50% Rule- Is it Really a Rule?
Methuen, MA · Member since 2010 · 40 posts · 29 votes
I've been reading on the 50% rule for calculating viability on a potential rental income property:
Gross monthly rent
-(minus)50% for operating expenses
______________________________(equals)
NOI(Net Operating Income)
-(minus)mortgage payment
______________________________(equals)
Cash flow (positive or negative)
My question is: Does the 50% rule ever become.. the 65% rule? Or is the 50% rule an actual rule and it's safe to assume that operating expenses will always stay at 50% or less?
Are there any landlords that can tell me all of their actual operating expenses (other than loan/mortgage payments)? I understand utilities, taxes, and landlord insurance.. the solid monthly fees that I know will come every month. The other fees, such as maintenance, legal fees, and eviction costs don't seem like solid monthly expenses... does the 50% rule account for these fees that will eventually pop up, but at an incalculable point in time?
Thanks,
Emily
This post is a great way to start an argument on here.
The 50% rule just says that over an unllimited timeline, and any number of units, your expenses will equal 50%. It doesn't mean you shouldn't do your due diligence, or that every individual property will have 50% expenses every month/year.
Its best used as quick test to see if a property is worth looking closer at.
A "rule"? In the sense someone enforces it? Absolutely not. Its just a "rule of thumb" that has been borne out by empirical data. There's nothing fundamental at all that says the expenses (really, operating expenses, capital, and vacancy) must be 50% of the gross scheduled rent. Further, there's nothing fundamental that says they should even be related.
If you've been reading you're seen the discussions. You're seen where people do offer numbers. Unfortunately one of the best large datasets is no longer available.
Some follks say 45% is a better number. 50% is just easier to calculate, especially if you do it in your head.
The 50% number is not an upper limit. No, you cannot assume expenses will be 50% or lower. Really, its a lower limit. If you do a good job and manage your properties well, you can get down to 50% (or a little better). You can easily get them to 65%, 80% or 150%. Since some screw-ups (e.g., fair housing violations) can result in the loss of your property, the upper limits is VERY high.
In any particular month or year the numbers for a particular property will almost certainly be much different than 50%. At the low end, you might have only taxes and insurance. If you have a tenant in place all year, no maintenance and no other expenses besides taxes and insurance, that's the best you can do. If you pay for management, take 10% off the top of the rent. More typically, you would have the management expenses, a turnover (which is another management fee, half to a full months rent in many areas), and some vacancy. So, a reasonable expectation might be taxes, insurance, a month's vacancy, half a month's rent to fill the vacancy, and some amount of maintenance.
Big ticket items, like furnances, roofs, and sewer lines, do need to be replaced periodically. Kitchens and baths need to be updated. If you own a handful of properties for a few years, you might avoid these. If you own 50 properties (which is the sort of number you need to make a living off rentals), and you are in this for the long haul, you're going to be replacing 2-3 furnaces ever year. And 2-3 roofs. And other big ticket items. Rather than being an occasional big expense, these things just become part of your routine annual costs.
Then there are the horror cases. A tenant decides to wreck the place. You have a run in with the city and get slapped with code violations and your tenants get evicted. A tenant stops paying and it takes six months to get them out. Again, a few properties for a few years and you may get lucky and never have these problems. Or, you may be unlucky and have one very quickly. Dozens of properties and in for the long haul and this sort of thing becomes routine.
Badly run buildings can have much higher numbers that 50%. I've looked at actual APODs (Annual Property Operating Data, a spreadsheet with income and expenses for a property) for real apartment buildings where the number was as high as 80%.
Its rare you'll see any meaningful data for a SFR. The data just doesn't get collected. The closest thing to good data would be the owners tax return.w
Great post to diffuse the impending argument Marc!
You will find some on here that pay homage to the almighty "rule" about 50% as if there are not exceptions. Anyone that deviates from said "rule" will be scoffed at and made to feel small and inexperienced.
Others will claim their property operates differently using actual data (higher or lower) and will later be ridiculed because they, "Haven't held it long enough to know better."
The truth is that THIS IS NOT A RULE! It is a good SCREENING device that is worshiped all too much on BP. The intent is to keep newbies from thinking rents - PITI = "Cash flow."
The REAL truth is that gross schedule rents/2 - debt service does not equal cash flow either. There are plenty of instances where INDIVIDUAL properties operate differently. This "rule" also has capex baked into it, which will not represent true cash flow year to year either. Some years will have higher cash flows as a result of not outlaying cash for capex...others will have large negative ones. If you buy a property with a large amount of deferred maintenance these large negative cash flows will occur in the early years. If you buy a bright, shiny asset they will occur much later. The "rule" treats the "cash flow" from these properties the same when they are very different from a time value of money standpoint.
Use the rule for screening and err on the conservative side in all cases. Don't worship it as the end all be all though...it isn't. Do your due diligence on each individual asset and engage some more experienced investors if you need help with your assumptions. These folks are easy to find at your local REIA.
Thanks Marc, that's what I was looking to hear. Not trying to start an argument. Just trying to learn.
And thanks Jon, your answer had a lot of good information. Also, I meant "rule" as in it's solid, unchanging.
Thanks Bryan. My bad if my question was in any way offensive to anyone..
Emily- it is not a rule. You may feel free to ask any question on here you want. Someone will let you know if it is offensive. There are TONS of threads and posts about this 50% thinking. Decide for yourself whether it makes concrete sense after reading both sides. Welcome aboard. Rich
The number one rule of Real Estate Investing is that there are really no rules at all. There are LAWS that need to be adhered to, there are expenses that need to be calculated, there are variables that need to be considered, but as for actual rules, everyone has their own set of 'rules.'
For instance, some will say that a rule is that you need to do your own due diligence. As for me, I let someone else execute the due diligence. They are getting a commission, they need to do more than just write up an offer.
Some people will say that you need to serve a 3 day notice if the tenant is one day late. I say you need to find out what is going on. My highest priced rental did not pay rent one month, or I thought. I live in Colorado and the rental is in California. They dropped the check in the mail and then went on vacation. It just so happened that they transposed two numbers of my address in their hurry to get out of town. I had several people check to see if they had vacated, and all it turned out to be was human error.
You will find dozens, if not hundreds, of GUIDELINES here on BP to help with your Real Estate Investment. I can show you a house where it is 20% and I can show you a house where it is 80% for operating expenses. I own property in six states and each state has a different Property Tax rate, so how can 50% even come close to being a rule? My property management companies charge anywhere from $50.00 a door to 8% of the collected rent. So you see, the variables just go on and on and on.
But to use the guideline, if you buy a rental that pays $1,000.00 a month rent, you would like to keep the PI around $500 or less. That way, you should see some cash flow.
I will give you an "anti-rule".
Cash flow = Rent - PITI
I see this one used on a daily basis. Every deal some wholesaler shows me uses this rule to claim "it cash flows". Its all over the MLS. Go to a REIA meeting and ask a dozen landlords what they mean by cash flow and this will be the most common definition.
If your use this anti-rule to decide what to buy you will fail.
Thanks for taking the time to reply Rich and Mike. I now understand that the 50% Rule is not a rule.
I do want to add one thing. When we say the PI should be around 50% of the rent, figure the PI on the PURCHASE PRICE, not the loan.
For example, at 6%, the PI on $100,000 is $599.55. But the payment at 80% or $80,000, is $479.64. So you would actually want rent of $1,200 (2 x $599.55) for a property you purchase for $100,000.
JScott said:
This is just a subject that has had some controversy here in the past, which is why you're seeing these carefully crafted responses.
As he and others know, my responses are never carefully crafted, and my reply in this post was pretty cut and dried. It is not a rule, period. Rich
There are several things to keep in mind here that can effect this.
Some investors may choose to mange their own rental properties.
Some apartments will have some or all of the utilities individually metered.
Some property owners perform little maintenance year after year and create deferred maintenance.
Vacancy can be a huge factor. Some areas may have periods that rent concessions may be necessary to rent a unit.
Location, market supply and demographics can be factors.
There are a great many variables to consider. Which is one of the reasons you will here people say it is very important to know your market.
So, IMO the 50% rule is a tool, but it can never replace due diligence. I would also say that if you find your expenses are quite ab it under this there is a good chance that you are missing something like CAPEX expenses.
As most replied, the 50% "rule" is more of a quick screening tool to see if further investigation into a certain investment property is warranted.
My take on the 50% "rule" is that it's applicable to lower-income, non-appreciating properties for investors who rely, i.e., live off, the rental income. IOW, it doesn't consider the other benefits to holding a property such as tax benefits, appreciation potential, and equity building through the pay down of the mortgage.
Emily, you have some good examples above of considering the 50% rule.
It's something you can do in less than a couple of minutes, as fast as you can compute your PITI.
I never used the 50% rule when considering properties myself, but when an investor was seeking financing from me it was an instant analysis that could tell me to continue with that loan application process or address the transaction in more depth with that investor.
I suggest a little more formal analysis to use for an investment decission.
If I am going to put out 22K to acquire a property, I want a return on my money.
I treat that as an expense just as PITI.
There is a difference between opearting expenses and capital investments, some landlords really don't make any distinction between putting new carpet in a unit and repalcing a faucet. This can lead to overkill in analysis for a SFD or a triplex, but if you have 100 units, in a project the little things add up.
I require a rturn on my money, I charge myself 10% to "manage" the property. Depending on the level of rents, I generally use 5 to 7% for maintenance (this is an estimate based on the condition of the property and the rent levels). Someone paying $750.00 a month for a SFD, I have found actually has less damage per dollar than a $350.00 tenant. Then the same thing is considered for capital improvements, major stuff. I estimate the cost of heat and air and a new roof, two of the most costly items and amoritize these expenses of ten years, maybe longer if the property is newer, but never longer than 15 years. Now, I have PITI, return on my money, management fee and a sinking fund for maintenance. Now I have to apply a vacancy rate. 10% is a rule of thumb as well. I have found that on the average my properties were never vacant more than six weeks, so I break this down weekly and apply it as an expense.
So my gross rents, less PITI, Return on Investemnt, Management, Vacancy, Maintenance, Capital Sinking Funds will give me an amortized cash flow to apply to my consideration. Next I consider taxes and any rate of appreciation estimated out to ten years. Alot of this is based on experience and can actually be accomplished pretty quick.
Mentioned above was something I would not do, that of allowing someone who has a vested interest in selling a property to do my due diligence. Realtors can only be held liable so far for errors in judgement and I'm not buying any property based on what the selling agent might put together. Inspections should be done and the agent can certainly do alot of coordination and foot work, but don't trust any numbers other than those you put together, IMO. You're the one ultimately responsible for your investing. Good luck, Bill
Mitch succinctly summarizes the reality of rentals. And really answers your question, Emily, "is this a hard and fast law". No. Actual numbers will vary all over the place.
The reason I like the 50% rule (or, in my case 40% since I'll self manage for free) is that it avoids using a bunch of different numbers. When I first started I was given a spreadsheet that computed a return on my investment. It split out management, maintenance, utilities, etc. It also accounted for tax rates and future appreciation. The trouble with that is with enough knobs to twist, you can make any investment look good. The 50% rule is a dead simple way to analyze a potential investment. If a property passes screening using that number, it will probably be a good investment. If it doesn't, move along.
Might it turn out better? Yeah, perhaps somewhat but probably not radically. Might it be worse? Absolutely. That's the risk we take investing in real estate. Check out this thread.
As soon as you start guessing about appreciation you're looking at a different investment strategy. One that's been very profitable in the past, but also one that's been disastrous in the more recent past. In the best of times its difficult to predict appreciation. And its far from the best of times right now.
I wanted to jump in real quick and point something out.
Everyone who said the 50% rule isn't a rule is correct, but contrary to some opinions, it is a fact.
The 50% rule doesn't change for anything. The whole list that Charles gave doesn't matter, because the "50% rule" isn't dealing with one property or one investor.
He's correct in saying that YOUR expenses may be more or less than 50%, but that doesn't change the fact.
Bryan, in my experience, when the utilities are paid by the landlord, the rents are high enough to cover the utilities, and make market rent. Generally, the landlord will even make a little money on top of the utility costs. Does that change the "rule?" No, because there will always be a tenant that runs outrageously high bills at some point and balances it out.
The 50% rule accounts for all expenses other than the mortgage. Taxes, management, repairs, vacancy ect. But just because one property, or a dozen properties have lower or higher numbers, doesn't mean the fact changes. Something will always balance it out.
It's always best to do your due diligence on a property to see what you're short term number will look like, but in the long run, they'll be close to that 50% number.
Fair enough Marc, but that is not how the rule is applied to scenarios here on BP. Someone generally posts about their property and people go through and use the divide by two factor to produce a NOI. There is no accounting for when the expenses actually occur, hedging of language in the post, etc. and people are misled in many instance IMO.
I have also seen many posts where people outright ridicule people for claiming that their individual properties have higher or lower operating expenses. WRONG!, NEWBIE, etc. get tossed around even when it is obvious that the poster has more data on the actual operating history than the person calling them out.
If the rule applies to large portfolios over a long period of time it doesn't necessarily make it appropriate for individual properties for a short period of time. Some people may be buying properties to reposition them for 2-3 years and resell. Will they have to replace a roof in that period of time? Likely...no. Will the rents and vacancy be optimized for that particular property? Likely...no.
I have no problem with people using this to underwrite deals quickly because it would be impossible to do a detailed analysis via a message board. What I take issue with are the people that shout things from the rooftops and are downright close-minded when people say their property operates in a mannger different than what the "rule" claims.
I agree with you, so try not to take this as argumentative.
I'll try not to speak for anyone else, but I think the reason some people may do that is that it is near impossible to do a complete due diligence on someone else's property. That is a number that they know will be reached if that person continues investing, and it gives the poster a clear idea that they may be overlooking some things.
Regardless of the name calling, I do think it's done in the best interest of the poster. Unfortunately, I think you're right that it isn't always explained that each property will be different. I use the 50% rule because I know there will be expenses that come up, that I can't plan for. I've had A/C's go out the first summer I've owned a place, I've replaced roofs within 2 years, and I've even had a truck hit one of my houses. By giving myself a large enough buffer over the outgoing monthly expenses, I can plan for those types of events.
If there's anything about rental real estate that truly is a rule it is that it is risky. "Risk", when it comes to investments, has a specific meaning. A "low risk" investment like bank CDs is low risk not because the return is low but because the return is well known. Short of extremely catastrophic situations you WILL get your principle bad and you WILL get exactly the return the bank stated you would get. Even if the bank goes belly up, you get your money and your interest.
High risk is often equated with high return. That's incorrect. High risk actually means the range of ACTUAL returns is very wide. You can make a prediction of what return you expect. Unlike the CD, though, you actual returns are extremely unlikely to match that prediction. They might be higher, they might be lower, but they almost certainly will be different. High risk investments typically have the possibility of a high return. Otherwise, nobody would invest in them. But they also have the possibility of a low return or even a negative return (loss of principle).
The "50% rule" is merely a tool to make a prediction. You can take the rent and divide by two and get a PREDICTION of the NOI. Nothing more. As many of us have repeatedly said the ACTUAL NOI may be somewhat higher. There's always an upper limit in the it cannot possibly higher than the rent. Realistically because you have certain fixed expenses like taxes and insurance, it can't even be that high. And, if things go poorly, it can be much lower or even negative.
But ultimately the 50% rule is simply is simply a prediction of the NOI. Its useful in evaluating a deal. It does NOT tell you what the returns will actually be. If you own 50 properties for 20 years, do a good job with then, and carefully account for all your expenses, vacancy, and capital expenditures over that term, I'd be willing to make a pretty large bet the actual number will be pretty close to the 45-50% range. Just like if you set down at a video poker machine and play 200,000 hands with perfect strategy your return will be quite close to the theoretical return for that machine. But if you play five hands or own two properties for a few years (like me) your actual results will vary widely. I have, once, set down and played video poker for 15 minutes and won $1000. I have had months when nothing went wrong and my NOI was exactly "rent - PITI". Both are just luck.
When choosing a video poker machine, I look at the paytable. The paytable tells me if it has a good payout or a bad payout. That doesn't tell me what's going to happen when I play. The 50% rule is the same idea. Its just a tool to separate good deals from bad deals. Good deals can still go south and bad deals can actually work out OK. Its just luck. I like gambling analogies for real estate because, despite all the mumbo jumbo that sometimes gets thrown around, luck is a huge factor in your actual returns.
Marc, Perhaps it is true when you look at every rental that on average it will be 50%. IMO this still only gives me a guide when looking at a specific property.
Knowing what average home prices are in an area or in the country really doesn't help me a lot on a specific property investment.
Due diligence is still going to be necessary and is important enough that IMO I want to do much of it myself.
As Jon pointed out, the holding period will have alot to do with expenses rising. Just makes sence, the longer you keep something the more it costs to hold it. Hopefully, you'll select quality properties in a good or growing location that will appreciate as well.
How an investor evaluates a property will certainly be (or should be) to their needs. Fine tunning the analysis will come with experience. Using the 50% rule is fine in the beginning or at first, I think everyone agrees, but I suggest a little more due diligence and crank the numbers before buying.
Seems to that if someone gets use to doing something the simple way and they don't learn how to drill down in a deal, they probably won't later on. Taking an easier way out might cost you.
Last comment, Having money to operate with is crucial. The risk you take buying a property and not having the means to make a major repair can ruin you. Imagine having a property with a stiff mortgage, where you really need to income to make the payment. In the late fall the furnace goes out. You can't flip for a couple grand to have it fixed and then you lose your tenant...and they have right to break the lease and move out! You get behind on the mortgage payments and bam! You're had! As Jon pointed out it's the risk that needs to be assessed against the benefits. IMO, someone doing a buy and hold strategy should have cash in reserve from day one to cover such risks or do something else until such funds are available, then you're ready to be the landlord.
Ya know, when I consider all the man-hours that have gone into evaluating the credibility and applicability of the 50% "rule", we could have performed a comprehensive cost-benefit analysis for the purchase of Venezuela! :mrgreen:
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Note: I'm as guilty as anybody, i.e., I've been known to over analyze things to the point my brain tried making a break for it out my left ear.