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
So in your experience, you have had the same operating expense ratios in both sfr's and large apartment units of 24 or more units?
If you have, I will not say otherwise. In my experiences, I have had lower OE ratios on sfr's than on apartments.
Perhaps the difference in areas has caused us to have different outcomes, or perhaps we have different investment styles which has caused two different outcomes.
That said, I will repeat that in my opinion, it is very important that each investor identify and properly analize the particular investment they are looking at, rather than going by some estimation rule of thumb. Wouldn't you agree?
So in your experience, you have had the same operating expense ratios in both sfr's and large apartment units of 24 or more units?
If you have, I will not say otherwise. In my experiences, I have had lower OE ratios on sfr's than on apartments.
In my experience, SFR OE have been just as high as MF.
To be perfectly frank, I believe one's opinion on this matter purely depends on the self interests of that person.
For example, it is obvious that a perpetual buyer would argue that true expenses are higher than a broker would argue. That's just human nature. It's not even a knock on brokers. I broker more than I buy or sell, so I acknowledge that I need to remind myself to keep my self interest out of the deal.
That said, I will repeat that in my opinion, it is very important that each investor identify and properly analize the particular investment they are looking at, rather than going by some estimation rule of thumb. Wouldn't you agree?
To answer your question, I am learning that the best buyers have a system to buying. This system will prevent them from making emotional decisions. Emotion permits buyers to justify bad decisions with bad logic. I agree that every deal should be analyzed based on its' own merit. However, deals with significantly discounted expenses are doomed to fail.
There is no self interest on my part from my statements here.
Of course there is. You have properties for sale on your web-site. Someone buying a property wants to paint the subject property in as ugly a light as possible. A seller would do the opposite. A broker is just trying to match the two up.
It's ok to have self-interest. We all have self serving needs. I was just pointing out that a person's view of the situation largely depends on their role.
Back on topic:
I've been using 50% to analyze various investment opportunities because it seems very conservative but I'm not sure I truly understand the theory behind it.
Bear with me please:
Does it represent an overall average ratio of expenses over a long timeline?
or
Instead does it represent a typical down-year scenario which includes notable and unusual expenses such as legal fees?
While I own a couple apartment buildings I have never really experienced a down-year so I am realizing that I may be very naive. Thanks in advance for the insight.
The problem with trying to do due diligence and figure this out before you make a purchase is that its impossible to determine when you going to have some of these expenses. You can get taxes, insurance, and management expenses. You might be able to figure out if it needs a new roof, boiler, or sewer line. You can find some local average vacancy rate and apply that to your gross rent. But, it more likely you'll actually have no vacancy at all, a short vacancy if the rental market is good and competition is small, or a long one if the market is slow. Its impossible to predict when you'll have a tenant need eviction or do some major damage, or when you'll be served with a lawsuit.
You can rest assumed, though, that a deal presented as "This cash flows! Payments of $700 and rent for $1000!" like I often see in MLS listings is NOT as good a deal as that math would imply.
Thanks Jon. That has been my assumption but I realized that I had no real knowledge to back that up. In my experiences I have seen expenses run about 35% including reserves but I haven't been doing it long. It sounds like I just need to make sure my DD can keep me from having a down year on year 1!
Will,
I didn't mean to take us off topic. And, I wasn't trying to "get at" anything. I just thought it was pertinent to note that people look at property valuation and expenses differently depending on their roles...whether they be buying, selling, or brokering.
That's all.
That's exactly right. In fact, without exception, every single person that has claimed otherwise on this forum has been proven wrong once they posted the numbers. In fact, almost every one of them were ommitting expenses or pretending that they didn't exist.
If the operating expenses were really higher for multis as a percentage of income, why in the world would anyone buy one? Because they don't like making money?
Mike
In this thread, I am only offering my experience and knowledge with expenses and evaluations between multi commercial and sfr's so that others may have MikeOh's point of view, and mine to compare and thus make their own decisions. :D
I think David asked a valid question about YOUR definition of Class D property. In my experience, there are about as many answers to that question as there are investors to answer it.
Below is just one reference that describes the different classes of multi-family property and you can see that it is very vague and even somewhat contradictory. In my opinion, this entire class description is just so much gibberish. There isn't any standardized, hard and fast definition that I know of and every investor seems to have and use their own individual idea.
Here's the link:
http://myapartmentlender.com/Multifamily_20_Property_20_Ratings.html
Mike
Someone with extensive experience in multifamily is sure to know classification ratings of multifamily properties from A to D, how they are rated, and what peramiters are used in the ratings.
I don't want to get into a "who has more real estate credibility" thing. I'll just tell you that I don't own any apartments....and I never have. I have owned SFD, duplexes, and Quads. I have brokered apartment deals. I have done due diligence on small, medium, and large apartment deals. I have run a company that manages SFD and apartment complexes (small and semi-large).
But, that's no big deal. I'm sure you have much more experience. That aside, the real experience that I was referring to when I said, "Yes, I do" is from personally witnessing people make terrible buying decisions based on three key components:
1. Dumb financing - over leverage.
2. Underestimating expenses.
3. Overestimating income. An example of overestimating income (other than under-estimating vacancy), is the “Rent Guaranteeâ€. Rent guarantees are a joke. If you need to guarantee the rent, then you are basically saying that, “I cannot prove that this rent is achievableâ€. Therefore, you are over-estimating future potential gross income. We have all seen this tactic. It looks great on paper, but it’s really a sign of weakness. Smart investors know that.
4. Buying for "Appreciation" or future land use, or whatever. I have seen this blow up on several occasions. The best example is when the city I live in committed to spending $18M to a specific area in town as part of a renaissance plan. When the economy started to sour, that money was lost quickly. Do you think any investors got burned by that one? The ones that used a 50% rule would have been fine. The ones that speculated on the validity of a revitalization plan got burned.
*I have even made some of these mistakes myself…like, all four of them at one point or another.
I bring these components up because these are four ways that the numbers can be made to look more attractive when considering a purchase. There is one cure all a buyer can use to protect themselves: the 50% rule. You can use the rule religiously. You could use it as a guide. You could even bend the rule. But, you must admit, it’s a pretty good rule…especially for the buyer.
It’s a bad rule for a seller, because it makes your property look less valuable. Run the 50% rule on anything that you have for sale. It’s depressing. I’ve done it myself. That’s what I meant earlier about someone’s opinion of the rule largely depends on what role they play.
Apartments are no different, just bigger.
If anyone chooses to use a 50% OE rule, that is fine too. I was attempting to discuss that using any rule, particularly a 50% OE rule, "Could" get an investor into trouble when dealing with commercial multifamily properties, as I have seen many with over 50%. So it is not my contention to use a "lower percentage" only to NOT use percentages, rather actual figures.
One of the greatest advantages of commercial property is that you can "force appreciation" by several methods. One way is to buy a poor or non-performing apartment, fix the problem, and get the occupancy level higher, thus increasing the Gross income, the NOI, the cashh flow, and the value of the property. If you were to use a 50% "RULE", you would be in big trouble on this type of purchase, as the larger vacancy would cause the OE percentage to be 70% or even higher.
I've pointed this out in a few posts. The 50% rule should really be considered a minimum number for expenses. Like you say, Will, its entirely possible to have nasty situations where expenses are much higher. In addition to vacancies, I've looked at APODs where the maintenance was 30% of rent by itself. In one case, I had a chance to speak with some of the tenants before I saw the APOD, and asked if they were happy with the property management company. Yes, they're very responsive to all our problems. I'd already spoken with the property manager, and he was a gloomy gus, talking about how easy it used to be to get tenants and how hard it was now. Clearly he was making it up with excessive maintenance.
As you say, an opportunity to force appreciation. In this case, though, there was so much deferred maintenance, in spite of what had been charged to the owner, it wasn't much of a deal.
Case in point Jon. Using "average" percentages can get you in trouble as many deals have more than 50% OE, particularly on multi commercial. For a SFR, I can not see how it would be possible to have expenses in excess of 50%.
A lengthy eviction accompanied by serious tenant induced damage? Even a new furnace or sewer line replacement could drive "expenses" (new furnace would actually be capitalized) up. For that matter, even a vacancy for a couple of months could be a killer. Four years ago, vacancy rates here in Denver were 12%. Much better now, but I see almost all of the Class C apartment with big "move in free" or "move in special" signs.
Would you also use the 50% rule when evalutating Apartment Buildings??
Depends. What are you using the rule for? To make a final purchase decision? To calculate your NOI and base your offer on that figure? Then I would say no.
To get a quick snapshot look at the possible NOI & asking price cap rate without spending a lot of time acquiring financial data? Then yes.
Steve,
Yes, I use the 50% rule in evaluating apartment buildings. In fact, I usually don't even ask for financials from the seller, because I don't believe them even when provided (most owners don't understand expenses and have very poor records). Likewise, I usually don't even ask the owner about rents, except I want a copy of the current lease and I get an estoppel letter verifying their accuracy. I KNOW what rents are in my area and I KNOW what I will charge once I have the building.
The 50% Rule gives you the average operating expenses you should experience over time and/or a large number of units. An individual property in a given year can have expenses somewhat lower and a LOT higher than 50% of the gross rents. So, you need to be sure to understand your market; the current leases; needed repairs; length of time it will take to stabilize the property; and other details relating to the property when you take it over.
Mike
This is an awesome thread! I know I'm a bit late to the game, but if you don't mind answering some questions Mike, I'd love to know you're opinion.
I bought my first 2 properties in 08, so as of now I don't have a good idea of what my expenses are year over year. That being said, going by your math, I've done well on one property, but not quite as well on the other. At the advice of my dad, who has some commercial property, I put down 25% and got a 15 year note. If in the long term your 50% rule does work out, I'm going to have a net of about $23. Should I look at refinancing this property to 30 years?
Hi Tony,
No, I would not refinance. Refinancing or changing the amount of money you put down does no change the quality of the deal. If you had a deal that had $100 per month cash flow using the 50% rule and 100% financing for 30 years, then I would consider that a good deal. Shortening the term to 15 years and putting some money down to get it paid off faster doesn't change the quality of the deal. In essence, you're just re-investing that cash flow to pay off the note faster.
Mike
I read this thread and found it really interesting. I have a property analysis worksheet I developed with my mentor to analyze cash flow properties and make the right offers. Now that I've learned about this simple formula, I want to discuss it with him - looks like a time saver.
I purchased 2 SFR's in Kansas City, MO within the last year. One conforms to the both the 50% rule and the 2% rule and the other is close on both, but not quite there. Just to prove it is possible to find deep discount properties from motivated sellers, that meet (or almost meet) the criteria, here are my real life examples:
property #1:
4 bed / 3 bath
total price: $51,700 (purchase+rehab+assignment fee)
I bought this one wholesale
rent: $880
mortgage: $408 (30yr fixed, 6.625%)
NOE (assuming 50%): $440
NOI: $32 (according to the 50% rule)
Rent on this one is 1.7% of the purchase price
I used 100% financing on this property and it cash flows, so not too bad...but it doesn't quite conform.
Property #2:
3 bed / 1 bath
total price: $40,450 (purchase+rehab)
I bought this one direct through a realtor
rent: $856
mortgage: $323 (30yr fixed, 6.75%)
NOE (assuming 50%): $428
NOI: $105 (according to the 50% rule)
Rent on this one is 2.1% of the purchase price
I also used 100% financing on this property. So this one conforms. Nice!
In terms of headaches and Murphy's law - I can fully agree with Mike and Jon. Sounds like they both have extensive experience. Property #1 was our first purchase, and everything went really smooth from start to finish on the project. However, the rehab on Property #2 was a nightmare. I had to fire the first contractor due to poor work and bring in another one to finish. Fortunately I built in contingency fees into the rehab escrow and was able to quickly complete the job w/no extra out of pocket.
So it can be done -- you just have to be very selective as a buyer and make sure your offer is at the right price. Keep in mind that it's a BUYER's market! If anyone is interested in Kansas City, there is great cash flow there. There is also the ability to take advantage of 100% financing. I am more than willing to help anyone looking to invest there - especially out of state folks like myself. Just PM me for details.
Thx,
Tom
I would like to add that the 50% rule is overrated in this forum. Basically, the management fees is in the 50% so I subtracted that. Also, it depends from where you live and the type of property you have obtained.
I've been checking my father's rentals operating expenses record book and so far, I've seen only 30% of it goes to expenses over time. Like I said, it depends on where you live and the type of property and tenants you are managing.