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
In 2017 we already had a water service pipe fail between the house and the street and had to have the plumbers work on weekend overtime to correct the problem after over $1,000 worth of water leaked underground.
@Lee S., it's well known that the more expensive the rental market (either because of land value or newness of the property), the less reliable the "50% Rule" is. Fact is, MANY properties don't need many repairs from one year to the next. But it's also well known that in those SAME markets, gross rental return will generally be LESS than 1%/m of the property's value (not necessarily the original cost), which still makes it hard to get positive cash flow (when leveraged at 80%), even though expenses might be significantly less than 50% of gross rent.
Lee, you may well be benefitting from a buoyant rental market, but can I ask: what IS that $2,800/m as a percentage of your property's value? And would INVESTORS make a positive cash return if they bought your property at market value, with just 20% deposit?
That's another way of asking: would your property's equity earn you more* - elsewhere?...
* I know, I know, cash flow is just ONE factor.
@Brent Coombs like I said I shouldn't have commented because I had forgotten the content of the entire thread. To answer your question though, home bought for 319k as a short sale 6 years ago, it is 10 years old now worth 500k. Remaining loan balance is at 3.25% so that helps with cash flow. The best I can do in my area is right around 1% when buying off market at 60-70% of value depending on rehab costs of course. I have one I am just finishing that I'm into for 140k that would rent for $1400 a month but I'm most likely selling it.
I never liked following rules. Breaking rules is much easier. If I followed rules I probably would have never bought any property
Franklin
@Brent Coombs I think you bring up some really good points.
I bought a SFH in Florida in 2012 for 95K. In 2006, the house was worth about 260K. It is now worth about 225K and rents for 1700/month. My mortgage, taxes, insurance and PMI is $665/month. This was a 90K loan at 4% with a 5% down payment. It was my primary house for 3.5 years and it's been a rental for the past 2 years. I rehabbed it when I lived in it and made it look real nice. I fixed everything I could. I put 16K total into it. It was 10K in regular repairs and another 6K for a new A/C system.
I don't really think the 50% rule applies to this rental. The tenants and house operate like it's worth 225K. However, I was lucky enough to get it for 95K.
Taxes: 6.5%
Insurance: 5%
Vacancy: 0% (It's a college rental and leases are signed 2-3 months in advance)
Property Management: 8.5% (I used a service my first year, but self-managing this year).
Repairs: 5% (This estimate is from another property. I pretty much fixed everything when I lived there).
Cap Ex: 5% (New roof in 2004 and I put a new A/C in 2014).
I'm at 30% with property management.
I'm at 26% for another house with property management that I have had for 10 years. It's a similar situation. It had massive rental appreciation. It might have been 40% when I first purchased. However, rent still went up, but not repairs or vacancy.
Just adding to the discussion with a 2-Family Rental property use case (rough numbers):
Mortgage Payment & Interest: $1400
Mortgage Related Expenses (Insurance, Taxes, *PMI): $1050
Maintenance (10% of rent per month): $365 per month budgeted
Total Expense: $1415
Planned Rent: **$3250
*PMI - I use to live there and purchased via FHA 5 years ago.
**The reason it is planned is I am trying to renovating this property.
Ok, l've read this thread and it reminds me of a political debate that has no chance of changing someone's opinion.
From my experience, there are two basic ways to make money owning real estate. Buy and Hold for the objective of positive cash flow. Or, buy and either hold or flip for capital appreciation. To over simplify, I call it the Texas method or the California method. I live in Texas so I subscribe to the buy and hold method for cash flow. It works best FOR ME. Can you flip in Texas for capital appreciation, sure but if your looking to cash flow, it is certainly easier in Texas than California. That being said if your objective is to cash flow then -$100 month is not a positive cash flow situation no matter how you rationalize the investment.
Now to this 50% rule. If it works for you in evaluating property then keep using it. Here in Texas, I'm either applying the rule wrong are it doesn't help me evaluate my deals. I'm afraid I would be leaving good deals on the table by applying that rule.
I went back and applied the rule to properties I have owned from the beginning of 2002. For me the biggest expenses I have for my duplexes (all my properties are multifamily) are Taxes and Insurance. Occasionally the A/C unit needs to be replaced and roof replacement is the other significant expense I have had in Texas. Even the roof is not bad as you usually can wait for a hail storm or strong wind storm to help you out. Let the insurance company help pay for that expense.
Take a typical duplex getting $1000 a side $2000 a month, $24,000 a year. Taxes and Insurance is about $4500 a year and if I spend $3000 a year in maintenance in a year that would normally be high. The 50% rule would say I should be spending $12,000 a year. I come no where close to that. My experience is about 30% expenses a year but that includes taxes (high in Texas) and insurance. I don't pay property management as I do it myself so that might be an issue for some. My vacancy rate is extremely low. In fact the first duplex I bought in the Austin area in 2005 has both renters in each side since I bought it. Also, the rents were $725 each side and now $1000 and I am still $200 below market. I own 17 doors, so I am a small fry in comparison to some of you. But for the last five years I may of had a total of 3 months vacant of ONE UNIT. Now I know many of you won't believe me but the rental market is crazy strong along the HW 35 cooridor around Austin, TX. So think about the 50% rule when my rents were 725 X 2 = 1450/mo $17,400 yearly. So my expenses (50%) would be $8700 and those expenses should now be $12,000 because my rents have increased? So my rents could go up another $200 per side a month if I wanted to raise; that is additional $2400 a year so by raising my rents I am raising my expenses $1200.....really? I guess I could see that logic if increase rents caused additional delays in renting here in Austin, but that just hasn't been the case. Here in Texas I use the 1% to decide if I am even going to take my time to further evaluate the property. The 1% rule keeps me out of trouble and the numbers seem to work here in TEXAS.
@Joe Scaparra - I think you answered your own question with respect to the 50% rule / guild. By excluding management and vacancy, the expenses are going to come in well below 50%.
That your vacancy is so stable is WONDERFUL but not all properties have that attribute. Vacancy is a normal aspect of being a property owner. You are in a high demand market so 'get away' with it. Hope it never happens to you but Imagine 10 years from now that the market changes, as all market do, and demand decreases and tenants roll over more often resulting in needing to turn the unit every year or two. The unit may be down for weeks or months depending on how dated it is and what upgrades you put in. Also with lower demand, you may be waiting on suitable applicants rather then having your pick.
Similarly, the PM services are needed for all properties. You have chosen to self manage which is fine but are also NOT paying yourself for this service. Remote owners or even those who simply can not / do not want to do these services is also a normal aspect of property ownership. In 10 years you want to take an extended vacation of several months. You could try leaning on a friend but then run the risk, even with the best of intentions, that they don't do things right or unfortunately have an accident. At some point you need to engage a professional company to cover while you are away. If this was part of your budget, no problem but if it is not, you take a big hit to the cash flow.
Add these costs back in and you are very near 50%.
As any number of other BP members will tell you, the long term average all-in costs will trend towards 50%.
No problem, I do see your point and it is generally valid, but maybe with a caveat that breaks down the percent of each category comprising the 50%. If you notice, property taxes are high in Texas and even estimating 3000 per year in maintenance only get me to just over 30%. The other discrepancy is that the more your rent increases the higher your expenses. In theory, if you call that inflation then you might think taxes, insurance and maintenance cost also will go up but I don't find that the case necessarily. Most first time real estate investors, might do their own PM duties to save money. Experience real estate investors should do a more comprehensive analysis on the profitability of an investment. The 50% rule to me is too broad a stroke to get any real value. I've never used it but I do use the 1% evaluation on every property I consider.
@Joe Scaparra - I think you answered your own question with respect to the 50% rule / guild. By excluding management and vacancy, the expenses are going to come in well below 50%.
That your vacancy is so stable is WONDERFUL but not all properties have that attribute. Vacancy is a normal aspect of being a property owner. You are in a high demand market so 'get away' with it. Hope it never happens to you but Imagine 10 years from now that the market changes, as all market do, and demand decreases and tenants roll over more often resulting in needing to turn the unit every year or two. The unit may be down for weeks or months depending on how dated it is and what upgrades you put in. Also with lower demand, you may be waiting on suitable applicants rather then having your pick.
Similarly, the PM services are needed for all properties. You have chosen to self manage which is fine but are also NOT paying yourself for this service. Remote owners or even those who simply can not / do not want to do these services is also a normal aspect of property ownership. In 10 years you want to take an extended vacation of several months. You could try leaning on a friend but then run the risk, even with the best of intentions, that they don't do things right or unfortunately have an accident. At some point you need to engage a professional company to cover while you are away. If this was part of your budget, no problem but if it is not, you take a big hit to the cash flow.
Add these costs back in and you are very near 50%.
As any number of other BP members will tell you, the long term average all-in costs will trend towards 50%.
In order to manage from a distance all you need is a good handyman. I don't need a property manager to call a handyman. I have a great handyman. I call him and the conversation usually lasts for about 5 minutes. He then sends me a quote via email. I email and/or text him back to approve the repairs. He emails me a bill with before and after pictures and I pay it on-line with a credit card. The entire process takes about 15 minutes of my time.
I do fly into town when the place turns over. However, both of my properties are located next to family. I always time it in combination with a family trip and then I can write the whole trip off as a business expense.
The 50% rule also doesn't work when your rents increase more than inflation. After holding a property for 10 years, the rent is now 50% higher. However, my expenses are probably only 15% higher.
The 50% rule also doesn't work when your rents increase more than inflation. After holding a property for 10 years, the rent is now 50% higher. However, my expenses are probably only 15% higher.
I'm going to disagree with this, for the most part...
Property management costs are going to scale directly with rent increases (assuming you're paying a percentage of gross income for your PM).
Rent loss and vacancy "expenses" are going to scale directly with rent increases -- a month of vacancy at any market rate is going to impact your margins exactly the same.
Rents tend to increase based on market economics. If rents are going up, it's likely that labor and material costs are going up as well (higher maintenance, capex, turnover costs).
Rents are correlated to total mortgage costs. If rents go up, it's likely that local taxes are increasing, and potential insurance costs.
In other words, rent increases don't happen in a vacuum; the conditions that impact rents are also going to generally impact expenses, capex and rent loss.
@J Scott I'll preface this again with I have not been following the thread closely. To touch on rents going up faster than other costs, I'll use an extreme example to make a point and assuming mortgage costs are part of the 50%.
Had I bought a house that is worth 200k now 20 years ago for 70k, with financing, this house would cost no more as a rental as paying 200k for it today because and finance costs would be significantly lower.
Yes, "the past does not guarantee the future" but that goes for every single thing you could do with a dollar today with some expected return in the future so it's moot.
With this above scenario I would be "cash flowing" $300-$500 more per month on the exact same house had I bought it earlier, not to mention pay down and appreciation.
@ J Scott
My argument is that my rent is going up more than inflation, so there's a gap. I'm not saying my expenses are flat. They have gone up. However, they haven't gone up nearly as much as inflation. Now I'm going to bust open my calculator.
Original rent in August 2007 was $1300/month. Today it's $2000/month. In August 2017, rent is going up to $2200/month. Over 10 years, this is an increase of 69%.
1) My original taxes were $1530/year and they are $1700/year today. That is an increase of 13%.
2) My original insurance policy was $750/year with a $1,000 deductible. Today it's $775, but with a $5,000 deductible.
3) Vacancy has been 0% for the past 10 years. The vacancy rate for the neighborhood is less than 1%. The house is located 1/2 mile away from a University with 35,000 students.
In all honestly, has the cost of a water heater increased by 69% over the last 10 years? Is there anyway to look that up?
If your expenses have been lagging inflation, it is an enviable, but transitory, situation as costs will increase to catch-up ... the increased rents themselves fuel local inflation and lead to increases in the costs of goods (retail) and services (labour).
Unless your rents have been rising in isolation of the market - in which case, they will eventually encounter a demand limit - the growth rate will flatten (if vacancy is <1%, barring a zoning/regulatory restriction, you will eventually see an increase in supply).
The premise behind this 50% rule-of-thumb - and other such guidelines - is that over a large sample size of property and/or a large sample period of time, the cumulative operating costs and capital re-investment are going to approach 50% (somewhere in the 40% - 60% window as stated earlier).
There will be properties which, for a variety of reasons, will be outliers for a period of time - when you have one which runs below this window, you smile and profit, but it would be unwise - and unsupported - to build a business model based upon a {temporary} outlier.
Windfalls are more pleasant than shortfalls.
If your expenses have been lagging inflation, it is an enviable, but transitory, situation as costs will increase to catch-up ... the increased rents themselves fuel local inflation and lead to increases in the costs of goods (retail) and services (labour).
Unless your rents have been rising in isolation of the market - in which case, they will eventually encounter a demand limit - the growth rate will flatten (if vacancy is <1%, barring a zoning/regulatory restriction, you will eventually see an increase in supply).
The premise behind this 50% rule-of-thumb - and other such guidelines - is that over a large sample size of property and/or a large sample period of time, the cumulative operating costs and capital re-investment are going to approach 50% (somewhere in the 40% - 60% window as stated earlier).
There will be properties which, for a variety of reasons, will be outliers for a period of time - when you have one which runs below this window, you smile and profit, but it would be unwise - and unsupported - to build a business model based upon a {temporary} outlier.
Windfalls are more pleasant than shortfalls.
I meant to say that my expenses have increased at inflation. I'm estimating 15-20%% over 10 years. However, my rental income has increased above inflation, which is 69% over 10 years.
It's theoretically possible for rents to outpace inflation, right?
I have another rental house in Fort Myers, FL. It had the largest increase in rent in the nation in 2015-2016. Rents went up by 26%. However, inflation did not go up by 26%.
I meant to say that my expenses have increased at inflation. I'm estimating 15-20%% over 10 years. However, my rental income has increased above inflation, which is 69% over 10 years.
It's theoretically possible for rents to outpace inflation, right?
I have another rental house in Fort Myers, FL. It had the largest increase in rent in the nation in 2015-2016. Rents went up by 26%. However, inflation did not go up by 26%.
Roy said everything I was going to say...
But, I'll add that rents tend to correlate to housing prices, and in most parts of the country, housing prices tend to correlate (and track) inflation. At least if you look at the data for the past 100 years.
So, to answer your question, yes, it's theoretically possible for rents to outpace inflation, but for most parts of the country, over long periods of time, that doesn't happen.
Perhaps you live in an outlier, or your property is an outlier. They doesn't change the fact that rents and expenses will tend to correlate to both each other and to inflation, again over large samples, diverse geographic areas and long time periods.
Why would I care about the rental market in the entire United States? I have two rentals. One is in Florida and one is in Colorado. We all agree that real estate is local. National trends mean very little to most landlords. However, we are supposed to follow this guideline that is the aggregate of the entire United States over the last 100 years?
Why stop at the United States? Why don't we take the aggregate of real estate of the entire world over the last 1,000 years and use that information to make decisions for your local neighborhood in 2017? Would that information be helpful?
Last rant for today. According to the national data on Zillow, housing real estate for the entire United States peaked in May 2007 at 196K.
This is the exact same month that I purchased my first rental in Fort Collins, CO for 182K. It was the bottom of the market for 80526. Prices were flat for the first 4 years (2007-2011) but there was good appreciation over the last 5.5 years. A total of 9.5 years later and it's worth 330K.
If I was looking at the national data, I would have known that real estate was at an all-time high and a horrible time to buy. However, that national data provided 0% meaningful information on my local real estate purchase. Nationally housing was at an all time higher but locally it was at an all time low.
This is what popped into my head reading through this thread (or at least most of it).. not sure if this is right, but it's how the info in the thread looks to me..
I think the 50% rule is coming from the laws of economics, but our point of view (as landlords trying to evaluate potential investments) has us looking at it backwards.
Obviously, the gross rent does not determine the expenses. However, the expenses for a typical (well-managed) property of whatever type / in whatever area are a major part of what determines the market rent. The 50% left over is what we care about - it determines the value of a particular property, as a rental. If that amount is lower than what the seller can get for it, it means that either someone else made a poor investment, or the property is more valuable for some other purpose (ie, owner occupied).
We tend to use this rule as a baseline for our deals. However, if you manage the property well you will often get better returns. If a property is exceeding 50% it often has value-add options the new owners may be able to capitalize on.
I find it hard to imagine being able to find a SFH home that would cash flow anything with 50% of the rent as expenses, unless you paid cash each time.
The 50% rule is expenses, not including mortgage (principal/interest). It include taxes, insurance, utilities, repairs, management and vacancy. It is definitely not accurate in every case, but it can be used to analyze something very quickly.
Personally, I do not use this ratio. I know that it works for a number of people, but I like to run the actual numbers with a slight overestimation. If you buy a house and knock it out of the park on the purchase, your overhead should be well below 50%. Just my experience. I know that everyone's is different.
If you buy a house and knock it out of the park on the purchase, your overhead should be well below 50%.
What does the purchase price have to do with the expense ratio?
If I purchase for less, my mortgage costs are obviously less. Therefore, 50% of my gross may not need to be assumed as operating expenses.