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
Something else to consider when you are purchasing a long term rental. Are you buying someone else's "50%?" If you buy a house that rents for $800 a month and needs a new roof every 30 years, and the current roof is 25 years old, you just bought 5/6's of a need for a new roof. And if you replace the roof in the fifth year of ownership, you will most likely approach 100% of your market rent in expenses for that year. Maybe you can factor in the need for a new roof in the purchase price, but comps are most likely going to be houses with newer roofs.
I will admit, I have bought 10 rentals in the last five years, and NONE of them are close to being 50%. The two main factors I have are that they were all less than 10 years old and all but one already had a tenant in it, so vacancy was low. But if we were able to look at them 20 years from now, all with a new roof, a couple of re-carpetings, re-paintings, replaced HVAC, etc...., and a few months of lost rent due to vacancy, I am sure it will be very close to 50%.
Nobody argued MORE against the 50% guideline than me when I first joined Bigger Pockets, I thought it was way too high. I argued, how can a house in TX where the property tax is 3 months rent compare to a house in Arizona where the property tax is 1 month's rent? I argued that a water heater costs the same for a house that rents for $500 a month and a house that rents for $2,000 a month. But after reading study after study after study, I concluded that a well managed rental can keep expenses closer to 40% but that in the long run, using 50% was a great guideline to use for long term returns.
Hi everyone,
A few questions, but first an introduction. I'm a new landlord (as of January) and have successfully flipped two other houses. My partner is a long time friend and a great contractor. For my first rental, we bought a condemned propery and fixed it up, so basically everything is new. It's also a pretty large and expensive rental for the area (pittsburgh). It's currently rented out for $1,650.
When I figured expenses I was pretty conservative in most regards and without knowing about the 50% rule. It turns out that I estimated about 40%. I assumed nominal propery costs each year for upkeep. This is a nice house rented out to top tenants (for now) and everything is new, so unless vacancy is an issue, I think will be conservative in the near term.
So here are my questions.
1. Is 50% more or less valid for larger or smaller properties and better or worse areas?
2. Since everything is brand new and my assumptions were not so far off, am I being stupid to think this is still possible a good rental property? I feel like I should be able to get good net yields for a while and either repair and flip my house, or sell it to another investor who doesn't fully take into account the aging of many aspects of the propery (roof,furnace,etc..).
I should note that I'm holding this property for appreciation or to live in some day (I live in nyc and invest and am from Pittsburgh), but I'm asking purely from a rental perspective. The 50% rule is a great tool, I'm glad I learned it, but like any rules there are variables that provide the potential for upside. I'm thinking newer construction,nicer areas,and higher rents are those things that, on the margin have potential for upside?
I'm not a big fan of "Rules of Thumb" in general, including dare I say the 50% rule.
I track expenses for every property, every year. The best that I've been able to get was 11%, the worst more than 50%.
Capital improvements should be amortized over their life, i see some investors expense all. Obviously that would inflate your expenses.
And whether the LL pays for heat and utilities should not affect the %age of expenses, since the rent should be proportionately higher when heat and other utilities are included in the rent.
For many building the rents are too low and the expenses are too high, which would result in a much higher percentage of expenses.
Sometimes a new owner can correct this by raising rent and reducing expenses making the investment much better than it was for the former owner. However, sometimes with particularly older building it is just too expensive to make lots of changes. A big old building with 1 boiler and old windows and little insulation is going to be a heat guzzler. But to change all the things wrong and update to individual tenant paid heat, and new windows and new insulation are not economically feasible.
That's where the rubber meets the road, when you find a property with low rent and high expenses, can you "economically" correct both the rent and the expenses? That's the real question not whether the expenses are 50% or 60%.
Those who are leveraged are probably the ones hoping they have low expenses, just like people with no savings hope they do not lose their jobs. Better to be prepared, and if things work out better, is is a nice surprise.
...
A user with the BP login of "Taz" once posted the numbers being mentioned, in the post I am linking below, but I believe that the link he provided is either no longer functional and is behind a paywall for members only at his site:
http://www.biggerpockets.com/forums/48/topics/26378-validate-the-5-rule?page=3#p127882
A few posts before that one, somebody else offered some actual data, and Jon Holdman calculated numbers in the high 40% - not quite 50% but close.
And then Bryan Hancock posted in this other thread:
Hello, I am new at BP and have been avidly reading the very informative threads here. I can understand why this thread is a sticky. I wouldn't have thought that 50% of the monthly rent would be a safe operating budget.
I have two questions:
1] Do you cap your operating reserves, or continue adding to them even if there have been not significant expenditures in a long time?
2] Where would you typically place these funds: a savings account, or in another investment? Obviously (most) of these funds need to be liquid.
Thanks.
So, is this really that easy? Double your mortgage add a hundred dollars and if the rental comps are there, then it's a good deal?
I feel like I'm oversimplifying?
Eric Lasley, yes, that's oversimplified. If you pay cash your mortgage is zero. Double that, and its still zero. Add $100. If you've just investing $100,000 and you're getting $1,200 a year, that's not a good deal.
Really, you have almost zero control over rents and only minimal control over the price you pay. So, figure out what you're going to pay in down payment, rehab and any other up front costs. Figure out what your payment will be. Then use the 50% rule to estimate your cash flow. Finally, figure out your cash on cash return. Do you like that number? If so, its a deal. If not, keep looking.
Here's an example with a hypothetical $100K house, 80% LTV mortgage, and $1000 rent. You can see my calculations:
Price: $100,000
Rent: $1,000
Down %: 20%
Rate: 4.50%
Term: 30
Down Pmt: $20,000
Loan: $80,000
Payment: $405.35
Rehab: $0.00
Total cash: $20,000.00
Expense %: 50%
Expense Amt: $500
NOI: $500.00
Cash flow, monthly: $94.65
Cash flow, annual: $1,135.82
Cash on cash: 5.7%
CAP rate 6.00%
@Roy n. What is the big red flag on this deal? I know that 5.7 isn't a great return, but is that what you are solely looking at?
Yes, I'd consider 5.7% cash on cash return to be too low. If you could get $1000 in rent for $80K, cash on cash jumps to 13.2%. That's more interesting. Alternatively, if you could get $1250 in rent for $100K, that's also 13.2%.
Now, there may be reasons to by a rental with a low cash flow. This calculation doesn't address those.
It is very true that cash flow and cash on cash via cash flow is not the ONLY return you may derive from holding RE, however, this is the 50% rule thread and thus, the topic is based on the cash flow while using the 50% rule.
With that said, getting a hypothetical $1000 monthly rent and paying $100k equates to a 1% rent to purchase price ratio and even with historic low interest rates, the return of cash on cash is small in my opinion and that of other pros at sub 6%. You could do better with a note without the tenant issues.
The purpose of the 50% rule is to quickly do a napkin evaluation of a buy and hold investment to see what your cash flow is. If your plan is to have enough cash flow to live off, then you need to concentrate on deals that offer good cash flow, hence higher returns. Of course, if your play is appreciation and you can afford break even or negative cash flow with expectation to sell at a later date for the profits ( could also be called lump sum cash flow), that is certainly a strategy too, but has less to do with the 50% rule.
Eric Lasley
As Will Barnard has already eloquently stated, a 5.7% cash-on-cash return is just not worth the risk and work of running a small business (which is a small property in this case). If we were looking at a 100-unit, stabilized, apartment complex, then a 5.7% return (in the right market) could look a whole lot more attractive.
so if i made a spreadsheet to figure all these things out. would someone be willing to look at it and make sure i'm understanding right and to check my math?
Is there any common percentage differences when comparing say a 6 unit residential unit property versus a 100 unit apartment complex? Or would most experienced investors just slap the 50% number on for expenses?
Will Barnard I sent you an email to the email in your profile with the spreadsheet attached. thank you very much
I've been searching the market in here in STL for 2-4 four family deals that pass the 50% rule with 20% down payment. I haven't come across any yet.
I have been able to run some numbers where all expenses would be paid with half of the gross monthly income, but the property wouldn't cashflow $100/door. The $100/door has been my "white unicorn" lol.
I suppose I could always increase my down payment, but I think that's trying too hard to justify the property purchase. Am I just looking in all the wrong areas. I've been looking in A, B, and C type neighborhoods. Or is the current market getting out of control?
It's really frustrating!
When you are purchasing a property for a rental you should always request to see their previous tax forms. Landlords should be filing the Depreciation and Amortization on form 4562. When it comes to taxes people want to get the most of there money back at the end of the year and if there expenses are inflated or not accurate from what they are telling you this form will show, review part III on the form. As an example when a landlord replaces the roof it will depreciate at a different rate than the original rate at 27.5 years, this will have to be recorded on Form 4562. This should help you find any red flags on information the seller is providing.
If you have a property where the:
1. Tenant pays all utilities
2. Tenant supplies all their own appliances
3. Tenant takes care of grass mowing and snow shoveling
or you have a NN or NNN Tenant
Then the expenses will be much lower. In a perfect world the tenants would be willing to pay LESS rent when any or all of the 5 items listed above are their responsibility.
Its NOT a perfect world!
I suppose I could always increase my down payment, but I think that's trying too hard to justify the property purchase. Am I just looking in all the wrong areas. I've been looking in A, B, and C type neighborhoods. Or is the current market getting out of control?
It's really frustrating!
Perhaps it is just improper wording, but I see many people state this, "I've been searching the market for deals that pass the 50% rule. I haven't come across any yet." It is not a matter of a deal "passing the 50% rule! that rule simply applies! the issue is does the deal cash flow after using the 50% rule. Perhaps this is just splitting hairs, but I wanted to be clear.
Now, to answer your questions, looking in a class neighborhoods will cost you more and thus, reduce your cash flow, but have more appreciation potential and less defers maintenance on a class buildings. You may be having difficulty due to your local market conditions possibly being very competitive or you may be looking for something that likely does not exist like an a class building in an a class neighborhood with a 10 cap or better. To get cash flow up, you typically have to look in lower b class to c class.
Also, increasing your down payment does not make the deal better. While it technically increases the cash flow, you had to use more liquid capital to obtain that gained capital so the metric to compare is the cash on cash return. Using more leverage almost always increases your cash on cash, of course, over leveraging can get you in trouble.
@Vince Rosario you write:
IMHO, a new investor cannot possibly make "reasonable assumptions" about these costs. They get flat out lied to by agents and sellers who tell them they will have 100% occupancy and their only expenses are taxes and insurance. They underestimate routine expenses. The completely neglect big, long term expenses. Even if they build a spreadsheet and put a bunch of lines on it, they will tweak the number down to make the deal look good. This is where the 50% rule really helps. Its a reality check. If you come up with a total that's 25%, you're just fooling yourself. If the total looks like 75%, 100% or more (there is no upper limit), something's seriously wrong. That can be good if its something than can be corrected. Or bad if there's a fundamental problem.
All evidence presented shows that, over the long term and for a portfolio of well-managed properties, vacancy, expenses, and capital do, surprisingly, turn out to be right at 50% of the gross scheduled rents.