others can require CapEx greater than their current market value.

  • Rental Property Investor · Mercer Island, WA · Member since 2008 · 22k+ posts · 14k+ votes
    17y

    Jon, Yes, the "50% rule" includes all the money you spend or don't collect. That's everything that's truly expenses -- management, maintenance, utilities if you pay them, taxes, insurance, legal costs, tenant damage, etc. It also includes capital items (e.g., new furnace) that aren't expenses for the IRS, but do come out of your pocket. It also includes vacancy.

    Now, if you mean the rehab costs you would pay to make a new purchase rentable, then, no, I do not include those. I lump those costs in with the purchase price to determine my "all in" cost of the property. That's the same as the IRS. Costs incurred to get the property rent ready adjust your basis rather than being treated as expenses.

  • Developer · Garland, TX · Member since 2008 · 8k+ posts · 4k+ votes
    17y

    OK, but typically I'll amortize and depreciate those CapEx's. I put a new HVAC into a property this summer. $26K. I am not going to expense that for me, my banker, or Uncle Sam. I'm going to depreciate it.

  • Manhattan, NY · Member since 2008 · 801 posts · 61 votes
    17y
    Originally posted by MikeOH:
    Originally posted by Taz:
    First, a description of what is included in the operating expense numbers for analysis and what is not.


    Taz, if you're doing this for the purpose of comparing it to the 50% rule, it is important that you include the vacancy expense and the capital expenses. That will require a little extra effort, because vacancy usually isn't calculated as an "expense".

    I'm looking forward to seeing the data!

    Mike
    Mike, we track vacancies as an expense item. On the capital expenses, for the purpose of analysis we track reserves accumulated for capital expenses. The report will go into detail but as an example, suppose we are buying an apartment building today and the inspection indicates the remaining life in the roof is 10 years. We will estimate the cost to repair the roof in today's dollars and project forward based on anticipated inflation the dollars needed 10 years from now to replace the roof. When the roof gets replaced, we use the reserves to replace it. If there weren't enough dollars, we go back and adjust the reserve projections to improve the correction factor of our model. The same is true if we set aside too much.

    This makes our analysis model a closed-loop self adjusting model. As a result, the accuracy improves over time. With almost a quarter century of data, it is pretty close. However, it will be interesting to see how well it adjusts over the next few years, just as it was to watch it adjust in the late 1980's. But, back then, I only had 5 years of data.

    This is why it is critical he explain his business model because an analysis model had better damn well be built to support a business model. Otherwise, it will never be even close to accurate.

    If someone were to use my analysis model to buy property as an appreciation speculator, I guarantee they will lose money over a long enough period of time. They may see some success with it for a while, maybe even a few years. But, over the longer haul, it won't maximize your appreciation except by sheer dumb luck.

    On the other hand, it will maximize your cash flow, which does directly affect the net present value of the investment at any given moment.

    A major change we are making to the model this year is to provide continual updating numbers. That means if we are three years into our 10 year roof example we can see based on recent history how likely our current reserve projections are and adjust them.

    I think you can begin to see that while we use the 50% thumb nail rule as a quick gating number, we do not buy based on it. The devil is always in the details.

  • Rental Property Investor · Mercer Island, WA · Member since 2008 · 22k+ posts · 14k+ votes
    17y

    This rule of thumb isn't intended to identify exact expenses every year. Regardless of the tax treatment, you either paid that $26K out of pocket, or you got a loan to cover it. If you did your evaluation of the building assuming you would never have to replace that HVAC, you would be hurting if you had to suddenly cough up $26K.

    Over the long term, and over multiple properties, you WILL have to pay these big capital items. Too many deals are offered as "rents for $1000, your PITI payment is only $800. This cash flows!!!!" If you own 20 houses for 20 years, you're going to have to pay for a bunch of roofs and HVACs. You better account for them in evaluating those properties. The 50% rule is just a simple way to try to account for some of those "lumpy" expenses.

    Nobody can predict when you're going to have a nasty eviction with months of lost rent and a bunch of damage. But there's a real chance that will happen. If you have 20 properties for 20 years, you're pretty much guaranteed to have one, and probably one every few years.

    Anything you can identify as a problem and capture should be included in your accounting.

    And, yes, the 50% rule is irrelevant for doing your taxes.

  • Manhattan, NY · Member since 2008 · 801 posts · 61 votes
    17y
    Originally posted by Jon Klaus:
    OK, but typically I'll amortize and depreciate those CapEx's. I put a new HVAC into a property this summer. $26K. I am not going to expense that for me, my banker, or Uncle Sam. I'm going to depreciate it.
    That brand new HVAC system has a useful life. For discussion purposes, let's assume 10 years. You know the replacement cost now is $26K, you can project the cost to replace 10 years from now. You can base the reserves you need to accumulate on that number and include those in your analysis numbers now.

    Not really doing the math, but suppose your projection was it will take $35K to replace the system 10 years from now. You can either simply divide by 10 and figure your reserve amount for the system is $3500 a year. Alternatively, you could simply use the depreciation schedule but adjust it for projected inflation.

    The thing is, somehow, some way you must be accounting for what you are going to have to spend in the future if your intent is to hold for the long term. If you have enough properties, your pooling of these reserves performs much like an insurance pool. Something may happen and you may have to replace something earlier than anticipated but over the long haul, by setting aside the amounts you project, you build up enough reserves to keep your business running smoothly when major repairs/replacements are needed.

    I hate to beat on this dead horse, but that is why the business model is so important.

  • Contractor · Philadelphia, PA · Member since 2008 · 183 posts · 17 votes
    17y

    Our remodeling business peer groups had similar back and forth and arguing for a period of time until they set upon a standardized chart of accounts all the companies agreed to use. In this way they could really compare their company operations, and see where each might improve.

    Until you standardize, its apples and oranges.

    Perhaps the originator of this thread would propose a standard chart of accounts to use and then this group could really start seeing the numbers operate?

    Its very worthwhile.
    Diane

  • Manhattan, NY · Member since 2008 · 801 posts · 61 votes
    17y
    Originally posted by Jon Holdman:
    This rule of thumb isn't intended to identify exact expenses every year. Regardless of the tax treatment, you either paid that $26K out of pocket, or you got a loan to cover it. If you did your evaluation of the building assuming you would never have to replace that HVAC, you would be hurting if you had to suddenly cough up $26K.
    EXACTLY!

    This is a conversation I have, especially with desperate agents and brokers, at least once a week.
    If you own 20 houses for 20 years, you're going to have to pay for a bunch of roofs and HVACs. You better account for them in evaluating those properties. The 50% rule is just a simple way to try to account for some of those "lumpy" expenses.

    Nobody can predict when you're going to have a nasty eviction with months of lost rent and a bunch of damage. But there's a real chance that will happen. If you have 20 properties for 20 years, you're pretty much guaranteed to have one, and probably one every few years.

    Anything you can identify as a problem and capture should be included in your accounting.

    And, yes, the 50% rule is irrelevant for doing your taxes.
    Well said.

  • Developer · Garland, TX · Member since 2008 · 8k+ posts · 4k+ votes
    17y

    Thanks Jon, that helps clarify. Another variable that has probably been dealt with is the average age of the portfolio. Expenses will run higher on a portfolio with an average age of 60 years vs. 5-10 years. Anyone mind addressing that linking to where it's discussed?

    Thanks

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