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
You wouldn't. If you think you're interested, put the property under contract based on the numbers you're provided pro-forma. Once you're done analyzing the "real" numbers, if it turns out they don't match what you had been previously led to believe, you renegotiate based on the real numbers.
The other option is to put in a low offer based on what the real numbers likely are...
Thanks for the suggestions.
As for putting in a low offer, is there a point where a low offer becomes an insult? I don't want to offend anyone, but I've also heard from different places on the website and podcasts that if your offer doesn't make you blush it's probably not low enough.
A real example for me is a house that is for sale for 160,000 that appears to have everything going for it except for the price. When running the numbers it only makes since if I paid 100,000. Is there any point in even putting in the offer?
I'm fairly new to real estate and I don't want to start off looking like a jerk to sellers in my area. I know reputation is everything is this business.
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.
Chris:
Jason is correct, you will most likely need to put the property under contract - in the case of a commercial property, perhaps only a Letter of Intent - to get the detailed financials and/or tax returns from the Vendor ... though we have had them provided to us by simply asking.
Once you have a little experience in an area with a particular building stock, you will have a good idea of what a property's revenue and expenses should look like and can usually tell if the pro forma numbers from a vendor are excessively optimistic.
50% I have heard for wholesaling, buying for rehab, etc. That is what you want to pay for the property based on project worth at end of project.
I suppose 50% would be a great figure for net for rent, but this seems unlikely.
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.
(From instructions form 4562) Section 179 property does not include the following.Property held for investment
My CPA says the roof is basis, 27.5 years
I suppose 50% would be a great figure for net for rent, but this seems unlikely.
What does that mean? What seems unlikely?
I apologized for posting incorrect information. @Mike Moreken is correct in pointing out that section 179 is not used for rental properties, but can be used to depreciate leasehold property improvements . The roof is depreciated over 27.5 years when replaced and repairs are deducted in the year they were made.
Google IRS Publication 527 for more details on Residential Rental Property, including IRS Topic 414 on Rental Income and Expenses.
I suppose 50% would be a great figure for net for rent, but this seems unlikely.
What does that mean? What seems unlikely?
net income 50% of gross income.
Some succeed, some don't. Yes costs come down usually with longer rental periods. You can be done with rainy day funding, vacancy fee funding. Maybe I will set up 2 bank accounts for that! ;)
I suppose 50% would be a great figure for net for rent, but this seems unlikely.
What does that mean? What seems unlikely?
net income 50% of gross income.
Why does that seem unlikely? What is your typical allocation of expenses on a single family rental?
| Income | Annual rent | Monthly rent amount | |
| Rent Income | $14,400 | $1,200 | |
| Rent Expenses | |||
| Taxes | ($4,300) | -$358.33 | |
| Insurance | ($440) | -$36.67 | |
| ADT | ($600) | -$50.00 | |
| Vacancy | ($2,000) | -$166.67 | |
| Trenton permit | ($100) | ||
| Repairs | ($14,000) | ||
| Legal | ($75) | ||
| Miscellaneous | ($100) | ||
| Landlord fees | ($100) | ||
| Inspections | ($250) | ||
| Lawn | |||
| Net | ($7,685) | $588.33 | |
| per month | ($640) |
All ~projected/real #'s. Repairs/Supplies/Cleaning for 2015 $14k, done. But will fund Vacancy + Rainy day funds. Not to levels shown. Got this property ~for a couple $K in foreclosure. Then spent $$ on repairs etc. I can not write off until 2015 tax season as that is when rental sign finally went up. :)
Vacancy + Rainy day to be a high priority. Some other fees will fall away.
So 588/1200 = 49% holy cow if true.
I will admit I haven't taken the time to read through this whole thread, so maybe this has already been answered. Also I'm a newbie so I'm more asking for my information than challenging anyone.
Sounds like this a useful rule of thumb, but I am assuming the 50% rule probably only works well for roughly 75k-150k properties, and I can't imagine it would work for the super cheap or more expensive properties. While some expenses like property tax and insurance may be somewhat proportionate to the property value and rent, a good portion (like maintenance and utilities) are not.
For example I'm assuming the 50% empirically works in the 75k to 150k property value range. But for a 25k house where you might be charging $400/mo rent, I'd think using 50% would grossly underestimate your expenses because maintenance and utilities would be a huge number relative to the rent. Likewise, if you're buying a 300k house and charging 3k/mo rent in a higher land value area, I'd think 50% would be grossly overestimate your expenses. A roof costs the same independent of the land value of the house.
Am I missing something here?
For example I'm assuming the 50% empirically works in the 75k to 150k property value range. But for a 25k house where you might be charging $400/mo rent, I'd think using 50% would grossly underestimate your expenses because maintenance and utilities would be a huge number relative to the rent. Likewise, if you're buying a 300k house and charging 3k/mo rent in a higher land value area, I'd think 50% would be grossly overestimate your expenses. A roof costs the same independent of the land value of the house.
Am I missing something here?
I roof doesn't cost the same for a $25K house and a $300K house. For the $25K house, not only is the roof likely smaller, but I would hire a cheaper (and probably less reliable) contractor and ask him to put on whatever shingles he has from a previous job that he can give me inexpensively. For a $300K house, I'm going to use a better contractor (since the aesthetics will be more important), will likely use architectural shingles, and will be particular about the color and brand. Not to mention, on a $25K rental, I may just do a second layer of shingles, thus keeping my price down for about 40 years.
As for maintenance, the maintenance on a $25K house is likely to be a lot less given that it will likely have fewer bathrooms, will likely have lower end finishes, and will likely not required as skilled labor to complete the maintenance work. For a $25K rental, I'll spray the house all one color; for a $300K rental, I'll make sure it's hand-brushed in three colors (walls, trim, ceiling).
Additionally, the expectations of a $400/month renter are going to be much different than a $3000/month renter. The lower-end rental probably won't have owner-supplied appliances or washer/dryer; the higher-end rental would. That covers a large portion of the typical maintenance items right there.
As for utilities, a $25K house likely is MUCH smaller than a $300K house...so the monthly utilities are likely to be much less.
You might be surprised, but the 50% rule scales pretty well...
The 50% "rule" s only a target. A lot depends on where the investment is and what your investment goals are in addition to your cost of capital.
The correct way to view this is to calculate your operating expense- compare that to your income, and then compare that to other investments. If you track several investment opportunities, after awhile you will see a mid point that is appropriate for your specific situation.
As a down and dirty calculation, it should never be used as I have seen some people on BP use it by taking your Income and assuming that your expenses will be 50%. Expenses are what they are and rents are a factor of the market.
Having managed over 20,000 units I can tell you that I have seen expenses as low as 30% and as high as 125% ( yes thats negative cash flow). States that have high property taxes really skew the numbers. For example, in Texas, property taxes run between 2.5% to almost 3.0%. By comparison Colorado property taxes are about a 1/3 of that. So if you take a $100,000 property, your taxes in Texas would be around $2,800 or just under $250 per month. In Colorado, that same $100,000 investment would cost you less than $100 a month.
Following the 50% rule would mean that rents in Texas would be $300 higher ((250 - 100)/.50%) for the same investment. I can assure you that is not the case for most properties.
My advice, do your homework and make sure that you consider all your operational cost including an allowance for repairs and replacement. If the numbers make sense after that, then you can see if the 50% rule has merit.
invest wisely
The 50% rule doesn't JUST account for taxes, as your example did. So, your statement above is incorrect.
In Texas, you'd like almost certainly see lower utility bills than Colorado and you'd almost certainly see lower maintenance costs. You'd probably see lower capex as well.
So, just using the example you gave, the expense ratio in Texas and Colorado would likely be pretty close. And over a sufficient sample of rentals, I'd be willing to bet that the expense ratios are in the 45-55% range, which is what the 50% rule says.
As for your comment about outliers, that's always the case with averages and large samples. Nobody has ever said that the 50% rule applies to every property or that it should be used a decision making tool.
Btw, I'd love to see the long-term expense numbers on the property that had 125% expense ratio. Sorry, but that doesn't make sense to me unless the property was highly non-conforming or there were property management issues.
It's probably worth noting that, if you take a look at some of my posts from 7 and 8 years ago, you'll see that I used to argue with all those who were espousing the 50% rule. I couldn't believe it was accurate, and I didn't believe it.
Now, after talking to literally hundreds of investors around the country, there's little doubt in my mind that, across a large sample of well-run properties, 45-55% expense ratio (including vacancy and capex) is the right average.
I was only using taxes as just one of many expenses.
Btw. Texas has the one of the highest utility cost in the country. It cost a lot more to cool than to heat.
I appreciate your prospective on the 50% and I am not attempting to discredit it. I just not sure that it is a solid tool for making decisions since each property has many factors that should be considered. There are many stats available from all sorts of data providers and I agree with you that the bell curve would support a 45-55 ratio.
The issue I have is that like all statistics, you need a large enough population to get a std close to 1. We own and manage over 3500 units nationwide, and if I take all those and average out, we are at 43.45%. But, if I look at individual properties in our portfolio, some are in the high 30%s and some over 60%. Yet by comparison, there is no correlation to our profitability based on the expense ratio. For many on BP, the discussion is based on one single rental unit, and this is where I find concern. As the sample population decreases, the std increases and hence those outliers are more relevant an the 50% becomes less relevant.
My argument is that when investing in a property with few units, you need to count every penny and following a statistical formula is not always a good thing. For example, if you have an 8 unit apartment building and market vacancy is 5% - turning each unit once a year will result in a rental loss much greater than 5%.
I think we have exhausted the discussion so I will stop here and leave the issue for others to ponder
Ps. As for the 125% expense, two pipe system in 100 plus degree, all bills paid, low income area, high maintenance, high default turn/over, etc. in the end, we torn down the property. Property was 100% leased and it was still given to us plus cash. Sometimes there is bad real estate deals and some times there is just bad real estate.
Invest wisely
And there's the problem...you're arguing against using a tool without understanding how it's supposed to be used.
In every thread about the 50% Rule (and there have probably been hundreds of them), at least one (or two or twenty) people point out that the 50% Rule is a great rule of thumb for doing a first pass analysis of a property, but that it should NEVER be used to make decisions.
In fact, I said this in my post directly above yours.
Arguing that the 50% Rule is bad because it can't be used reliably to make decisions is like arguing that a hammer is bad because it can't be used reliably to tighten a screw. The 50% Rule isn't meant be used to make decisions (and hammers aren't meant to be used to tighten screws). When you try to use a tool for something it's not meant to be used for, there's no arguing that it will get you in trouble...
you mentioned above that you "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." Can you tell me sources where I can get this sort of data? I'm trying to understand more about multi-family investing. Thanks.
Johnny
I have 24 rentals. My expense ratio is 45.55% across all of them. I am using actual for hard expenses, and 5% for vacancy, 10% for maintenance and 7% for property management.
I manage them myself, but a 'real' property manager will likely be 10%. So, the 50% number is accurate.
And the expenses do NOT include a mortgage.
Hypothesis: repairs and maintenance in very high cost real estate environments like San Fransisco or Manhattan will be less as a proportion of rent compared to repair and maintenance costs in relatively low cost real estate markets like the Midwest.
Potential theory: because low-skilled labor and parts (like toilets or faucets) are probably consistently priced throughout the country, the actual cost of repair and maintenance as a proportion of rent will be less in a high cost real estate market compared to in a low cost real estate market. In other words, a toilet and a repair man cost the same in Tulsa and San Fransisco but rents are way more in San Fran than Tulsa. Therefore the 50% rule will break down depending on the market dynamics.
Does anyone have evidence to support this idea one way or another?
Hypothesis: repairs and maintenance in very high cost real estate environments like San Fransisco or Manhattan will be less as a proportion of rent compared to repair and maintenance costs in relatively low cost real estate markets like the Midwest.
Potential theory: because low-skilled labor and parts (like toilets or faucets) are probably consistently priced throughout the country, the actual cost of repair and maintenance as a proportion of rent will be less in a high cost real estate market compared to in a low cost real estate market. In other words, a toilet and a repair man cost the same in Tulsa and San Fransisco but rents are way more in San Fran than Tulsa. Therefore the 50% rule will break down depending on the market dynamics.
Does anyone have evidence to support this idea one way or another?
Maintenance is a very small percentage of total expenses overall. While maintenance costs may very well be disproportionately lower in high-cost areas, you'll find that the following will tend to be disproportionately higher:
- Capex
- Taxes
- PM Costs
- Insurance
I don't have specific evidence either way, but I'm guessing that within a few percentage points one way or the other, the rule will hold. When we say "50% Rule," we typically mean "Somewhere Between 45-60% Rule"...
Just a quick question on the 50% rule. I think the % may be less (35-40%) IF the property is in a low tax area, mild environmental area, (i.e. Arizona), vs. a high tax state and harsh environmental area (i.e. New Jersey). What's your thoughts on that? Also, if the tenants pay the utilities, wouldn't that also maybe bring it from 50% to 40%?
Thoughts?
This type of specific data from existing and experienced landlords is great info. BP often suggests to do pro forma analysis of income and costs but without any specific knowledge its very hard to do anything other than use common assumptions.
Eric, do I understand you correctly? You use a total of 22% for vacancy maintenance and property management?
Are you not using your actual hard expenses for maintenance? How come?
That also means you are paying 23% for actual expenses besides these. Can you break down the categories in this expense %?
In general, how does one move past the 50% rule to specific expenses if one doesn't have any properties and can't get specific from the current landlord?
Originally posted by @Eric D.:
I have 24 rentals. My expense ratio is 45.55% across all of them. I am using actual for hard expenses, and 5% for vacancy, 10% for maintenance and 7% for property management.
I manage them myself, but a 'real' property manager will likely be 10%. So, the 50% number is accurate.
And the expenses do NOT include a mortgage.
Eric, do I understand you correctly? You use a total of 22% for vacancy maintenance and property management? Yes, 10% for maintenance, 5% vacancy and 7% for management. the 7% number is light for most SFHs. That totals 22%
That also means you are paying 23% for actual expenses besides these. Can you break down the categories in this expense %?
Taxes, Insurance, licenses, utilities (water, garbage, elec/gas, etc.), HOA Dues, etc. You should be able to use actuals, but even if you do not have them, it will be close.
Are you not using your actual hard expenses for maintenance? How come?
Because it is impossible to know the actual maintenance costs. You can go years without any major maintenance, then have to repaint, install new appliances, fix broken plumbing fixtures, replace a roof or driveway, etc. Remember, this is a general estimate number, meant to average the costs over the years.
In general, how does one move past the 50% rule to specific expenses if one doesn't have any properties and can't get specific from the current landlord?
It is difficult. If you are in an HOA that covers a lot of maintenance, maybe it can be a lighter maintenance budget. If your place is very old or in disrepair, you should probably make the 10% maintenance budget 20%. If you want, you can add back in any principal payments, although they are syill out of pocket expenses.
Remember, the previous landlord wants to make the property look better than it is, as the ROI numbers look better and it will command a higher price. I have seen some listings say "repairs and maintenance $300", when they take in over $15K a year in rents. It may well be the previous 5 year average, but what do you do when you need a major capital improvement, like a HVAC system or a 15K roof? It could blow away 5 years worth of profit. Even painting can be expensive when you hire a professional shop.
I agree with James, but usually use other calculations in determining the best properties to buy.