Why the 50% rule is so important....

Question

I know a lot of people come on here seeking advice about rental deals they have and many of them don't hold up to the 50% rule.  I will admit I guilty of justifying the deal in my head even when it didn't make true sense on paper.  Luckily I had (and still have) a great mentor that snapped me out of that.  There were times I felt like she was being unfair to the deal because the property was beautiful or in a good location, etc.  
This past April one of my rentals, a duplex, caught fire.  Thankfully no one was hurt.  The tenant's dryer had a faulty part which ignited lint in the dryer.  Combine that with the fact that the duplex was wood frame from 1920s and pesto chango you have one hell of fire starter.
I have been out of 2 rentals incomes on this property.  First waiting for the insurance money (in FL they have 120 days and of course they took every last day) and now waiting on the renovations.  Yes I received some of the lost income in the insurance payment; BUT I still had to float several months before that came through.
Reserves are so very important.  If I hadn't used the 50% rule and funded my reserves, this could have been catastrophic for me financially.  Luckily its not and while I do cringe every time I check on it, I'm not losing my butt on this deal.
I urge everyone looking into deals to buy with the head and not the heart. Its easy to get caught up in the excitement of buying something; but the money is made in being smart financially...not because the unit looked pretty.

Heather C. · Answer

Chris Masons the utility area was on the back porch, so in a comedy of errors the tenants had a bag of match-light charcoal laying near the dryer.  So make sure your tenants are storing anything flammable next to it!! LOL

Fred Maul That is the first thing I did- replenish my reserves!!!

Craig Sturgill Yes the 50% rule is just average; but I would never go below that even if my expenses were less.....meaning I would just add more to my reserves if my true expenses were less.  Then again I'm a very conservative investor and its served me well.

Callum K. · Answer

Along with everyone else, thank you Heather for sharing this.  I have been fortunate not to have gone through what several of you have experienced and I have always tried to keep a nice cash reserve available however I was not aware of the 50% rule.  Thanks again!

Heather C. · Answer

Joshua Dorkin Its been a slow process and since the rebuild is so extensive, I don't expect it to be done until early December.  Surprisingly, the whole situation has worked out well even if slow.  Plus now I feel as if I have a PHD in fire safety.

Joshua Dorkin · Answer

Heather T. - As the others have already said, thank you for sharing your experiences (though I'm sorry about the trials & tribulations), as I think these serve as the perfect example of why the 50% rule is really so very important.

How are things going now?  Is the property back in order?

Al Williamson · Answer

Heather T. so cool of you to share this reminder. Thank you and sorry for your misery.

Scott W. · Answer

Craig Sturgill@ Craig Sturgill - yes, if you manage the property yourself, you would save the 10% paid to a property manager & your costs should be "hypotheticall" be 40%. Again, look at my example. I am clearly not at 40%.

Scott W. · Answer

@ Craig Sturgill - 50% is all your operating expenses, including taxes & insurance.  This half of the market going rent.

You then take that # & add the Principal & Interest.  This total # is subtracted from your rent. This is what you make a month.

This is just a model to help those looking for a property average throughtout the U.S.

Obviously, you want to docment your own costs.

For instance, I have a condo I "inherited thru marriage."  My taxes/insurance/HOA alone is 32% of my rent of $975/month. There is only 8% left for vacancy/expenses/etc to make the 40% rule. Obviously this isn't going to work & is a bad deal. Another reason to stay away from buying a condo for a rental.

I also pay $89/month in PMI so I need to add that to the principal & interest.

Craig S. · Answer

I'm a newb here. When you factor in the 50% reserve, this is basically saying that you take 50% of the top of the gross rents and save this for maintenance, repairs, and other operating expenses. Then after that, the left over 50% you have to work with pays for the PITI. So even if the property is paid off with no mortgage, you are still leaving 50% for the operating expenses and "reserves", correct?

Also, if you manage the property yourself, should you still factor in the 50% or maybe closer to only 40% because you will save roughly 10% managing the property yourself?

I just want to make sure I am understanding the 50% rule correct.

Craig

Ryan Tucker · Answer

I always figure a reserve into the purchase of any property I buy or recommend. Otherwise, people don't think about it, and aren't prepared. Thanks for reminding everyone of this necessity.

Fred Maul · Answer

I had a similar situation.  My rental house caught fire and I had a reserve of 6 months payments built up for emergencies (didn't know about the 50% rule at the time).  It allowed me to pay my  mortgage and do upgrades to the house.  Thankfully, I have an awesome insurance company and I was fully paid for lost rent and the house looks way better then before.  I think I would have been freaking out had it not been for that specially designated reserve.