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
Just a quick question on the 50% rule. I think the % may be less (35-40%) IF the property is in a low tax area, mild environmental area, (i.e. Arizona), vs. a high tax state and harsh environmental area (i.e. New Jersey). What's your thoughts on that? Also, if the tenants pay the utilities, wouldn't that also maybe bring it from 50% to 40%?
Thoughts?
In an area where taxes are disproportionately higher than the average, you'll likely find that rent is disproportionately high (all other things being equal) -- otherwise, there would be a big shift from owning to renting, and most jurisdictions won't hike taxes to the point where they are having a major negative impact on homeownership.
I've talked to LOTS of experienced landlords all around the country, and I've yet to find any that indicate long-term numbers less than 45%. In my experience talking to successful landlords, I'd say that within about two standard deviations, the range is 45-60% operating expenses (including capex and rent loss).
Many new and inexperienced investors like to look for loopholes in that, but if you ask most experienced investors, there aren't many...
Just a quick question on the 50% rule. I think the % may be less (35-40%) IF the property is in a low tax area, mild environmental area, (i.e. Arizona), vs. a high tax state and harsh environmental area (i.e. New Jersey). What's your thoughts on that? Also, if the tenants pay the utilities, wouldn't that also maybe bring it from 50% to 40%?
Thoughts?
These questions about the 50% rule and the debate over if it is accurate, useful, or useless will likely be going on for generations to come. Each time, someone will come in and say that they believe the % is X or Y rather than 50% and provide some type of example or assumptions to debate their point.
Can one investor have 25 single family residence doors over a 25 year period, invest in a certain specific market with a certain specific strategy and nail a total expense ratio of 40% over that 25 year span? Can one investor state that over the last 10 years, he has never had an eviction and never had a vacancy throughout his rentals? Can one investor state that his/her strategy is to buy new and sell after 10 years so that he/she avoids any major Cap Ex and have much lower repair/maintenance costs? Can one investor state that he invests in an area with much lower property taxes (keep in mind in areas where one expense is lower, it is common that another is higher and thus, they average out)? The answer is YES, however, can we all assume that we all can be lucky enough to have lower than average vacancy ratios, lower maintenance costs, lower this, and lower that and over a 25 year period and over 25+ doors base our financial decision on such wild assumptions? NO, that would be foolish on our parts.
This rule is merely a guideline and nothing more. It does not mean you should base your purchase decision on it, and it does not mean you WILL average 50%. Can I or you average 40%, sure, I guess so. Can we also average 55%, yes we can.
To specifically answer the question quoted above, if tenants pay utilities, your ratio of costs do not go down because in that such circumstance, the average rental rate for doors in which tenants pay utilities is typically lower than when owners pay utilities. In other words, it averages out. Same with HOA communities. The HOA fees increase your costs but the repairs made by the HOA decrease the owners costs, again, it averages out. Hence, the 50% "average" guideline.
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
Wow, Jon Holdman, this sounds like some serious price negotiation experience. It makes so much sense. If you know your multiplier, it doesn't really matter what they claim their expenses are, as long as they agree to your multiplier and the resulting price. Then they have to prove the expenses and revenues are accurate, and if they are not, then you get a discount, or if they are, then you are paying the correct price you wanted to pay. If you have any suggestionsor tips on how to determine your multiplier, which takes this to the next level, please share. Thanks
As yet another note on this subject. When I first came to this board. I knew nothing about operating expenses, while the 50 percent rule is not perfect, especially for newbies, it gives them a good estimate on whether or not a property actually cash flows, instead of the phony cashflow, that is thrown around by some realtors. Rent- PITI
It's not perfect and if you can get more specific numbers please do.
But at the end of the day, the only exact numbers we really know is property tax and insurance. We can create an depreciation schedule on the useful life for capex of the major systems that will need replaced. However, those are just estimates as well. Some roofs last 30 years, others you may only get 15 or 20 out of. Some HVAC equipment is still going after 30 or 40 years, but some need replaced after 10(bad luck or bad brand). etc. The best we can do is take our exact expenses on property taxes and insurance, and then make reasonable assumptions on everything else. If that number works buy it, if not move on to the next. If you have a decent sized portfolio, there seems to be enough evidence, that you can expect operating expenses somewhere in the 50 percent range. Some may be closer to 40, and some may be closer to 60. I would make sure your property when buying cash flows at an acceptable level at 50 percent OE's and still cash flows at 60 percent OE's(worse case scenario). If you do that, you limit your chances of losing money over the long term.
I believe it would depend on the area. Different areas have different rent scales. And different areas attract different tenants...some take care of property more than others. I think it might be close to that in some low income areas I believe.
I agree with Oscar's comment.. the 50% is probably accurate for lower-cost of living areas. I was suprised that it is supposedly accurate for New Jersey, but maybe I had the wrong impression of New Jersey.
I have one rental that has been rented out for 10 years now.. monthly rent started at $2000 and is $2300 now (market rent would be $2750, my bad).. let's look at tax returns, for annual (!) repairs,supplies, cleaning and maintenance:
2015: $1870
2014: $750
2013: $0 (!)
2012: $650
2011: $7068 (complete new paint and some other stuff)
2010: $225
2009: $0
2008: $709
2007: $1835 (get rent ready)
Looks like $13k in 9 years.. averaging $1500 a year.. $125 a month.
So.. rent is $2300
HOA $350
Condo insurance $15
Property tax $300
Variable expenses $125
Total expenses: $790
790/2300 = 34%
If I would discount rent by 50% to figure out cash flow, I would NEVER buy any rental.
Vacancy is minimal. I frequently get the keys returned Saturday evening and sign the next rental contract the same or next day. For this particular unit, I had a few of those turn-overs with under 5 days vacancy except in 2011.. I think I had it empty almost 2 weeks while I had the unit painted and some upgrades done. It is still the same tenant since then.
Total expenses: $790
790/2300 = 34%
If I would discount rent by 50% to figure out cash flow, I would NEVER buy any rental.
Vacancy is minimal. I frequently get the keys returned Saturday evening and sign the next rental contract the same or next day. For this particular unit, I had a few of those turn-overs with under 5 days vacancy except in 2011.. I think I had it empty almost 2 weeks while I had the unit painted and some upgrades done. It is still the same tenant since then.
But, since this is going off your tax returns, this doesn't include rent loss (which is just an income adjustment) or capex (which goes to the balance sheet, not the P&L) -- I typically estimate those at about 8% and 4%, respectively. Add that to your 34% expense ratio, and you get a total cost ratio of about 46%.
I also noticed that you didn't include Property Management in your costs (or maybe I missed it), which would bring the cost ratio up another 8-10%. So, on this property, your total cost ratio is actually likely somewhere in the 46-56% range -- squarely the range that most people would consider in the 50% rule range.
If anything, you just proved my point that too many people think they are spending far less than they really are...
Not really.. the $7068 in 2011 were cap ex and should have probably been depreciated. I think at least $2000 of it was a special assessment by the HOA after a lawsuit.
I manage the property myself. By the low repair bill, you can see that I rarely get a call.
The numbers would look slightly better without those cap improvements from 2011. And much better if there were no HOA.
The rent loss is maybe 25 days in 9.5 years.. what is that.. 0.7%? It may also be a sign that my asking rent is too low.
I may go through this exercise with another property.. maybe a 4plex that we have had since 2012.
I really appreciate all the comments in this thread. I have struggled with this rule over the past few years. I have two rentals that are single family homes. Based on all of the comments, it seems as though the 50% rule applies more to multi-units in lower income areas.
I have some issue with the 50% rule for single family homes. These issues include utilities, yard maintenance and vacancy. My tenants agree to pay all utilities and complete all yard maintenance. In reference to vacancy, I have averaged 0% over the last 9 years. Both rentals are close to major universities. The majority of leases are August 1st to July 31st. You typically show properties 3-4 months before they are vacant. All the students pretty much move during the same 1-2 days. For one rental, the average vacancy for the entire neighborhood is .5%. Forcing myself to use a 6% vacancy rate doesn't seem to be very helpful.
I'm sure that some landlords have found the 50% rule to be spot on after 30 years and 30 properties. However, I don't think that has very much to do with my properties for the reasons I have listed above.
We have a fair number of student rentals (houses, apartments, rooms) and, like you, we typically have them rented before they become vacant.
Regardless of your vacancy rate or how short your turn-around windows, your properties are still going to require routine maintenance and capital re-investment over time ... or you eventially will have vacancy and a set of huge bills :-(. When you consider your reserves for the replacement of floors, cabinets, fixtures, roofs, DHW, HVAC, etc., you will find most residential properties (1 - 4 units) will fall into the that 40 - 60% window over the long-term.
I really appreciate all the comments in this thread. I have struggled with this rule over the past few years. I have two rentals that are single family homes. Based on all of the comments, it seems as though the 50% rule applies more to multi-units in lower income areas.
I have some issue with the 50% rule for single family homes. These issues include utilities, yard maintenance and vacancy. My tenants agree to pay all utilities and complete all yard maintenance. In reference to vacancy, I have averaged 0% over the last 9 years. Both rentals are close to major universities. The majority of leases are August 1st to July 31st. You typically show properties 3-4 months before they are vacant. All the students pretty much move during the same 1-2 days. For one rental, the average vacancy for the entire neighborhood is .5%. Forcing myself to use a 6% vacancy rate doesn't seem to be very helpful.
I'm sure that some landlords have found the 50% rule to be spot on after 30 years and 30 properties. However, I don't think that has very much to do with my properties for the reasons I have listed above.
With 9 years of data, I'd love to see how your expense ratio (including capex and vacancy) breaks down over that time... Perhaps you have figured something out that can help the rest of us!
Why are you asking me about vacancy? I stated that it's 0%. The post before you also commented that it's very possible to achieve this with college rentals.
I have one more issue with the 50% rule. When I purchased rental #1 in 2007 the starting rent was $1350/month. Right now it's $2,000/month and next year it's going to be $2200/month. This is a 63% increase. During this time, my property taxes increased by 14% and my insurance has increased by 16%. Aren't they supposed to increase by the same amount? Vacancy is also still at 0%.
I really appreciate all the comments in this thread. I have struggled with this rule over the past few years. I have two rentals that are single family homes. Based on all of the comments, it seems as though the 50% rule applies more to multi-units in lower income areas.
I have some issue with the 50% rule for single family homes. These issues include utilities, yard maintenance and vacancy. My tenants agree to pay all utilities and complete all yard maintenance. In reference to vacancy, I have averaged 0% over the last 9 years. Both rentals are close to major universities. The majority of leases are August 1st to July 31st. You typically show properties 3-4 months before they are vacant. All the students pretty much move during the same 1-2 days. For one rental, the average vacancy for the entire neighborhood is .5%. Forcing myself to use a 6% vacancy rate doesn't seem to be very helpful.
I'm sure that some landlords have found the 50% rule to be spot on after 30 years and 30 properties. However, I don't think that has very much to do with my properties for the reasons I have listed above.
No need to "struggle with this rule"! Just consider yourself very blessed when your expenses are a lot less. But for your NEXT buy, will you estimate your return ONLY using your current percentage?
THAT could be a mistake. Isn't it best to be more conservative than you're actually hoping for?...
(Wow! This thread's still going after 8 years. Sorry, I haven't read all the posts).
It s rule in the sense of a rule of thumb, not an absolute rule. I've had expense some years as low as 11%, only paying taxes and insurance, all other expenses paid by tenant. and I've had several tenants stay 30 years, so I've had some property with extremely low vacancy. As a rule of thumb use it if you want, or NOT. I was investing for a long time before I even heard the 50% rule. Don't lose any sleep over it, since you're so far below it, ignore it.
Why are you asking me about vacancy? I stated that it's 0%. The post before you also commented that it's very possible to achieve this with college rentals.
I didn't ask you about vacancy... I asked what your expense ratio (plus capex and vacancy) numbers were for this property over the 9 years...
We talk about expense ratio (plus capex and vacancy) typically being in the 40-60% range -- I'm curious what your number is. And, if it's below 40%, I'm curious what factors contributed to that. You've already mentioned low vacancy, but I'm curious to the other numbers as well.
Are you willing to post your P&L (plus capex) for the past 9 years?
Like I said, maybe we can all learn something from you...
@J Scott I think you are on the right track. Out performing the 50% ratio significantly for a 5-10 years over multiple properties is very common. However, it would be a mistake to assume that this performance will continue indefinitely and using a lower expense ratio for analysis will lead to overpaying for deals in the long run.
As you mentioned the tax and rental rates tend to correlate. Insurance rates have historically moved in cycles by region but tend to even out in the long term. The causes of wear and tear vary by region but also generally equal out over time. For analysis sake I will assume:
Taxes: 10% of rent
Maintenance: 8% of rent
Capex: 8% of rent
Insurance: 8% of rent
Total: 34% of rent
Investors who choose to self manage their properties can eliminate the direct property management expense. However, the time and resources spent on self management take away from other money generating opportunities you could be pursuing generation an opportunity cost. Adding the 10% property management expense puts the ratio at 44%. This leaves vacancy as the final remaining piece of the puzzle.
@Adam Christopher Zaleski's properties may well have a 0% vacancy rate due to the nature of the university market. However, if one of lease falls through due to a fluke right before the school year, a student drops out and leaves town or tenants are evicted due to partying and bad behavior. Damage to the property can also make it uninhabitable until repairs are made. Long story short there are an unlimited amount of fluky reasons a property could be vacant and deal analysis is meant to ensure that in the long run you will have positive cash flow to withstand those situations.
An experienced investor with a large portfolio may develop a process to cut a few percentage points off their expense ratio but for most smaller investors it pays to be conservative.
Here's an estimate of my numbers below. Rent is $2,000/month. Because I did a 10K rehab on the house, my repairs for the first 5 years was around $1200/year or 5%. However, the last 4 years it's been closer to $1700 or 7%. As a result, I'm taking the average of 6% ($1450).
As stated in my previous post, rent during the first year (2007) was $1350. However, the current rent is $2000/month, so that is what I am using for the 50% rule.
Taxes: $1700 (7%)
Insurance: $750 (3%)
Maintenance: $1450 (6%)
Capex: $1450 (6%) -This is an estimate. After 10 years, it's actually been around 2%-
Vacancy: 0%
Management: I manage myself, but the going rate is 8% for my area. Most of the management companies in town have a poor reputation and one of the main reasons I management myself. It costs me about 20 hours/year. That is like paying myself $1920 for 20 hours of work, which breaks down to $96/hour.
You might say that my cap ex is low. However, when I bought in 2007, the roof was replaced in 2004. I have lots of shade trees and it should last 25 years. I did 10K of rehab, when I first bought it. That included a new furnace ($2200) and a new water heater ($800).
I have had two capex expenses after 10 years. One, I installed a new air conditioning system in 2010 for $2100. It previously didn't have air conditioning, only heat. Two, I am replacing old carpeting in the basement for $1500 in summer 2017.
If I sold in summer of 2017, I would have had the property for 10 years and averaged 18%, which does include managing myself. If I paid for management that would be a total of 26%.
I don't count on these numbers for making purchasing decisions. However, when people tell me that all rentals have the same expense ratio of 50%, I disagree. I would agree that all rentals could average out to be 50%. If the average expense ratio is 50%, then half the people are going to do better than this and the other half are going to do worse. Almost all variables in life are normally distributed.
I agree with your post
I'm guessing that means you haven't yet had to replace the roof, or the HVAC system or the water heater or any other capital items that will eventually wear down (siding, gutters, electrical, plumbing, countertops, cabinets, appliances, etc).
And keep in mind that repairs are only a small part of the 50% loss ratio you'll see -- the rest is taxes, insurance, vacancy/rent loss, property management, turnover costs, utilities, exterior maintenance, legal fees (you'll eventually have to evict someone), etc.
It's not uncommon for the first few years (in your case, at least the first six) to cost significantly less than the average year. You just need to ensure that you're pro-rating for the stuff that doesn't come up as often, like capital expenses and bad tenants.
Amen @J Scott
In 2016, I replaced 2 total new roofs, repaired 5 others, installed all new windows in 2 properties and replaced a few windows in 2 others, replaced exterior french doors....
new electric service at 2 houses, new heat pump at 1 house, new kitchen and bath at one house, 3 houses extensive landscaping, one concrete sidewalk (municipal cited), carpenter ants, major mold job, minor mold job, major fire damaged house, major sewer backup, storm blown down large tree..... just an average year.
One time I had a fire, flood and explosion all in one year!
In 2017 we have already replaced the waste-side plumbing (to the lateral) in one property - after one of our trades poked his finger through a 4" cast-iron elbow (45) while tapping on it. As we {literally} dug a little deeper, it turned out not to be the worst section of pipe.
We have another property in the same neighbourhood which is of similar vintage (~130yrs) and are anticipating a refresh of its plumbing later in the spring.
Everything has a serviceable life.