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'm not one to take sides, and apparently I'm late for the fireworks, but in this case, I'm going to have to agree with both Jon and Mike. The "50% rule" is one that is discussed because it works. I've seen this in my own investing, and I invest in markets quite different than Mike.
If you have some evidence of another "formula" that works, please do share it with us. I know that I'd certainly love to hear about it, given real world examples.
Thanks, and I hope we can bring the tone back to civil. (that was not a request, BTW)
It would be frightening to actually disagree with you folks! :nono:
Thank you for the warm welcome to the message baord........LOL
[b]
Great Quote: [/b]It's only through listening that you learn, and I never want to stop learning.
Drew Barrymore
Sorry if this was posted earlier, but I didn't see it and wanted to ask...
Does this 50% rule include vacancy as well, or should that be calculated as an additional expense?
Thanks!
Vacancy would be part of the 50%.
Jon
Jon
Good, cause if it wasn't I was going to ask who you guys are holding guns to get positive cash flow :P
Usually when you get one of these deals it's the other person holding the gun to you saying "I'm going to make you an offer you can't refuse"
(the text between the lines says that they NEED to get rid of the property NOW)
Jon
Good, cause if it wasn't I was going to ask who you guys are holding guns to get positive cash flow :P
Ammunition is part of the 50% as well.
Jon
Good, cause if it wasn't I was going to ask who you guys are holding guns to get positive cash flow :P
Ammunition is part of the 50% as well.
Thats good to know!
:goofy:
These are the problems I have with Mike's 50% rule:
1. According to this valuation, a property with a 25% vacancy has the same expenses as a fully occupied property? No way. Taxes, insurance, and some other OE are fixed and they do not increase or reduce depending on the vacancy.
2. Residential properties are different than commercial properties and OE must be adjusted accordingly.
I take the current gross rents, subtract out the current vacancy, arrive at the AGI (Adjusted Gross Income) and then take out the OE to arrive at a more accurate NOI.
Also, residential and commercial properties are valued differently and have different expense ratios. Some apartment complexes have the tenants pay utilities and some the owners do. By Mike's 50% rule, he would say they have the same expenses and that just isn't the case. In a retail center, the tenants are usually on a double net or triple net lease, thus they are paying for some or all of the expenses which can include taxes, insurance, common area maintenance, etc. so that property would have a different expense ratio.
I still can not figure out why Mike talks about commercial properties when by his own statements, he is a residential landlord and has no experience or knowledge on that subject.
Commercial properties are valuated based on a cap rate and residential properties are based on comps. I can go to 1000 sfr owners in each of our 50 states and ask them how much their home is worth and none of them will arrive at their figures based on "cap rate" let alone know what that is. Just the same I can ask all the apartment owners how much their complex is worth and none will tell me because the apartment down the street which is the same size, etc sold for that.
So to be clear, when evaluating a residential deal, your calculations will be based one way, and on commercial, in another. If the 50% rule works for your SFR analysis, then go with it. I do not persaonlly recommend it for commercial properties including apartments.
"1. According to this valuation, a property with a 25% vacancy has the same expenses as a fully occupied property? "
Where did you pick this up?
The "50% rule" is just a rule of thumb. My background is physics and engineering. Physicists want to derive all rules from backs principles. Engineers are perfectly happy to go with an empirical rule.
There's nothing that fundamentally makes all expenses, including capital expenses and vacancies, 50% of the gross scheduled rents. Expenses can certainly be higher. I've looked at more than one set of apartment APOD where expenses plus vacancies were north of 70%. One was a 8 unit building of student apartments, another was three large buildings of 40 some odd units each.
Even the apartment "gurus" say to use 50% when evaluating deals. Given gurus perpetual optimism, that hints to me that's the best you can do.
I think this quote from nationwidepi:
is meaning that if expenses are always 50%, then they're 50% whether vacancy is 5%, 25% or 100%. Clearly, that's not true. Implicit in "the 50% rule" is doing everything correct. If vacancies are 25%, you're total "expenses" are going to more than 50%.As far as owner paid utilities, the theory is that the rent is higher on a unit where the owner pays utilities. The higher rent offsets the higher expenses, and the ratio stays about the same.
Now, I don't like this rule one bit. But I'm pretty sure the other rule I hear, and much more commonly, is absolutely false. That rule is cash flow = rent - PITI. I've heard many, many deals described as "this will cash flow", when they were in reality applying this bogus rule. I'm sure I could find many more acceptable properties with this rule, though.
Maybe the real rule is somewhere in between. I'm certain that owning one property for a few years does not give any valid data. Some of the expenses are highly variable. Even minor maintenance is sporadic. Major items (hopefully) come only once every several years. So, you really need many, many tenant years to have good data. In his posts, Mike often refers people to their local apartment associations to try to get enough data. I would love to see some real long term data that would support or refute this rule of thumb.
Also, I don't for a minute think this applies to stand alone NNN Walgreens, strip centers or office buildings. No idea how expenses work for those, or how to evaluate them.
Thank you Wheatie. That is exactly what I meant about the 50% rule. As vacanciy rates reduce, so do expnese percentages and vice versa.
As far as rents being higher if the owner pays the utilities, that is not always true in the commercial world. It is possible, however, in many cases, a particular complex may be master metered and the average rent in the area does not compensate for that expense. In other cases, it does. Therefore, using a flat 50% rule is not relevant for commercial circumstances. It can be used as a quick scan check before going into details of any particular deal.
Here are some better quick scan checkpoints as they relate to commercial apartment complexes:
Take the sq. footage of the rentable space and divide by the ask price which gives a price per sq. ft. If that figure is in the $40's or below, you know the numbers are close enough to take a more complete look as you can not build a complex for that price. Another quick check scan is the price per unit. You will know the average price per unit in a particular area (once you get experience) and when the number comes in under that, you look into it more.
Well, I like what they have to say about "rule of thumb" here:
http://dictionary.die.net/rule%20of%20thumb
To quote in part-
Rule of thumb, any rude process or operation, like that of
using the thumb as a rule in measuring; hence, judgment
and practical experience as distinguished from scientific
knowledge.
IMHO, this particular rule of thumb applies only to the long term buy and hold REI model. ANY property can have zero vacancy and/or zero repairs/maintenance over a short time frame. Indeed, most slumlords are quite proficient at NOT spending any money. Sooner or later, however, you have to pay the piper. Everything wears out, Nothing lasts forever in this business. OVER TIME, you will average +- 50% for ALL expenses, lost rents, uncollected damages, insurance claim deductibles, roof replacements, service calls, ad infinitum. You just lack a certain amount of control over the timing of these expenses (unless you perform adequate due diligence, and evaluate each system to determine remaining life and cost of replacement- even then, sometimes equipment/materials just fail. Sometimes Mother Nature speeds the process.).
It is also possible that you, or someone you know of, is just extremely lucky. You have one or two properties, with nice little old ladies that have lived in them for 15 years, taking perfect care of everything. Zero expenses, No lost rent. Lucky You. Better hope they don't croak in the heat of summer and decompose into goo. That'll change your numbers!
IF you are in for the long term, using this rule of thumb will give you a realistic view of what to expect. In theory, if you establish a reserve account, and deposit to that account the difference between actual expenses (including the pro-rata portion of known periodic expenses such as insurance) and 50% of gross income, you should have adequate funding when it IS time to replace the furnace, or the roof, or other major expenditures. This DOES assume you are not starting out with significant deferred maintenance. If you start out in the hole, you will need the cash to pay the tab, but can expect to recoup it over time.
Quick & dirty rule i use when buying rental property.Don't waste time looking at property.
100x multiple.If the asking price is over 100x monthly rent i move on.My limit is usually 80x max.
100x multiple.If the asking price is over 100x monthly rent i move on.My limit is usually 80x max.
That or the 2 year rule - if the properties gross rent can't buy the property in 2 years, move on... :-)
The 2 truths behind all this is: 1. It doesn't matter what rule of thumb you use as long as it is financially sound. 2. Doesn't matter how cheap you get a property if you can't manage it.
Nationwidepi,
We were never talking about a retail center, we are talking about residential rentals, whether commercial residential rentals (more than 4 units) or not. So trying to change this into a discussion of retail centers vs. residential rentals just a red herring. Of course, residential rental properties do not have the same operating expenses as strip malls and I didn't say or imply that they did.
Beachbum did an excellent job of explaining why operating expenses at 50% of gross rents is a good average over the long term. Therefore, I'm not going to repeat that. Just re-read Beachbum's post if you still don't understand this issue.
You've finally said something I agree with - sort of. What you've described above is EXACTLY how the vast majority of newbies WHO FAIL in this business evaluate their "deals". They buy at (or close to ) retail value and then fail in a short period of time because they don't have the cash flow (and don't understand operating expenses). I again point out the "deal" that you have on your website, being sold at 93% of market value - NOT MY IDEA OF A RENTAL THAT WILL CASH FLOW! NOT EVEN CLOSE!
Again, I ask, are you in the rental property business or are you just selling rentals to newbies?
Mike
Mike, in a previous post, you lumped commercial properties with res. I never said you refered to a retail center specifically, I was only pointing out the vast difference in OE for different commercial properties for everyon'e benefit and to use different methods for res & comm investments.
I am so happy you finally agree with something. I must be a complete fool (or silly as you put it) according to you, as I must not know anything about investing, right? - Wrong!
Again, I need not prove myself to you and if some of the other members want to worship every word you say, that is their choice. Operating a landlord business of low income rentals is not the only way to be a landlord and many invest for long term capital growth in addition to cash flow. That, in my opionion, is a better choice than yours, as you will have to continue working each year to sustain your cash flow income, while others can cash out large sums of equity in the future, that of which can be eaten. I understand your 50% rule perfectly, I did not need you or Beachbum to explain it, I simply use different methods by choice, such as taking out vacancy rates first, then deducting OE.
As for what I do, yes I am a landlord, but operate differently than you. Yes, I know all about cash flow, cash is king, etc, but I only have two rentals in low income areas that have values under 100k. I also invest in the commercial area with apartments, retail centers, land development, and storage facilities. The 155k duplex on my website you keep refering to is much different than what you do. Yes it is currently priced at 93% of appraised value. Please show me a NEW construction property over $150,000 that you can buy for 70% on the dollar! Sure there are old units in foreclosure, auctions, desperate sellers, etc, but those units are pre-owned, do not have builder warranties, most likely are in poor neighborhoods, and do not come to the investor turnkey. These units will have greater appreciation in future years (this is not speculating, it is a fact as RE always repeats itself and always has its ups and downs, but for the long trem, 5-10 years, my new duplex will outperform your old 40k sfr) I have set up some of these properties for investors who are not investing full-time or maybe are just getting started and do not want the stress of repairs/maintenance/management. We have teams set in place to do that for them. So maybe they do not cash flow to your standards and maybe they do. The point is, it is an option for investors.
I can not possible buy all these units myself, and I have already arranged the deals and the teams in place, so why not pass them along to others who can benefit from my work and due diligence. If you do not like the deal, fine, do not buy one. I never asked you for your opinion on my available deals. I do not like yours either. I like lower maintenance/hands free operations, you do not. Fine.
Again the original question was where does the 50% rule come from. I gave other methods to arrive at more accurate figures, in my opinion, and other types of investments that require different calculations. So lets leave it at that and stop making this so personal. I am not slamming your product you sell on your site or your blog, or anything else, so refrain from doing so to mine. We simply have different investment styles and different methods for determining a specific deal. Let the others decide which is best for them. Otherwise, I hope a moderator steps in here to stop you from your personal attacks.
LOL @ 2 year rule.
I'd like to own a city full of those.
It doesn't make any difference if you subtract the vacancy rate first or subtract it as part of the operating expenses, the result is the same. So, if that's your "different method", it changes absolutely nothing with the cash flow.
It's very interesting the way you worded that. How many apartment units do you operate as rentals? You see, it's obvious that you don't understand the rental business and it's obvious that you are selling properties to newbies at or close to retail. It's also crystal clear that you are advertising cash flows that are very questionable (I'm being polite).
Here's another of your "deals":
4-unit building, $3,600 monthly rent, Price $340,000. YOU CLAIM A CASH FLOW OF $649 per month.
I have a bunch of 4 unit buildings and here is how I see the numbers on this "deal":
Gross Rents: $3,600
Operating Expenses (including vacancy): $1,800
NOI: $1,800
Mortgage ($340,000, 30 yr, 7% NOO): $2,262
Cash flow: $462 per month LOSS (OUCH!)
You claim that the cash flow is more than $1,100 per month better than that. Would you like to explain your cash flow claims?
I've never seen one and I've never seen a property that will cash flow at retail. So, where is the good deal in buying something at market value?
Oops, that's not quite right. You see, when I buy a property at a 50% discount, I've got 50% equity AT CLOSING! If I get only 3% appreciation per year, I'll have a minimum of 65% equity at 5 years. So, for you to match that, you'll need almost 12% annual appreciation over the next 5 years. Are you telling your buyers that they can expect that?
In my experience, when someone doesn't want the "stress of repairs/maintenance/management", they pay dearly for transferring that responsibility to someone else. How much do your teams charge to manage a 4-plex? Do they charge to place tenants? Do they charge to arrange maintenance?
So, to summarize, your business is to sell properties at retail (93% of market value), that have a negative cash flow to newbies in hopes of future appreciation. Is that a correct assessment? I can see how that's good for you, but how exactly is that good for the newbie? Do you guarantee the cash flow you claim on your website? After all, if you're in charge of the management and maintenance, then you are controlling the operating expenses.
That's certainly true. Virtually every property on the market can be bought at 93% of market value and it would be very difficult for anyone to buy every property in their market. My question is why would anyone want to buy a property at retail?
The only other "method" that I seen you offer so far is to subtract the vacancy before the other operating expenses as opposed to subtracting them all at once. As I pointed out earlier, whether you subtract the vacancies first or last, the mathematical result is the same.
I'm not trying to give you a hard time, but just trying to get you to disclose what you're really doing. You're being very elusive in describing what you do and are very carefully vetting your words. If you're selling negative cash flow properties at a retail price (93% of market value) to newbies with the promise of future appreciation, why not just say so? Speculation is a valid business model if a person is willing to accept the risk.
But Mike...you forgot about the tax benefits of holding negatively cashflowing property.... :wink:
You are not trying to give me a hard time, just trying to have me disclose what it is I do? All you do is give people, recently me, a hard time and I do not owe you anything nor do I feel the need to disclose to you what I do. If you want to brag about your few dozen low income rentals, that is your choice. It is not all that important to me tell you how successful I have been. It is fine for you to think I lack experience or knowledge, that is your poor assessment. It reflects more negatively on you than me.
You and I use different strategies. I have no desire to debate with you about who's investing is more profitable, more correct or more successful or who will have more investments or more cash flow some time in the future, as I am not in competion with you. All you speak about are generalities, never once giving precise examples of deals you have done either. I have some properties on my site, if you don't like them, no one is pointing a gun to your head to buy them. If you don't like them, keep quiet.
Your investment business is not the only one in town so stop trying to act like running poor rental units is the only definition of the landlording business, IT IS NOT. Not every one wants to spend their days painting houses, carrying firarms for protection, and dealing with drug dealers and the rest of the scum. Not everyone lives in close proximity to crappy neighborhoods where you CAN buy for 50% of value. Not everyone will "pay dearly" for hiring professionals to manage their properties.
You still have not shown anyone here one pre-construction property over $150k in which they can buy at 50 cents on the dollar. Obvioulsy your Mother never taught you to remain quiet if you have nothing good to say. I grow tired of hearing your negativity.
I have a very professioanl website in which I provide a number of services and information. Your website is an ad to sell your little program which there is no doubt consists of your 50% rule, your 2% rule, how to paint houses yourself, what to expect from the drug dealers living in your rentals, and any other usless generic information.
Everyone in this forum is not required to tell Mr Ohio what type of business they are in and how they operate it. People ask questions, others give answers. You act as the all knowing (which you are not), and consistantly trash other members who answer questions which are not to your opinions. Shame on you. Leave us all alone and keep your negative unprofessional opinions to yourself.
This will be my last response to anything you have to say as I do not intend on wasting any more of my time defending myself from your negative shots.
Josh, I request you jump in here and put a stop to MikeOh's negative comments. All he is concerned about is bashing my business and my opinions. I started off voicing my opinion to answer a question from another member as well as weigh in on some alternative methods to evaluate investments. He continues to attck me, and others personally, which is very unprofessional and not called for. I did not become a member here to be subject to his ridicule and I am sure the other members do not appreciate it either.
NO ONE on this website has attacked you. All I and the others have done is try to get you to explain your strategy. Why won't you do that? You're on here trying to sell properties to newbies, but you don't explain how they're supposed to make money. Is that reasonable?
If you think our expense numbers are inaccurate, post yours! Let us all see where we're going wrong and why your expenses are lower than hundreds of thousands of professional landlords in the United States.
Quite the contrary, I have frequently posted exact details of properties that I have bought.
Why should I or anyone "keep quiet" about the properties you have on your website. You are trying to sell those properties to newbies here and I'm sure that we would all like to know how the newbies are supposed to make money when buying the properties. Yet, for some reason you won't explain that. Why not? This is your chance to sell us all a property. I am 100% for making money. If you have found a better way to make money, please tell me and I'll buy a bunch of them! How do I pay retail (93% or market value) for a rental property and get it to cash flow? Please provide the details!
I've already said that you can't easily find new or pre-construction projects for 50 cents on the dollar. However, that doesn't change the fact that properties bought at retail normally will not cash flow. If I'm wrong, please provide the numbers.
Mike
Just to be clear, I am not here to sell this to "newbie investors" In fact, I have had all kinds of investors, both new and seasoned who have purchased this and other investments from my co.
Here it is anyways as posted on my website:
$155,000 Duplex - Currently appraised for $165,000.
Includes builder warranty and is guaranteed to have a minimum of one year lease contracts in each unit prior to investor's 1st months expenses.
Rental Income is $875-$925 per side/per month (we listed the low end)
Gross rents $1750
Taxes $222
Insurance $82
Management $140 (Original placement fees paid for, no other charges)
Repairs $0 (It is new with builder warranty)
Utilities $0 (Tenants pay all as wriiten in contract)
Maintenance $0 (Tenants pay all as written in contract)
Vacancy $0 (we have a variety of new tenants to choose from)
Vacancy $105 (Lets put 6% in there anyways to satisfy you)
Administration Costs $0 (Management handles everything for their 8% monthly fee)
Total Expenses $549 (should be $540 assuming the 6% vacancy reduce management fees, which is why I take vacancy out first as it Does affect the OE)
NOI = $1210
Debt Service = $906
Cash Flow with vacancy assumption = $304 ($152 per door)
WOW.... This explains a lot right here. I only adjusted on average $450,000 a year in claims resulting from tenant damage that they were contractually obligated not to do....
Nationwidepi,
Thanks for posting your information. Now, we can have a real discussion of operating expenses and cash flow.
To start, I would agree with you that the numbers you have listed are probably fairly close for the first month. However, the new landlord will probably be in business longer than the first month (or first year for that matter) and then the real expenses will come into play.
For example, here are just a few of the expenses that landlords experience that you didn't include. Advertising (or placement fees), legal fees, entity maintenance, office supplies, vacancies, evictions and the accompanying loss of rent during the eviction process (which could be a long time in California), court costs, utilities (if only during periods of vacancy and/or rehab), routine maintenance (when the builder's warranty expires and caused by the tenants and not covered by the builder's warranty), damage done by tenants (in excess of the security deposit), rental registration fees in some localities, inspection fees in some areas, capital expenses (not technically an operating expense), lawn care and landscaping, etc, etc, etc. You haven't accounted for any of these expenses and many others. That's why you're claiming that the expenses are so low - you haven't included MANY of the expenses that landlords experience in the real world. What you've done is what the banks did with their introductory rates and ARMs. Things look good for a short time and then - BAM! (the real world expenses kick in). BTW, a builder's warranty won't stop all the maintenance even in the short term. In my experience, most of the expenses are caused by the tenants, not due to the age of the building. Damage done by tenants is not normally covered by a builder's warranty.
In your example, you're already at 31% operating expenses (including vacancy) without including the expenses I mentioned. Just including the maintenance and capital expenses will probably bring you up to about 44%. Adding in the rest of the expenses will easily bring you to 50%.
Mike