Where does the 50% rule come from?
Ft. Worth, TX · Member since 2008 · 97 posts · 16 votes
I know the "50% rule" is bandied about as gospel here in the forums, but haven't seen any actual, hard data that says that operating expenses tend to be ~50% of gross rent income. I'd like to verify this number is, in fact, accurate. (I believe that it probably is; but I owe it to myself to verify my assumptions, right?)
It would not only help me ensure that I'm using realistic numbers, I also think that it would be good data (ammunition?) to have when negotiating.
Can anyone provide links to studies that address operating expenses as a percentage of gross rent income? The little searching I've done hasn't yielded anything.
NogginBoink,
When I first started in the rental business, I read all the "guru" nonsense books. By the time I was in business a year, I had probably read 30-40 books and had seen many "gurus" talk. Most of the "gurus" never mention expenses because they are trying to upsell the "student" to a more expensive course, bootcamp, or training. Of the gurus that did mention expenses, several talked about taxes and insurance. Others talked about taxes, insurance, management and maintenance. At the one year point, I had about 10 rentals and had been very lucky. I hadn't had a single vacancy or any other irregular expense, such as evictions, court costs, damage done by tenants (in excess of the deposit), etc. I felt like a GENIUS! I thought that I had found a business that simply made money hand over fist!!!
Unfortunately, that was short lived. As my portfolio continued to grow, I had a vacancy. Then an eviction. Then damage done by a tenant. Then a drug bust. Etc, etc, etc. In other words, I began to experience the REALITY of the business, which was quite a bit different than the silly guru hype. I began to fell more like an IDIOT than a genius. Shouldn't I have known that tenants get evicted? Shouldn't I have known that there would be vacancies? Shouldn't I have known that tenants would damage my property? The answer was YES, I should have known, but instead I had chosen to be ignorant and believe the nonsense that I read in the dozens of guru nonsense books!!!
I knew that there had to be an answer out there. I started looking at all the apartment and rental housing data I could find. This data included hundreds of thousands of rental units throughout the United States. What I found out is that throughout the United States, operating expenses run 45% to 50% of the gross rents. That's where my "50% Rule" came from.
The only thing that saved me from joining the majority of other newbies that fail is that I'm extremely competitive. After I bought one of my first houses, I heard of another investor that bought a house for the unbelievable price of $20,000. I knew that if that investor could do it, so could I. My competitive fangs came out and I was on the search for properties at a HUGE DISCOUNT. So, even though I didn't understand the operating expense issues at this early point, my competitiveness saved the day.
I've been preaching the "50% Rule" every since, mainly because I was so frustrated that the gurus were either lying about the expenses or didn't understand them. That's how the "50% Rule" came to be.
Mike
Member MikeOH is the main proponent of the 50% rule on this board. He is a very frequent contributor so a lot of other members have adopted it.
I believe that he rehabs in order to achieve this rule on low income properties and it works in his area. I have never heard of the 50% rule until I came across this forum, I don't think you are going to find data outside of this form.
I have seen this ratio numerous times in other places. Its a very common rule of thumb for multi-families. I've seen it in several books, including Dave Lindahl, who was recently mentioned here.
The reality is that may guru type books never mention any number for expenses. The leave it up to you to try to figure this out.
In other places when discussing single families, I've seen slightly lower ratio's used, 40% or so.
Its been discussed numerous times. Do a search and you'll find some of those other discussions. In one, someone listed all their recent expenses. That list didn't include vacancies, just actual expense vs. actual collected rent. Adding vacancy and comparing to scheduled rent, it was very close to 50%.
A bunch of the items are regular and period, and its pretty easy to come up with actual numbers. The tough ones are the irregular ones that only happen once in a great while. Those are unexpected and unplanned, and can be quite expenses. New roofs or furnaces, major tenant damage, or a lengthy eviction. You may get lucky and not have any of those for a long time. Or, you may get socked with one right out of the chute.
on
I used this "rule" before I met Mike. Regardless of the forum, rental property has operated for 12 centuries so it's only common that standards of cashflow evolve to what they are. I'm going to say one thing about this. Don't live your investing life on a web forum. Use the forum to gain information, then live it in the field and find more information. Mike has found through field testing that 50% works for him and is telling us about it here (for free I might add). If you find something in the field that works better, use it then tell us about it here. I won't mind if you find something out that can make me more money.
NogginBoink,
When I first started in the rental business, I read all the "guru" nonsense books. By the time I was in business a year, I had probably read 30-40 books and had seen many "gurus" talk. Most of the "gurus" never mention expenses because they are trying to upsell the "student" to a more expensive course, bootcamp, or training. Of the gurus that did mention expenses, several talked about taxes and insurance. Others talked about taxes, insurance, management and maintenance. At the one year point, I had about 10 rentals and had been very lucky. I hadn't had a single vacancy or any other irregular expense, such as evictions, court costs, damage done by tenants (in excess of the deposit), etc. I felt like a GENIUS! I thought that I had found a business that simply made money hand over fist!!!
Unfortunately, that was short lived. As my portfolio continued to grow, I had a vacancy. Then an eviction. Then damage done by a tenant. Then a drug bust. Etc, etc, etc. In other words, I began to experience the REALITY of the business, which was quite a bit different than the silly guru hype. I began to fell more like an IDIOT than a genius. Shouldn't I have known that tenants get evicted? Shouldn't I have known that there would be vacancies? Shouldn't I have known that tenants would damage my property? The answer was YES, I should have known, but instead I had chosen to be ignorant and believe the nonsense that I read in the dozens of guru nonsense books!!!
I knew that there had to be an answer out there. I started looking at all the apartment and rental housing data I could find. This data included hundreds of thousands of rental units throughout the United States. What I found out is that throughout the United States, operating expenses run 45% to 50% of the gross rents. That's where my "50% Rule" came from.
The only thing that saved me from joining the majority of other newbies that fail is that I'm extremely competitive. After I bought one of my first houses, I heard of another investor that bought a house for the unbelievable price of $20,000. I knew that if that investor could do it, so could I. My competitive fangs came out and I was on the search for properties at a HUGE DISCOUNT. So, even though I didn't understand the operating expense issues at this early point, my competitiveness saved the day.
I've been preaching the "50% Rule" every since, mainly because I was so frustrated that the gurus were either lying about the expenses or didn't understand them. That's how the "50% Rule" came to be.
Mike
Also remember that the %50 rule is a mish mash of both owner paid utilities and tenant paid utilities. If you have to pay for the heat and electric you can figure on a higher percentage used for expenses, and you have to build a buffer into your numbers expecting that utilities are going to go up more than the 1-2% that many gurus tell you. Just take your own utility bills for the last 2 years and see how close you are to 1-2% year over year increase.
I calculated on one of my apartment buildings that if oil goes up next year as much as it did this year I would have to raise rent 7% for each unit just to break even. I opted for choice two to spend even more money to put in an ultra high efficiency gas furnace to cut my heating cost in half and still raise rent 7%.
Thanks, everyone.
I believe the rule is accurate. But so far, all I have to base that on is personal anecdotes.
Are there any fomal studies that have been done that corroborate that? Something in print, with a respectable name behind it, that I can point to and say, "Listen, Mr. Seller, I don't care what you claim your expenses have been. The such-and-such organization did a study and found that the average NOE for this type of property is X. Here's a copy of their paper, and these are the numbers I'm using when I look at this deal."
While I do respect all of you and your experiences, seeing a study on this topic would help me a lot, both in negotiating and in understanding the business I'm wanting to enter.
I'd approach it by taking the NOI figure they give you and applying your desired multiplier to arrive at a price. Then, make them prove the NOI. If they're understating the expenses in their information, this should come out during the due diligence. If they've agreed on a price based on their stated NOI, then they've really agreed on your multiplier. When you turf up a missing expense you apply that multiplier to get a reduction in the price.
Sometimes expenses are low because needed work is not getting done. Could be deferred maintenance, which would require a repair credit. Could be a non-paying tenant who needs evicted. That could either turning a reduction based on the rent that's not coming in or a request to evict before closing.
Also, you want to work off actuals, not pro-forma. If it could be, then it should be. Otherwise, its just a guess. So, take their proforma NOI and price to figure their multiplier. Then apply that to actuals to get your price. That multiplier may still be too high. So, adjust to what you are looking for.
Jon
NogginBoink,
I never argue with sellers about their expenses. In fact, if truth be told, I never even ask the seller about their expenses. Why? Because I wouldn't believe them even if they told me. The vast majority of landlords in the U.S. are individuals. The vast majority of newbie landlords fail in a relatively short period of time. That's why there is such a big turnover in the rental property business. One of the main reasons these newbies fail is that they don't understand the operating expenses or cash flow issues. I'm certainly not asking a failure for their expenses, profit, or anything of the kind. All I want to know is the purchase price and obviously to see the building and the leases. I will make up my own mind what the rents should be; what repairs are needed; what the expenses will be; and what the cash flow will be. I KNOW my market and the business. Chances are that the seller doesn't understand any of this - THAT'S WHY THEY'RE SELLING!
Good Luck,
Mike
If you bought a gutted building and rehabbed it completely (everything, nothing left out), would the 50% rule still apply? Or could you assume for at least a couple of years that its going to be a little bit lower since everything is brand new?
Any thoughts on this would be appreciated!
Obviously, if you completely gutted and rehabbed the property, your capital expenses part of the equation is very high. The rehab is likely to make the maintenance a little lower, but in my experience, most of the maintenance is caused by the tenants, not by the age of the building. So, offsetting your high capital expenses, would be slightly lower maintenance expenses. Also, you must remember that the maintenance is only one of many parts of the operating expenses.
The point of the 50% rule is to say the operating expenses will work out to about 50% of the gross rents when averaged over time. It can not tell you what the operating expenses will be in any given year. That is IMPOSSIBLE to know.
Good Luck,
Mike
Nothing lasts forever, contrary to what most landlords think! You have to work the numbers backwards to plan on a replacement at an appropriate point in the life cycle- before maintenance costs rise dramatically, and a slow failure causes more damage to surrounding elements.
If the structure is new, or significantly rehabbed, you need to determine/estimate the design (or useful) life of each major element. For example, the roof, electrical system, plumbing system, floor coverings, interior wallcoverings, exterior surfaces, each appliance, HVAC systems, and so on. Each of these has a definite life expectancy (HINT: It's not 50 years!), which can be affected (positively OR negatively) by factors such as the environment, regular preventative service, amount of actual use, and varying degrees of wear and tear, among other things. YOUR JOB is to guess how long it will be before you need to replace each element or subsystem, estimate the future repair/replacement cost, and set aside the funds to accomplish this painlessly.
Another little factor to consider, is the fact that the specific products you select play a key role in terms of fundamental design life, as well as how well they hold up to average, or harder than average, tenant wear and tear. You have the opportunity to (in large part) establish your own maintenance schedule and long term cost basis with the choices you make.
Or, just follow the 50% rule, and you should be perfectly safe over the long haul, on average, with moderate preventative maintenance.
Great Motto: Shoot for the moon. Even if you miss, you'll land among the stars.
Les Brown
So, Harrison, I would love to see actual data about expenses. Can you share your experience on expenses on rental properties?
My background is physics. I fully understand the difference between a fundamental rule that's dictated by the laws of physics and an empirical rule used for engineering purposes. The 50% rule is totally emperical. There's nothing fundamental that somehow says expenses will be exactly 50% of the rent, even for 1000 units over 100 years. But, it is a consistent observation that's about what they work out to be.
What's your data? What markets and what circumstances? I fully agree its very difficult to find deals that survive and evaluation where expenses are 50%. And, I will admit I don't use that myself, since I AM willing to work for free for a few units, and I KNOW a property manager will charge me 10% of rent. So, I use 40%.
What's your experience?
Jon
Wheatie is exactly right. Being more aggressive and getting more deals done makes absolutely no sense IF you're in the rental business. Losing money is not a good strategy no matter how many rentals you buy! Moreover, the data from hundreds of thousands of rental units in the United States shows that operating expenses run 45% to 50% of the gross rents. Unless you are exempt or are working for free, then your operating expenses over many units and over time will be in the 45% to 50% range.
As Wheatie said, why not post your expense data, we'd love to see how you are exempt from the expenses that hundreds of thousands of your fellow landlords have experienced.
I would say that you are doing exactly what the average new landlord does. He pays too much for his rentals and then is out of business in a relatively short period of time. You are right, that is the REALITY of the situation - pay too much for rentals and you are certain to fail.
Mike
Great Motto: Stay Positive and Let's Make Every Day Profitable!
You're losing money. End of story. If you're buying "cashflowing" property in Indiana and are running negative $100 a month, you need to be in another business. I love this state but don't even try to say "appreciation" and "Indiana" in the same sentence unless it's forced appreciation at closing. It's a cashflow state. It's not Southern California.
Almost sorry (not really though) to be so blunt but guys like myself (and I'm going to stretch this and include Mike because I suspect he feels the same) are sick of 80% of the bullsh*% being sold in real estate investing circles and have found the 20% of information that truly makes us money. We drop 80% of the bullsh*% analysis for the 20% that we NEED to know. We drop 80% of the bullsh*% realtors for the 20% that take a minute to freakin' listen to us and deliver what we are looking for. When I'm buying, I'm analyzing in batches of 20 properties at a time have no time for "maybes" when all I want is basic, quick information that tells me whether or not a property is worth 30 seconds of my time to check out. The 50% rule saves me a lot of freakin' time of running through a property that just isn't going to work so I can go on to the next one that will.
Yes, if you have a negative cash flow of $100 per month, YOU ARE REALLY LOSING MONEY! If you had 100 of these properties, you would be losing $10,000 per month!
The key here is what business you are talking about. From your website, it looks like you're in the business of selling properties, not being a landlord. That is why (just like most other people who are not in the rental property business), that you don't understand the cash flow issue. Without cash flow, no business can survive.
I wholeheartedly agree that selling properties to newbies does not require that the properties cash flow. If that's your business, then it certainly isn't of concern to you whether it cash flows or not (although it might be of interest to the new landlord that buys it).
Appreciation has no effect on cash flow. If you're investing for appreciation, then you're speculating, not operating a rental property business. If a person invested for appreciation 2 years ago, how are they doing now? In most of the country, the answer is somewhere from NOT GOOD TO TERRIBLE and we're nowhere near the bottom.
You can find the expense data with any of the large apartment associations or landlord associations. Look it up!
Mike
I don't know why but I find it amusing that everyone on this board seems to be quite emphatic about their position on the 50% rule. I can not say one way or the other as I have no rental properties... *yet* but I can see that if it does hold true generally it could be a great time saving analysis formula...
Either way its good to see everyone's prospective on the subject!!
Point to Ponder: Negative energy is a waste of resources!
"Did I state that the negative $100 a month property was in Indiana?
I did not."
I did not know you were a licensed realtor for any area other than Indianapolis. Your website certainly seems to be solely Indiana properties. If this was strictly hypothetical, when it comes to "real" estate, there is very little room for hypothetical when you deal with the cash needs of landlording. You have to deal with "real" estate.
Taken from your website:
"Benefits of Investing In Indianapolis
* Instant Equity
* Positive Cash Flow
* Tax Advantages
* Appreciation"
I can only respond based upon the information you use to market your real estate agency. If you say here that appreciation is not why you invest in your area but say in your website that it is - do you think I'm not going to notice this as a buyer doing my due diligence? I am straight with people when it comes to Indiana. I tell them that many properties are now the same price they were 20 years ago - in fact you are sometimes looking at negative appreciation over some standard investing careers when you factor inflation. Because of this, you HAVE to maximize cash flow and dealing with any property that can't handle the constraints of the 50% rule as a minimum is not worth your time or analysis if you are in a mode of cash flow buying. If you're not in a mode of cash flow buying than you aren't as concerned with this rule.
This is the difference between realty and landlording. Landlord have to marry the property. It's a long term commitment. Realtors don't have the issues landlords do. I have nothing against this though I often have this conflict with my own realtor who, according to his sales pitch, believes the same house purchased for 10k and 50k will magically produce the same cashflow. I still use him as a realtor because I need him to present my offers and he's a friend of mine but there's not mistake that when it comes to due diligence, it's not my realtor's responsibility to make sure my property cash flows. It's his responsibility to sell me property. It is MY responsibility to do my own due diligence to make sure I buy cash flowing property. I've said this at least half a dozen times - with anything, DO YOUR OWN DUE DILIGENCE! Never forget your realtor's position and yours and the responsibilities of each to act in a certain capacity. This is nothing personal, it's business.
Tim
So, let me get this straight. You take your positive cash flow from your properties in Indiana and use it to offset the losses on negative cash flow properties in another state in hopes of appreciation in the future. If that's what you do, why don't you just say so on your website? Your website just looks like your selling property.
Quite the opposite, both Wheatie and I asked you to post your expense data so we could see where we're going wrong. Apparently, you've discovered a "secret" that hundreds of thousands of other successful landlords are not aware of.
So, if a market doesn't allow you to make money, do you just pretend the expenses are lower and buy anyway? Is that the strategy? I've said this a million times, but here comes 1,000,001: it doesn't natter what market you are in. Your expenses don't disappear because you are buying in an overpriced area. Paying too much for a property IN ANY MARKET results in negative cash flow.
So, why not tell us what your strategy is? Are you in the speculating business? Are you selling rentals to newbies? Are you primarily a real estate agent? Exactly what business(es) are you in?
Mike
Quote of the Day: Orville Wright did not have a pilot's license.
..........................................................................Richard Tait
I think that's what Josh has already done right here!
We've seen many people come to the forum pretending to be experienced investors, who in reality didn't even understand the basics of the business.
That why Jon, Tim, and I have questioned you about the operating espenses. The statement in your original post sounds very familiar to us.
It's hard to claim to be a successful landlord if someone doesn't even understand the basics. In addition, we're still trying to understand how losing money on one investment to speculate on appreciation in the middle of a real estate bust is a good investment. My research indicates that during a normal real estate bust (which this is not) that it takes 8-10 years for inflation adjusted prices to reach their pre-bust level. Since this bust is worse than normal and not nearly over, it could easily take a LOT longer than the normal 8-10 years.
I may just be some hillybilly from Ohio that only invests in his own back yard, but at least I understand the basics of the business and I'm not advocating that newbies be "aggressive" and buy properties even though they will not cash flow. To me that sounds RECKLESS, not aggressive.
Mike
Great Quote: Look at a day when you are supremely satisfied at the end. It's not a day when you lounge around doing nothing; it's when you've had everything to do, and you've done it.
Lord Acton
So, I am having a little trouble reconciling these two statements:
Also, while I do agree its reasonable for a property to be worth more than it was when it was purchased, that's not always the case, nor does that mean it was a good investment. I speak from experience because a property I purchased in CA in 1995 and sold in 1999 was sold at a LOSS. And not because it was in worse shape than when I bought it. I can also speak from experience about a property I bought in TX in 1987 and sold in 1995. It was indeed worth more when I sold. 18% more. But, on an annual basis, that amounts to a 2.1% return. After inflation, which was about 4% over that period, it was a loss. It would have had to appreciate 38% to have kept pace with inflation. Even now, that same property is worth about double what is was in 1987 (according to zillow, for what that's worth). Which exactly matches inflation. IMHO, that property was a very poor investment.