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
First off, 1st month, 1st year, & even 2nd year will have the same expenses. We are not renting in trashy communities where tenants are prone to demolish the interior. We have yet to encounter a tenant who casued more damage in excess of the security deposit, which by the way, is an amount that meets and often exceeds the monthly rent rate just for that purpose. In addition, it is true that over a ten year period, an eviction may occur, however, that is an expense that can not possibly be determined let alone predicted. The years of positive cash flow will more than compensate any eviction costs. There are no landscaping costs, utility costs (excluding a very small water bill), or maintenance costs associated with this property if a vacancy did occur. There are no office supplies, advertising costs, entity costs (an entity is not necesary for a newbie investing in one or two properties with small amounts of equity, and a seasone dinvestor with many properties, the entity costs of usually $1000 a year is divided between the 8 or so properties they have, the math would be $10 a month, hardly a large figure), no rental registartion fees (potential tenants also pay an application fee to cover the credit check, etc.), and capital expenses are just that - capital expenses, not operating expenses.
This is our world with these particular investments. So I stand by my assessment of the cash flow as I own some myself and consistantly get these figures. Now you mentioned the long term in 7 years or so when the building may not be as new. Point taken. I myself, as well as my advise to clients, is to be on to bigger and better things long before this occurance. The duplex is a stepping stone for a newbie into the market and to build confidence, cash flow, equity, and experience prior to moving up to say an apartment complex. It is also an advantageous way to enter the RE investment world part time, while keeping the W-2 day job, and have the depreciation tax deduction which adds to their cash flow in the form of a lump some at filing time. For you and me as full-time investors, we obviously utilize different (and in my case) more advanced strategies as we gain more experience and knowledge
I am sure you will counter with more points as to how I am miscalculating, however, I gave you my figures and explanations as requested and again, stand by them.
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....
I see you are also on the MikeOh bandwagon.
I am very sorry to hear that you had to fork out $450k in one year in excessive tenant damages. Perhaps it is time to find better tenants, better management, better areas, or better due diligence. Either way, that figure has nothing to do with my properties or the conversation I was having.
I am very sorry to hear that you had to fork out $450k in one year in excessive tenant damages. Perhaps it is time to find better tenants, better management, better areas, or better due diligence. Either way, that figure has nothing to do with my properties or the conversation I was having.
I used what Mike uses before I ever met him. I used it because it is what my father used for 20 years and his father used for 40 years. My family has been using these models for half a century. I was taught real estate lessons learned from the double digit inflation years of the Carter administration. We were into real estate before it was "cool". There is no bandwagon for financial principles that exist because they work across decades.
I never forked out 450k in tenant damage. You need to re-read my post. I was adjusting claims for other investors. Have you ever had to work with an insurance adjuster? If you don't, you soon will as you start to own rental property. My post has everything to do with this conversation. I viewed and estimated the repairs of the tenant damage to dozens of individual investors' properties - the kind of damage that happens in the real world of landlording.
My mistake Tim. Your post did not specify you were an insurance adjuster who did the claims of a multitude of clients which averaged the 450k. Either way, that still has nothing to do with my properties. Mike asked for the numbers on my property and I gave them to him. End of story.
I do not have any doubt that your insurance clients had losses, but their specific properties in their specific situations do not affect my property.
As far as your decades of family calcualtions, more power to you. everyone should have some type of calcualtions to consider an investment. I use different calcs. for differnt types of properties, not just a standard 50% rule. This is my choice and I do not push it on you, Mike, or anyone else for that matter.
Hope that makes it more clear. Good luck with your business.
My point was expect unexpected damages from tenants. No property is immune from this human element of landlording. That's part of the business. Good luck to you in your business as well.
I don't doubt that you believe this because as you've said yourself, you only have TWO rentals. You don't have the experience to know what happens over time in the real world. What you don't understand is that you don't need to have these incidents occur very often to wipe out literally YEARS of cash flow. For example, let's say that you own a duplex for 10 years before this happens to you. A tenant gets mad at you for evicting them and decides to trash the property, doing $10,000 in damage (it could be a lot worse than that). If you do the math, that's $83 per month out of your cash flow that you didn't account for. Most landlord insurance won't cover damage done by tenants.
Now, this is just ONE of those expenses that you excluded.
I completely agree with you that you can't possibly know how many evictions you will have in a given year (or over a 10 year period). However, just because you don't know how to account for the evictions doesn't mean that they are "off budget". This is exactly the thinking that causes newbies to fail in this business.
You may not have an eviction in a given rental for years and then you may have several in a relatively short period of time. In addition, many of the blue states have very long and expensive eviction procedures. Remember, all the while you are evicting someone, they are living rent free? I seriously doubt that your 6% vacancy factor is going to cover that!
In your last post, you said that there were no utility bills, now you're paying the water. How much is the water for a duplex in California? Even here in Ohio, it would be $50 per month. This is certainly another operating expense you've ommitted. Likewise, when units are vacant and being renovated between tenants, you will need some electricity if you want to run the vacuum; have lights; or use any power tools. That all adds up and you're pretending that it all doesn't exist. This is exactly what causes newbies to fail.
In addition, you're kidding yourself if you believe that a rental will have no maintenance just because it's new. Tenants cause a lot of the maintenance and those things will not be covered by the builder's warranty.
Do your "teams" charge a fee for placing tenants (after the original tenant)? How much is that? 1/2 month rent? A full month rent? There may be no advertising costs, but how about those placement fees?
The purpose of an LLC (or other appropriate entity) is to separate your personal assets from the rentals. So, unless all of the newbies that you're selling these properties to are poor, then they very well might need an entity. Without an entity, if the rental is sued, the owner's personal assets will be at risk.
Exactly right, but the point is that regardless of what you call them, they are an expense and once again, you ommitted them. So, there's another 5% or so that you've completely ignored.
The point is that you can simply ignore all these expenses and pretend that everything will be fine. Unfortunately, pretending the expenses don't exist or are off-budget won't make them go away. That is exactly why the vast majority of newbies fail.
This is a good discussion and hopefully will help new landlords better understand this issue before they make these mistakes and are forced out of business.
Mike
i would like to throw my 2 cents in here. Obviously we have 2 differing philosophies here. Which one is right? They both are!!
mike- goes for the lower end of renters. Here you will have more expenses in areas like repairs, advertising, legal fees etc.. However, it is here where you will get your biggest cash flow/profit. Also with this strategy you will be able to find those properties at a HUGE discount!!
nationwide-goes for upper end renters. Here you will have less expenses in areas like repairs, advertising, legal fees etc.... Also this is where you will get your smallest amount of cash flow/profits. So in nationwides case he will probably have to invest in 2 or more properties to get the cash flow mike gets.... Not that it is wrong, as mike has to deal with the headaches associated with low income renters...
SIMPLY put, there is a trade off and it is all in what one is willing to do
Kygregor: great point...
I've heard the 50% rule since I've been on this board...I've heard it hammered in my head over and over. But I talk to folks who have many (many) properties at networking events, etc and the vast majority of them they say that is a "worst case scenario" type of rule and is not truly what they experience.
It does depend on the demographic you rent to I believe!
As for this 50% rule being the national average......the law of averages would also dictate that you should feel average if you have one hand in a bucket of cold ice and the other hand in a bucket of hot coals!!
The headaches are not necessarily more for Mike than they would be for nationwides business plan, it's just that they have different sets of headaches. Mike has the headache of dealing with tenants and Nationwide has the headache of dealing with property managers. No mater which way you look at it there are management headaches of some sort that the RE investor is going to face. If you want headache free investing stick with savings accounts and CD's and keep one eye closed do you don't see the inflation rates.
you are correct, there ALWAYS will be headaches in this business... But you do have to admit the headaches you get from renters at the higher end of income are FAR FAR different than those at the lower end of the income spectrum!!! Mike seems to enjoy it and apparently has done quite well with it!!!
Kygregor,
Of course, the specific expenses will be different in different markets. In Ohio, the cost of an eviction will be MUCH less than the cost of an eviction in many blue states. On the other hand, the number of evictions will be higher here than in an higher rent area in California. That's not the point.
The point I am making is that Nationwidepi and (& others who frequently claim that their expenses are low) are OMMITTING many of the expenses (just pretending they don't exist). I pointed out just a few of the expenses that he's completely ignoring in my last post. Of course he thinks his expenses are lower - he's not including all of them.
Are you saying that a person will never have a maintenance expense? Are you saying that a person will never have capital expenses? Are you saying that a person will never have legal expenses? Evictions? Damage done by tenants? Etc, Etc, Etc. That's what he's doing - simply ignoring all these expenses.
Do any of them have any specific numbers? Are they doing the management themselves and therefore not including the management expense? Do they have accurate numbers or is that just the way they feel?
How many times have we heard these claims on this forum only to find out that the posters weren't including all the expenses?
Mike
mike, I will NEVER EVER say there are not plenty of other expenses associated with rental property... Hell, i incur new unexpected expenses all the time, but thankfully i have factored all those into my long term plan.... Now, nationwide is in the business of purchase and selling of properties (at least that is what i get from his web site) and this is where i will totally agree with you, his properties are newer and probably have not incurred any of those unforseen expenses.... I just hope those buying properties from him factor all those in. Honestly, when i am looking at property, the only thing i calculate in my head is how much can i get it for, and how much rent can i get out of it... Which is right along the lines of your 50% rule.
Now, being from cincy i know a little bit about columbus (which is where i believe you are).... Do you think you could apply your 50% rule for property in areas like worthington?
ABSOLUTELY! Where you live doesn't change the math. Now, is it difficult to buy a property that will cash flow in more expensive areas, like Delaware Ohio? Yes, it is, but the math is still the same.
Mike
To qualify as vandalism, a landlord would have to prove that the tenant damage was done with "malicious intent". I have denied thousands in coverage for tenants that were messy, negligent, or just plain careless and stupid because there was no "malicious intent". Also, any damage done by a minor in the household of the tenant is often not "malicious intent".
One interesting thing.... People keep assuming that higher cost properties have higher quality tenants. This is a dangerous assumption and if you think repairing a mid-quality rental property is expensive, just wait until a tenant damages your property that you dumped a fortune into to get the best finishes to attract the "high quality" tenants.
Tim
tim it would be moronic of me to say that ALL higher income tenants are good, and ALL lower income tenants are bad... But if I were a gambling man i would lay my money on that end, as opposed to the other end. Your odds are MUCH better. I guess my philosophy going into this is plan for the worst, and hope for the best
"One interesting thing.... People keep assuming that higher cost properties have higher quality tenants."
I follow you and my post wasn't directed at you personally - just a common mentality I've seen amongst REI folks. However, on a gamble I can spread my risk across 15 properties with gross rents of $7,500.00 a month for the price of one $150,000 property.
no issues here tim.. i did not take it personal
Tim,
What insurance company do you work for that will allow a vandalism claim for malicious tenant damage? Most of my properties are with Foremost (except the apartment buildings) and my policy says that damage caused by the tenants is excluded. They also tell me that on the phone each time I add new properties.
Mike
Mike,
I am no longer with them but it was Farmers Insurance and I was based in Illinois. With Farmers "excess wear and tear" caused by tenants was excluded but vandalism was covered. I would have to review your policy to see what is different. Can you e-mail it to me?
Tim
Note to any 3rd party readers of this thread - State Departments of Insurance determine what insurance companies shall and may cover in their policies within that state. Anything info I have may be different in your individual state, Texas especially. That state's policy is different from many I've seen.
TimWieneke wrote:
Hey Tim, Does this mean:
You can obtain 15 properties at $10,000 each... each generating $500/month in rent?
This makes the idea of buying that investment SFH for $150,000 ridiculous. $7,500/mo far outweighs the monthly gross rent you can get on ANY $150,000 property in the world today.
It's worth the risk if you ask me... not only are you diversified into 15 properties (less risk)... you also have potential to gross at least 5K more per month over that middle-class 150K property.
I'm assuming these 10K properties take some skill to find though ? ...and my guess is that they would need some work before being rentable at 500/mo? Even so, you still end up with a wide margin in diversification and monthly gross :beer:
As always, thanks for sharing!
Hey everyone . . .
I'm all for a heated discussion, provided we're talking about facts and sticking to them. I want to be sure this remains a civil discussion and does not turn into name calling or insults.
That said, many people seem to think that this website endorses the 50% rule wholeheartedly. We don't have a position on the matter and feel that there are different formulas that make sense in different parts of the country. I personally use something approaching a 50% (actually 40%-45%) rule for my own rental properties, but Mike's approach isn't the only one.
I'm going to go through this discussion very carefully again to be sure that I didn't miss anything (I think I may have) . . .
UPDATE: After re-reading this thread, I see that things got a little too hot for a minute, but clearly things have calmed down. I'm glad that everyone involved was able to work things out themselves (sometimes we aren't around to catch these things). With that in mind, I do want to reiterate that everyone is welcome to have their own opinions, and there is NO need to attack one another. If you disagree, feel free to do so, but do it in a way that isn't nasty.
Keep it cool, or take it somewhere else, people.
Thanks, and if anyone wants to discuss this with me, feel free to PM me.
[b]
Finally . . .
Lets get back to a MATURE and ADULT discussion![/b]
They do take a little skill but it is easily learnable. This has been an obsession of mine for some time. They need some work but if you find the right market you can cherry pick the ones that need a maximum of 2-3k in work (actually I buy most at 7-8k so the work evens it out to 10k). Again - I have a background in construction estimating so this is more skill come into play knowing what costs what to repair.
Thank you Josh!
I have been away for a while and wnated to respond to a few of the past posts.
To be clear Mike, I never said I had only two rentals, I said I only had two of my rentals that are lower income and valued below $100k.
Also, I live in CA but am not and have not been investing here. The duplex of mine you insist on bashing is in Texas, not CA and I do not choose to ignore expenses, I choose to avoid them via the new investments I do and having an exit strategy to move on before the big ones can hit. either way, any misc. expenses that may or may not occur will be minimal and more than covered by the cash flow, tax deductions, and principle reductions. The potential water bill utility expense would be only upon a vacancy in the hot summer months to water the lawns, not always, so this too would be very minimal and probably non-existant. This is my position on the subject, we all have heard yours. It may be valid with your investments and it may be valid with other's investments.
As for the others giving there positive input, like kygregor and grandwally (sorry if I missed anyone else), thank you. It is very true that there is not just ONE style of investing nor is there one formula for identifing a good deal from a bad one. Mike and Tim invest in low end properties, that works for them and their risk/tolerance/headaches/cash flow/etc. - That's great.
I and many others look at investments with much lower expense ratios (within the first 5 years or so) and look to move out and on to other investments. This strategy mixes a cash flow landlord business, with equity building and appreciation/speculation. It is simply another way to go.
Mine aren't low end. There's a difference between low cost and low end.
You know what this discussion reminds me of? Owning a cute, boutique restaurant and owning a McDonalds. I know an investor who owns a very nice restaurant that he spent 2 million dollars rennovating in a space he leases. 2 years later he's hurting like heck to make the payments because a new flashy place opened up 2 doors down from him. He is talking about closing his doors within the next year. 3 blocks away is a McDonalds that has been in operation for 15 years. Anyone see my point yet? There's a reason McDonalds is the most successful restaurant in the history of mankind. It's not because it is the "high end" restaurant in town. It is because they deliver an expected product to an expected pricepoint with an expected repeatability with a consistent return on investment.