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
I understand that, and that is my point. If you set aside 50% for expenses, and have a typical 15 year mortgage, you wont cash flow anything.
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.
A couple of errors there. #1: Mortgage doesn't get included in the "50% Rule" anyway. #2: If the purchase price is lower, the RENT is likely to be lower also, which means the expenses ratio might NOT be lower.
OK: "50% of my gross may not need to be assumed as operating expenses" (but, not because of "therefore").
I do reckon it IS useful to know your operating expenses as a percentage of your Rent return.
Just like it IS useful to know your return as a percentage of your outlay, rather than just how many dollars you're getting.
50% is a good guesstimate in MANY markets. If that's not so for YOUR market/property - find out what percentage IS!...
@Brent Coombs I would have to disagree on one point. Purchase price correlating to rent. Assuming you would get lower rents because you bought at a discount just doesn't go together in my opinion. One of the things that has made me successful in this business is to identify and purchase undervalued assets. In other words, if you aren't hunting down and digging up deals, you are walking into the batter's box with a strike on the count before you start.
My model has been to identify undervalued properties that have value as upside. In conjunction with that, there may be a seller with a need rather than a desire to sell. Case in point: I purchased a 3 unit fire damaged property for $40,000. I put $70,000 into it, and have an appraised value of $225,000. That $40,000 house gets the highest rents on the street at $1000, $950, and $800. Purchase price does not correlate to rents in my experience.
The reason why I personally do not utilize the 50% rule is because in my experience, my normal operating expenses should not come anywhere close to 50% of my gross rent, especially if the mortgage is not being factored into that scenario. When I look at a triplex or a 3 family as we call them in the northeast, 1 unit will cover all operating expenses. Water, sewer, taxes, insurance, etc. if I have a mortgage, a portion of one units rent will generally carry that with remaining rent left over, and the third unit is generally all profit.
Like I said before, everyone is different, and has different experiences. I just personally do not use the rule because I have a different way of looking at deals. One isn't better than the other, it depends what works for you.
It should also be noted that I invest in my market. I typically don't venture into other markets that I am unfamiliar with. Having a familiarization with a particular market leaves one with less unknowns generally where a quick rule of thumb may be less essential. You have the ability to run hard numbers.
I understand that, and that is my point. If you set aside 50% for expenses, and have a typical 15 year mortgage, you wont cash flow anything.
A typical mortgage includes taxes and insurance in the payment, so make you subtract those costs because they are part of the 50%. I would personally try to make it work with a 30 year for higher cash flow. If you are taking out 15 year loans, then your are prioritizing mortgage pay down over high cash flow.
@Brandon Ingegneri, I reckon it's line-ball as to whether you should keep deals like you're getting, or flip them.
A QUICK $100k profit, vs a SLOW 1.2%/m of its value as gross rent (less whatever expenses you DO pay).
Though, obviously it's nice to have both profitable options! Congrats on your bargain-hunting-only approach.
EVERYONE should use that leaf out of your book! [Hope you've got a good Tax Accountant]. Cheers...
I have always viewed the 50% rule as a very quick screening tool to narrow down a huge list of properties. Say you have 100 to analyze...doing a full complete analysis on all 100 would take quite a bit of time....use the 50% rule to narrow it down to 10-15 that get close to the 50% rule and then spend the time to do a full analysis for each one with real more accurate numbers
Did think people used this as the true target and "make or break rule" on what constitutes a good deal etc...
The reason why I personally do not utilize the 50% rule is because in my experience, my normal operating expenses should not come anywhere close to 50% of my gross rent, especially if the mortgage is not being factored into that scenario.
"Normal operating expenses" aren't the only expenses you'll have -- you'll also have rent loss (vacancy, concessions, non-payment, etc) and CapEx. When you factor in all three of things, that's when you will find yourself at about 50%. If you're seeing numbers far below 50%, you're not factoring everything in.
I can assure you that I have factored all of the numbers into each and every house in my portfolio. With all due respect, it is presumptuous to make predeterminations on the analytics of my portfolio without having familiarity with the portfolio, the numbers, and the specific deals comprising the portfolio.
As I stated before, I'm not knocking the 50% rule or questioning the validity of it. I am simply stating that it is not the end all be all and that it does not work for me nor is it my preference.
This site is about thinking outside the box to be most effective. Making attempts to poke holes in a model that has worked quite well for me for over a decade because it is not in line with a particular opinion is counterproductive to this site's mission. Rather, people should be trying to understand a more efficient and accurate way of making these calculations where the 50% rule may not be the best rule of thumb in a particular case.
Every single time I thought the same way the masses did, I did myself a disservice. When I began playing my own game instead of everyone else's was when I went from a run of the mill firefighter to a millionaire before 30. I'm not going to continue to dance back and forth on this.
Forgive me if this has been stated somewhere in the 11 previous pages.
I like using the 50% rule for a quick screen of properties, but I keep an eye on the property taxes too. One property may look like it's better at first using this screen, but when you find it has a much higher property tax (sometimes double), you need to end up running the numbers more specifically anyway to really see which is a better deal.
Has anyone noticed that two seemingly equal properties with the 50% rule, where one has a much higher property tax, should actually be about the same in the long run? Maybe this difference is too small to matter much? I would think not, but if anyone has something else in mind I'm willing to hear it.
Matthew,
It's nearly impossible to determine a fixed percentage for the costs associated with a rental portfolio without more information. Things like taxes, property condition and tenant quality all come into play. You also have to consider ongoing capital expenditures, management, leasing and maintenance. All of these will vary slightly based on the investment.
You should always budget for vacancy, local licensing, property and school taxes, insurance, leasing fees, management fees, maintenance and capital costs. In my market in Philadelphia, these range from 25-45%.
My best advise for a first investment would be to either buy a fully renovated, turn key type investment (full disclosure: I'm a turn key provider), OR go through the process yourself. Buy the house. Complete the renovations. Lease the house and then manage it for a year or two. If you have the time and inclination, the hands-on approach will teach you a lot more than reading books or listening to the local guru at your REIA meetup group.
If you don't have the time, look into a turn key provider close to home. Ask a lot of questions and watch the results.
Whatever you decide to do, make sure you actually like investing in buy and hold properties before you're too invested. Start off with one. If you like it, buy another property. If not, get out.
Hopefully you'll be posting in a year letting us all know how well that first property turned out. Best of luck.
@Brent Coombs I would have to disagree on one point. Purchase price correlating to rent. Assuming you would get lower rents because you bought at a discount just gdoesn't go together in my opinion. One of the things that has made me successful in this business is to identify and purchase undervalued assets. In other words, if you aren't hunting down and digging up deals, you are walking into the batter's box with a strike on the count before you start.
My model has been to identify undervalued properties that have value as upside. In conjunction with that, there may be a seller with a need rather than a desire to sell. Case in point: I purchased a 3 unit fire damaged property for $40,000. I put $70,000 into it, and have an appraised value of $225,000. That $40,000 house gets the highest rents on the street at $1000, $950, and $800. Purchase price does not correlate to rents in my experience.
What is your strategy of finding good undervalued properties, if you don't mind sharing ?
Thank you
Cash. Plain and simple. Someone calls, I pay.
@Matthew Mucker when I have run the numbers, it is pretty close. It can vary depending on condition of the property and owner paid utilities. I just threw this together to show you how you can get to 50%:
| Mainenance | 5% |
| Vacancy | 5% |
| Capex | 5% |
| Insurance | 3% |
| Property management | 10% |
| Taxes | 20% |
| Utilities | 2% |
Before everyone picks this apart, keep in mind this was a quick estimate and it will vary for everyone. I questioned this rule the first time I heard it, until I looked at my true operating costs.
Cash. Plain and simple. Someone calls, I pay.
Are you doing like a fund raising or where is all that ca$h comes from:-)
it came from hard work. Despite what people say, having real money in the game changes everything. Owing no one or anything money puts you into what I call the position of f*** you. Your in the drivers seat of your business. No one has leverage on you. If an investor can’t pay a bird dog $5000 for that bird dog giving them a deal, that investor is already not actually an actual credible investor and belongs greeting people st Walmart or working their *** off to stack chips and put cash together to be an actual player.
When you have real cash, not some angle on money, you will make exponentially more.
@Brent Coombs I would have to disagree on one point. Purchase price correlating to rent. Assuming you would get lower rents because you bought at a discount just doesn't go together in my opinion. One of the things that has made me successful in this business is to identify and purchase undervalued assets. In other words, if you aren't hunting down and digging up deals, you are walking into the batter's box with a strike on the count before you start.
My model has been to identify undervalued properties that have value as upside. In conjunction with that, there may be a seller with a need rather than a desire to sell. Case in point: I purchased a 3 unit fire damaged property for $40,000. I put $70,000 into it, and have an appraised value of $225,000. That $40,000 house gets the highest rents on the street at $1000, $950, and $800. Purchase price does not correlate to rents in my experience.
Whether your purchase (and rehab) cost correlates to rent minus expenses %, vs what the market value for the property is vs rent minus expenses %, was not the point I was making. I was referring to the overall generalization that: Lower-valued properties get lower Rents. Simple. (But never consistent enough to become a "Rule" that can be applied everywhere!) Which means that OTHER factors need to be taken into account before it can be determined whether the "50% Rule" is appropriate for a SPECIFIC property. Cheers...
@Brent Coombs which is why I don’t use the 50% rule as a rule of thumb. If you need to run numbers to determine if the 50% rule of thumb is applicable, why not just run the real numbers and be done with it?
I do need to clarify that a lower priced property does in fact have zero correlation to lower rents if the right deal is found and you are seeking out value add properties.
If you need to run numbers to determine if the 50% rule of thumb is applicable, why not just run the real numbers and be done with it?
I can't speak for others, but if I ran the *actual* numbers on every property I looked at, I'd never have time for anything else. I put a 38 unit property under contract about three weeks ago, and it's taken me about 40 hours so far to get the *actual* numbers for the property during due diligence.
I don't have time to spend 40 hours analyzing every deal. Using the 50% rule to weed out (or in) properties, I can analyze about 100 properties in less than an hour.
For example, the other day, I looked at about 30 multi-unit properties (on paper) sent to me by a broker I work with. Using the 50% rule, I was able to narrow those 30 properties down to six in about a half hour. Today, my partner actually looked at those six and submitted LOIs on four of them using closer-to-actual numbers. Assuming we get agreement on our LOIs, we'll start looking at *actual* numbers for those properties.
Had I spent time running the *actual* numbers on all of those 30 properties the other day, I'd still be analyzing those deals...
That said, if you prefer to use actual numbers, all the more power to you -- nothing wrong with that. I just have better things to do with my time...
Well said @J Scott
I think people here need a constant reminder that the 50% rule, the 70% rule and all others like them are not rules, rather guidelines intended solely for the use of a quick (back of the napkin) analysis. They are not intended to be the sole means of detailed analysis.
For those who are interested, the link below is from a 2020 study, and page three has the chart that shows expense ratio.
https://www.naahq.org/sites/default/files/2020_ies_exec_summary_final.pdf