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
This is not what the 50% says or does. In fact, the rule is a reasonable assumption based on many different properties in many different areas and "averages" them, thus, one property may have 45% in expenses over a 20 year period and another with 55% over same period. It is the averages that make this rule "reasonable" but never does the rule state that each line item expense would be the same for every property. Where one property may have higher property taxes but lower utilities, another may have lower taxes and higher vacancies, in the end, the rule states all will average 50%.
I understand @Will Barnard . Just to be clear, I'm always on the side of conservatism. I didn't articulate that properly, I meant to say that the expense to income ratio profile for a property will be exactly the same for every property. When I mentioned expense line items, I'm referring to the ones that aren't always clear: vacancy, repairs, maintenance, legal. Quality of management will tend to change this expense to income ratio, along with the condition of the building and planned holding period for a particular strategy.
I was under the impression that the 50% rule is used primarily for valuations and developing an offer price on income producing property. If that is the case, wouldn't holding period, quality of management and the current condition of the property distort valuations if the 50% rule was strictly followed? That would say the ratio of expense to income must hold at .50. And because expenses are 50% of income, one could find themselves discounting the price of a property for no legitimate reason, leaving room for another investor to snatch up the deal. That was a bad statement. I made earlier..good catch.
I would not say that the rule is to develop an offer price, rather, get a quick idea of the ask price vs. what the actual cash flow would be. That said, I too appreciate these discussions and beyond that statement, you make some very legitimate points that I do not believe have ever really been addressed on BP.
So, as far as an offer price, if and when a seller provides operating expenses below 50%, I would use the rule to argue and negotiate. If they come up with numbers that are higher, I am going to stay quiet on the rule and dig real deep to find out if it is a case of actually honesty or if there is some upside in better management, etc.
Since we all know that some landlords will operate better and others will operate worse, yet all of them are, in essence, lumped into the average, I wonder if your point is something that we should really consider here. Perhaps we may discount a property and lose out. Jump in with your thoughts!
I've read through most of this thread. The 50% rule sounds good, conservative enough that an unexpected expense won't kill the profit for a year.
Question - is the math using a 15 or 30 year mortgage? I'm looking at a $120K mortgage, and the difference is about $300 between the two terms. If the rent is about 2% of the house cost after rehab or $2400/mo, the $300 is a 25% swing on expenses. On the flip side, if the answer is 30, how do you feel about pushing the 50% higher for the sake of cutting the mortgage term?
Hey Frank,
You may want to reread the thread...the 50% rule has nothing to do with the mortgage. The 50% rule helps you to estimate NOI...mortgage is factored in after NOI to determine cash flow.
This might help:
Holly cow, base an offer on a rule of thumb? Got to be kidding, let's sharpen the pencil and get the calculator out, look to the market and assess the value traditionally, knowing what your cost of money is, your cash available, market rents and post closing factors. That "rule" gives you a gut check as you drive by to see if you should stop, not make offers from. :)
J Scott - Much thanks, I'll update after I'm up and running. The first few years expenses should be lower, as I'm already starting by putting in new roof and appliances. The seller replaced the heating system about 3 years ago. The video set me straight. The remaining 50% goes to debt service and profit. Makes sense.
Bill - I already ran the numbers, overestimated expenses, underestimated costs, and the cash flow projected positive enough to move forward. I wasn't using a rule of thumb, per se, but worked backward from the projected rent. I know the area well enough to know the going rate for the apartments I'll rent.
Thank you both.
Funny, my old rental, a condo I lived in years ago, that I kept -
Rent is $1450. $17,400/year. 50% of that is $8700. Condo fee $285/mo, or $3420/yr. And tax is $4000/yr. Water is in condo fee, but sewer is $250. Total $7670. That leaves $1030/yr to be at 50%. And $1000 is what I'd been setting aside each year for 'other'. It builds up, and then something goes. $2500 for an AC condenser. $750 for the fridge. But as others have said, log term, it doesn't accumulate, nor go much below zero, so 50% is as good a long term estimate as one is going to get.
Rules of thumb come into being for a reason, if it was wildly off, it would fade away. This one looks right to me. My latest purchase in my new life, is a 3 family, that should rent for $24,000/yr total. I'm going to plan for the 50% rule, and figure that I'll have the other half to comfortably service the mortgage, which is another story.
50% is a safe starting place and the first year I own a property it has even been higher. However the longer I own a property my costs slowly decrease over time. Some of the properties I have owned the longest are down to 30%.
1. Put all utilities in tenants names.
2. Replace all carpet with Tile.
3. Paint all walls, ceiling, and baseboards the exact same color of pre-mixed semi gloss paint.
4. Write the lease so tenant is responsible for sink and toilet clogs, and all repairs.
5. Require tenants to mow lawn.
On the first year I buy my expenses are always higher but each year I seem to have less and less work as I don't have to repaint all the surfaces and just do a quick touch up with the exact same color of paint. Ceramic tile is terribly expensive to install but becomes nearly maintenance fee once it is in.
Keep in mind you want to save up lots of cash to handle the big hits such as a new roof, hvac, etc.
Keep in mind you want to save up lots of cash to handle the big hits such as a new roof, hvac, etc.
If you're not factoring capital expenses into the 30%, it's not really 30%... :-)
OK, so something I don't understand about the 50% rule... Wouldn't the proportion of rent to expenses be higher for lower-rent properties? For example, the cost to replace the roof on a 1500sf ranch is going to cost X, but if the rent on that home is only $500 per month, the repair is going to be a much higher percentage of the rental income than it would be on the same sized home that goes for $1000.... Same for replacing a furnace, HVAC unit, marketing costs, paint job, carpet replacement, etc... Can someone help explain this?
OK, so something I don't understand about the 50% rule... Wouldn't the proportion of rent to expenses be higher for lower-rent properties? For example, the cost to replace the roof on a 1500sf ranch is going to cost X, but if the rent on that home is only $500 per month, the repair is going to be a much higher percentage of the rental income than it would be on the same sized home that goes for $1000.... Same for replacing a furnace, HVAC unit, marketing costs, paint job, carpet replacement, etc... Can someone help explain this?
Most likely, the size of the $500/month property is going to be considerably smaller than the $1000/month property, so the capital costs will be lower. Additionally, smaller properties will have fewer repairs (fewer toilets to break, for example), lower insurance costs, lower property taxes (not always, but typically), etc. Lower monthly rent also indicates that the property is likely lower quality, so finishes will cost less to replace and repair. Additionally, property management costs will scale with rent.
All in all, less rent will typically mean lower costs.
The National Apartment Association publishes a survey of operating income and expenses every year.
Operating expenses for multifamily properties averaged between 40 and 55% of gross potential rents for 2013.
Important to note is that operating expenses, as defined by these studies, do not include vacancy loss, or capital expenditures. Vacancy was an additional ~6% and capital expenditures ~7% of gross potential rents.
If we assume that operating a portfolio of single family rentals is less efficient than operating a multifamily property, 50% is a good rule of thumb for operating expenses as a percentage of gross potential rents for single family, assuming that the property is managed by a third party and outside vendors perform all maintenance. If you manage the property yourself and do most repair work yourself, your operating expense ratio will be lower, perhaps significantly lower - maybe 15-20% lower depending on how much work you do yourself.
In managing close to 200 properties, we have found the 50% rule to be a very good rule of thumb for third-party managed and maintained single family.
The 50% does not include a new roof or HVAC system. Those are capital expenditures, not operating expenses, and should be depreciated, not expensed.
Thanks for the research.
Many of my properties are SFH, which are not part of the Apt studies. Every year I track the ratio of expenses to income. SFH tenants pay either most or all of their own utilities. They mow the lawn, shovel the snow, plant flowers and take care of minor maintenance.
The best that I have ever been able to do was 11% expense ratio. That is not an every year occurrence. The property was brand new, tenants paid all utilities, lawn, snow and minor maintenance. I've had years were at certain properties there was no maintenance required. But that's the exception.
This year I've replaced 15% of the hot water heaters due to failure. I've had a furnace replaced, roof repairs, plumbing repairs and a catastrophic event.
If my expenses are above 40%, I'm concerned and am looking for corrective actions, possibly even selling the property.
Happy Thanksgiving!
I posted the apartment data as a benchmark. Because an apartment complex contains many units in the same location and affords the owner economies of scale, it follows that single family will have higher operating expense ratios. Walmart will always have better economies than the ma and pa corner store.
Your expenses are lower because you are having tenants handle maintenance issues. Are you also doing your own management and leasing?
To make it clear again, 50% is a good ballpark figure for singe family average operating expenses as a percentage of gross potnetial rent, assuming the property is managed and maintained by a third party.
The more management and maintenance that you do not pay a third party to take care of, the lower your operating expense ratio will be.
Happy Thanksgiving
I own apts as well as SFH.
Apts have:
1. More utilities paid by the owner like water, sewer & trash. Back in the old days water bills were $15 for a qtr. Sewer & trash bills were also low. One municipality that I invested in didn't even charge for sewer! Now WST are much higher.
2. Owners pays to cut grass and shovel snow.
3. Tenancy has shorter life span. (on another BP forum long term tenancy was discussed, I currently have a few 30 year tenants.)
4. Tenants have higher repair expectations, I've never had a SFH tenant call about a burnt out light bulb.
5. Apt tenants have more appliance requirements/needs. Most SFH, tenants bring their own frig, washer & dryer, microwave. Apt tenants not so much.
6. Higher vacancy, appliance, and expense requirements.
Am I correct in interpreting your statements to mean you believe single family has lower operating expense ratios than multifamily for comparable assets?
What is your average single family operating expense ratio for your entire portfolio over multiple years?
Do you do your own property management and leasing?
Do you do any maintenance work yourself? How much do your tenants perform?
I think this rule works best for multi family homes and to an extent single family homes.
For condominiums, the maintenance fee includes the larger forseeable costs (elevator breaking, building paint, roof, etc.), but it can vary WIDELY. For example, my own residence condo can fully rent for $3000/month and the maintenance fee is <<$500. There is no HVAC or roof to worry about. Assuming the 50% rule, this means I will need to spend an additional $1000/month on repairs? Please. Not even $1000 per YEAR.
On the other end of the spectrum, I have seen $1400 rentals with $700/month maintenance fees, ie. = a bad investment. I think it all comes down to knowing your market.
Am I correct in interpreting your statements to mean you believe single family has lower operating expense ratios than multifamily for comparable assets?
What is your average single family operating expense ratio for your entire portfolio over multiple years?
Do you do your own property management and leasing?
Do you do any maintenance work yourself? How much do your tenants perform?
I don't have a lot of first-hand experience with landlording, but talking to many single-family and multi-family landlords, I'm under the impression that expense ratios for single family tend to be a little less than multi-family.
The big economies of scale for multi-family come from property management and insurance -- insurance can't be scaled with single family, but property management can if you buy in a relatively small area, use the same PM company and have more than a few properties. So, a single family landlord can get most of the economies of scale that a multi-family owner can, plus with single family you tend to have fewer expenses (no common areas), tend to get higher rents for the same sized units, and tend to get less turn-over than apartments for similar units.
I'm guessing there are a lot of factors that contribute, but again, my *impression* is that single family tends to have lower expense ratios...
@Steve Olafson - Any thoughts?
I would not make a blanket statement either way, apt have lower expense ratio than SFH or vice versa.
I have both and I look at the expense ratios every year. It the expense ratio is higher than 50%, then I need to lower expenses, increase revenue, or sell the property. and since many of my properties are SFH, they sell to owner occupants, who don't care about expense ratios.
I do 90% of my own management and leasing.
I, in general, don't want tenants doing maintenance work, change light bulbs, cut grass, shovel snow, plant flowers. home decorations, yes sure.
I do have some corporate tenants who have their own maintenance staff on their payroll and they do fix things around their properties, which saves me.
I also have had tenants do major work, with my permission and with professional contractors. One place they had a deck built on the house. One place they re-carpeted the entire house, and another place they built a sports court, all these were at tenant expenses and done by professional contractors. The deck and the sports court also required building permits
At another property the domestic hot water was supplied by a coil in the heating boiler. The domestic coil could not be repaired but the rest of the boiler was fine. There was no natural gas at the property. I offered to put in a separate electric hot water heater. The tenants didn't want that and suggested an oil hot water heater, which costs $1,500, but they would pay for it. I agreed.
I've bought and sold over 800 properties and have been doing this awhile and in my experience, apartment tenants never buy decks, new wall to wall carpet, new hot water heaters and new sports courts, but that's been my experience.
There was another thread here at BP where we discussed vacancy. I have a 30 yr tenant who told me that they are never moving. Not many apt tenants stay for life, and vacancy is a big expense that does effect your bottom line as well as your expense ratios.
Great discussion points. There are a ton of variables involved. The only definitive method of determining which is higher would be to conduct a similar survey of single family investment owners or property managers. I will ask NARPM if they're interested in doing such a survey.
My data is based on sampling multiple properties with rents ranging from $700 - $1500 / mo within our ~200 property management portfolio. The conclusion that I have drawn is that the 50% rule is a good rough estimate for third-party managed and maintained single family in Tulsa, OK.
My first post was intended merely to add another data point to answer the question posed by the OP.
The 50% rule, or any other rule of thumb for that matter, is only useful for general discussion and should never be used as a substitute for thorough due diligence on an individual property.
I've been reading over this whole discussion for a possible answer to my question and after about an hour of reading I realized I was only half way through. So forgive me if a similar question has been asked...
I'm looking for properties that cashflow at least $100/unit. If I run the numbers quickly using the 50% rule and say a duplex cashflows $175, should I take a closer look at the numbers or just drop it and move on? I guess I'm wondering if it doesn't match my criteria using the 50% rule, is it not worth a second look or is there some wiggle room there?
I've been reading over this whole discussion for a possible answer to my question and after about an hour of reading I realized I was only half way through. So forgive me if a similar question has been asked...
I'm looking for properties that cashflow at least $100/unit. If I run the numbers quickly using the 50% rule and say a duplex cashflows $175, should I take a closer look at the numbers or just drop it and move on? I guess I'm wondering if it doesn't match my criteria using the 50% rule, is it not worth a second look or is there some wiggle room there?
Chris:
If the vendor has supplied the information indicating the duplex would cash-flow $87.50/door, it is probably rosy. In reality, if you were to dig into the analysis, you likely may find it only cash flows $50/door. If there is something about the property, or your experience with this type of property which makes you confident you can improve those numbers ... through negotiating a lower purchase, improving operational efficiency, or upgrading the finish of the units to demand higher rent (if the area supports it) .... then it may be worth an in-depth analysis.
If you have little-to-no experience analysing properties, then the exercise of a detailed analysis will have educational value .... you could even post your analysis and conclusions to BP to receive feedback on the sharpness of your pencil.
How would I go about getting accurate numbers for an in-depth analysis without taking a property under contract? Like you said, the numbers indicated by the seller are probably "fluffed up" a bit and I'm assuming he's not going to go out of his way to get me his rent rolls and actual expenses unless he thinks I'm going to buy the property.