50% Rule and $100 Cash Flow

29 Replies

I guess my question is how accurate do you find the 50% expense rule?

If you gross rents are $2500, a margin of error of 10% on your expenses would result in a $125 difference in cash flow. This might result accepting poor deals or rejecting good ones.

So in the end, the accuracy of the 50% number is critical, isn't it?

The 50% rule is not an excuse to avoid doing your homework. It is a guide that can help you to evaluate a deal quickly. If it makes sense on the surface then you need to take a closer look at the actual numbers. The 50% rule is simply based on averages.

:cool:

I'm not sure what you're asking. Certainly for one property in any one month, the expenses will not be 50% of rent. If its vacant, you have no rent at all, so fixing a toilet would make your expense ratio infinite. If you have a tenant and the taxes and insurance are the only expense, it might be only 10-15%. I consider 40% or 50% or whatever number you like to be a budget over the long term. When its below that, I accumulate the money for the inevitable vacancy or big expense.

Yes, try the 50% rule at first and then save like heck until you are holding 6 months operating expenses. Of course you should verify all numbers prior to making an acutual offer (i.e. if you figured insurance to be $100 a month and it's really $200, your viability could go out the window.)

I think what the OP was asking was if you are aiming for $100 cashflow per month, but allow a 10% window of error on your expenses, then you could potentially be over your cashflow and be negative.

What the OP doesn't understand is that the $100 is what is left over after all expenses are paid. Using the 50% rule, your expenses will be taken out of the 50%, and your cashflow at the end of the equation will be your profit. As others have mentioned, this is just an estimate though.

So, to put this in words and be clear, if I have $100 in cash flow using the 50% rule, theoretically I can do whatever I want with that cash as long as whatever part of the 50% of expenses I don't use is saved for times of higher expenses?

That would be correct Bob, assuming your expenses were 50%. But what if they were 55%? Then your $100 cash flow is no more. The point of this rule is simply to do a quick evaluation of a property, not as the end all, be all of yoiur expense ratios..
Ultimately, you need to dig deep into the particular investment and accurately figure the expenses. Obviously, expenses that do not occur on a monthly basis and may or may not occur can only be averaged or guesstimated.
For that very reason, along with a few others, I personally do not use this rule.
I have a reserve account set aside for capital expenses and possible future vacancies. This way, I do not rely on the cash flow alone to support these items when they occur. Also, from an accounting perspective, replacing roofs, ac units, etc. are capital expenses, not operating expenses.

So, to put this in words and be clear, if I have $100 in cash flow using the 50% rule, theoretically I can do whatever I want with that cash as long as whatever part of the 50% of expenses I don't use is saved for times of higher expenses?

Bob - that is exactly right!

The point of this rule is simply to do a quick evaluation of a property, not as the end all, be all of yoiur expense ratios..

The point of the 50% rule is that over time and a number of rental units, your operating expenses will be 45% -50% of the gross income. It is impossible to accurately figure the expenses for a particular property and a particular time frame - there are simply too many expenses that can not be predicted. However, over time, your expenses should approach the 45% to 50% range.

We've had many people on the forum that have claimed that their expenses were lower than this, many times ridiculously low. However, when the real expenses were added up, IN EVERY CASE, their expenses were in or very close to this range (sometimes even higher).

Mike

The statistical theory of large numbers bears out the 50% estimation.

That does not mean in some cases your actual expenses may be MUCH higher or lower. But, if you hold any give property long enough your expenses will even out to 50% of gross rents over the holding period.

Yes, you will exceed that when you have to replace the roof or get the joy of paying for some other large expense. But, over time, large numbers take over and it will settle to around 50%.

The people who get into trouble using this long term view of expenses are the ones who are doing short term deals.

For example, you buy a building based on estimating the expenses at 50% but six months after you buy you are force to repair a failing foundation. Unless you are holding for a long time, your particular average expenses on that particular property could be more than 50% of rents.

The 50% estimation rule is not sacred, nor guaranteed, it is just a tool investors can use to evaluate a potential deal. But, it is a tool grounded in lots of data, history and experience.

Taz reiterates my point. Large capital expenses could easily raise your expense ration above and beyond 50% which is exactly why these expenses need to come from reserve accounts and not rely on cash flow.
Why guess or estimate?
Why not equate all the expenses that occur monthly, and the balance is your pre-taxable cash flow. Then, whne the capital expenses occur, you pull form the reserves. What is so difficult to see here.
Everyone wants to use a 50% guess rule, rather than lock in actuals with reserves.

I apologize for adding to the confusion here.

Will, I don't think anyone is saying rely on the 50% guestimate.

I use it as a gating factor to quickly look at possible deals. It is the first step only for me. After that I do exactly what you describe and dig into the details including reserves.

I've bought and owned over 1000 homes in my career and not once have I looked at a 50% rule. Different properties are going to adjust differently on expenses-- newer compared to older, apts to cheap houses, cheap(bread and butter homes) compared to expensive. Turnover will cause big differences also. I've never tried to micromanage my rentals that way and I don't feel it is necessary, imo.

I can appreciate that Taz, and THANK YOU Rich. That is what I have been saying for months and months here!!!
I was referring to Mike's comment about having everyone use a 50% rule for the end all be all.
Here is a quote from Mike:
"We've had many people on the forum that have claimed that their expenses were lower than this, many times ridiculously low. However, when the real expenses were added up, IN EVERY CASE, their expenses were in or very close to this range."
I will assume I am one of the people he is referring to as he has accused me of this several times before.
I realize not everyone fully understands accounting methods and processes, but here it is in a nut shell.
Over a year period, you take all the rental income and minus all the actual expenses (interest, taxes, insurance, prop. management, any actual repairs, accounting, advertising, etc.) What is left is your net income (pre-tax) also known as cash flow. You then get a depreciation deduction and if the cash flow is then positive, you are taxed on that income. Using Mike's 50% rule, he claims to use a portion of the expense ratio for future unknown capital expenses and future possible, but unknown operating expenses like vacancies, etc. For arguments sake, lets assume that 35% is the actual fixed expenses each year. That means that 15% is left over or carried over for possible expenses next year. Unfortunately, the IRS does not allow you to deduct expenses that have not occurred and therefore, you will be taxed on that income. This is one reason why I state that capital expenses and future possible/probable operting expenses need to come from a reserve account, not the monthly cash flow. I do not pretend that expenses do not exist, I merely pay for these expenses when the time comes from a reserve account.
I hope I have made this point clearly enough to understand.

Rich, since you've owned a lot of houses, you should have more complete data. On your rentals (I'm guessing some of those 1000 houses were flips), what does your data say? For lots of properties over a long time, what do vacancies, expenses, and capital items look like vs. scheduled rent? The "50% rule" lumps all three of these items into "expense", even though we all know they are really different items.

I really see the 50% rule as a warning. If you assume that rent - PITI = cash flow, and go with a rental that only makes you $50 a month, or is break even, you're going to be in world of hurt if you have a long vacancy, a nasty eviction, or need a new roof. With enough properties and enough time, you will have those items, so you have to budget for them. If you get lucky, you have good tenants for the long term, and cash flow is close to rent - PITI. Or, you get unlucky and can't get a tenant or have a major expense and you get foreclosed.

So, Rich, do you have any real data you can share?

Originally posted by Jon Holdman:
I really see the 50% rule as a warning. If you assume that rent - PITI = cash flow, and go with a rental that only makes you $50 a month, or is break even, you're going to be in world of hurt if you have a long vacancy, a nasty eviction, or need a new roof. With enough properties and enough time, you will have those items, so you have to budget for them. If you get lucky, you have good tenants for the long term, and cash flow is close to rent - PITI. Or, you get unlucky and can't get a tenant or have a major expense and you get foreclosed.

Jon, neither I, Rich, or Taz are saying that you do not account for these expenses, simply that averaging or guessing a percentage ratio for expenses is not very accurate or feasable.
I also do not think your blanket statement is fair. For instance, someone could have only $50 monthly cash flow, or even negative and in 5 years sell for $50,000 profit. Did they make a bad decision or choice? No, of course not. I realize we are discussing a landlord business, but it does not have to rely only on cash flow for profit or to pay for capital expenses, vacancies, evictions, etc.


Of course you're correct that there's more to it than just the cash flow off the rental. Lots of people made out like bandits during the bubble buying properties that were badly cash flow negative.

OTOH, you don't have to look very hard to find numerous cases where tenants are being kicked out of their rentals despite paying the rent on time every month because the owner is being foreclosed. I think we do a disservice to our community by getting into deals assuming the best only to find ourselves faced with the worst.

I would contend there are many areas where you will see little or no profit on the sale of a house whether its in one year, five years, or 10. Especially if you account for inflation. So, you better have a profit on the monthly rent if you want anything.

I wasn't claiming that $50 in "cash flow", where cash flow = rent - PITI, was a overall losing deal. I was claiming, and stand by the claim, that it would be an extremely rare rental where that was a profit on a monthly basis.

Mike is correct that in the past when someone has said "my 'expenses' are lower than 50% of the scheduled rent", the claim has not stood up to scrutiny. Either the poster never coughed up any data, or the data actually did come pretty close to 50%. Lots of folks, like me, manage their properties and do minor maintenance, and don't count that against the property. But, I acknowledge I'm "working for free".

And I do acknowledge that different areas are going to have different expenses, and different ratios. One guideline I've seen is that warmer climates have overall lower expenses than colder ones. And that some places, like FL, have very high insurance rates. And some, like TX, have very high property taxes. I for one would love to see some actual data that really does detail this out.

This seems like a good thread, so here goes. I've NEVER kept a % to determine my returns. I also have NEVER limited my purchases to cash flow projections.
In my seminars I explain that there are 4 main benefits to owning real estate.
first- APPRECIATION, which has averaged over 5% per year for the last 59 years.
second-tax benefits- This can either be paid to the irs or can become an additional investment pool to draw from'

cash flow
principal paydown.
The last 2 are so FAR from providing the same benefits as the first 2, they shouldn't even be in the same paragraph. You may buy many more properties if you'll keep a reserve for repairs or negative cash flow, rather than having to pay more down to earn a cash flow, that you'll then pay taxes on!! I buy and hold on all properties I acquire on seller financing. I have built and held, bought forclosures and sold or held, etc.
My background is real estate. At age 21 I began in Fullerton, calif and became a broker and did real estate syndication. We started buying properties in Co and I opened an office in Littleton, Co. At the age of 29, I retired and moved to Ore. I've continued investing, mostly in warm weather areas. Ca, AZ, and currently TX and MS. I'm not one of the cash flow gurus. I will argue that method with anyone. As you get older and retire, then your properties will provide the income without the tax consequences.That is the only time to look at the cash flow methods,imo.
I can't help on the %'s that Jon asked about. It would take too much of my productive time to calculate those #'s and I've been very successful with my monopoly approach. Control as many properties as possible and let the market make me richer..
I've enjoyed this board so far, but am still learning it.

So, not trying to get into a general discussion about all the ways RE can make money. Just trying to focus on the OP's question about expenses. It would sure be nice to have someone who really has a bunch of properties and who has kept detailed records speak up about what they've actually seen. I know apartment association capture this data, but its not generally available to non-members. Which is to say, I've not seen any of it.

My feeling is that apts are easier to track and compare, like apples vs apples. Houses are much more difficult and "one size or model" doesn't fit all. By the way John, I owned apts in CO MANY years ago. In colo springs, The Colony 161 units, The Bella Vista 202 units, and 156 units in Aurora (can't recall name). I lived in Bow Mar South in Littleton. Only there 1 year, 1979, 100 year storm!!! Drove me away!!

We had a huge storm a couple of years ago. We had 6' in my yard on the west side of Denver in about 30 hours, 9' up a little higher. But still beats Houston and Bakersfield. I'd love to get 156 units in Aurora right now. Better still would be along one of the future light rail lines.

But, I digress.

We're talking about several different businesses here.

If you're talking about selling properties to newbies like Will does, then the 50% rule is meaningless and you do not experience the expenses.

If you're talking about speculating on appreciation, then that is a completely different business. Buying a rental with negative cash flow and betting on runaway inflation in the near future really is not the rental business.

Yet another thing completely is the mom and pop investor who only wants to own one or two rentals for their retirement. In this case, they may be able to handle the negative cash flow out their paycheck and will still end up ok with the appreciation, tax benefits, and principal paydown by the tenants.

I'm not talking about any of those scenarios. I'm talking about running a rental property BUSINESS. A business is an organization whose purpose is to MAKE MONEY! In other words, to have cash left over at the end of the month.

Taz and I don't agree on much, but I agree with this:

The statistical theory of large numbers bears out the 50% estimation.

That does not mean in some cases your actual expenses may be MUCH higher or lower. But, if you hold any give property long enough your expenses will even out to 50% of gross rents over the holding period.

This is exactly right. The 50% rule tells you nothing about the specific expenses for one house in one month - NOTHING! However, it is very accurate for a large number of rental units over time, WHICH IS CRITICAL IF YOU ARE TO RUN A SUCCESSFUL RENTAL PROPERTY BUSINESS. If you pretend that expenses don't exist or that maintenance is $6 per month like Will does, YOU WILL NOT SURVIVE IN THE RENTAL PROPERTY BUSINESS. You can get away with that silliness if you have a hobby, but not if you are in BUSINESS.

Why not equate all the expenses that occur monthly, and the balance is your pre-taxable cash flow. Then, whne the capital expenses occur, you pull form the reserves. What is so difficult to see here.

So, how do you know how much reserve you need and where do these reserves come from? Do they magically just appear from thin air? You see, this is just silly. No matter how you slice it, over time and over a large number of rentals, the expenses will be in the 45% to 50% range (assuming that you're managing the property properly). You're still going to have the same amount of money going out, you're just calling it something else and it doesn't appear to me that you have any idea how much that is. I could go back and quote all the silly things you said in your early posts (like maintenance expense being $6 per unit per month), but I'm not going to waste my time doing it again.

So, if you don't use the 50% number or some other number, how do YOU determine the proper expense number to use for a given property? Just to be clear here, we're talking about SFHs and small apartment buildings, not large commercial projects. Please explain your technique to us Will and please be specific. I'm particularly interested in knowing how much reserve you need and what that reserve is intended to cover.

Mike

Give me a break Mike. Again with your foolish stupid attacks. Have I created new investors - YES. Has anyone who has never bought a RE investment before, purchased from me - YES.
Do I pretend some expenses do not exist - NO.
I explained in great detail how I figure those out. Perhaps a tutor to assist you in reading the thread can explain that to you. I do not pass off $6 maintenance fees - you are acting ridiculous!
The reserve account does not magically appear nor is it created out of thin air. Again a foolish and ridiculous comment. If I need to explain to you how you obtain a reserve account, then you are in big trouble Mike.
Not everyone is talking ONLY about the RENTAL PROPERTY BUSINESS, and the only way to make $ in the rental business is not cash flow. There are several income sources from owning RE. Just because you personally rely only on cash flow, does not mean everyone else has to or needs to. It does not mean that you are the only one in the rental business. Just more ridiculous comments. You really need to tone down your approach, it is not useful here.
I do not intend to argue with you on this point as it is futile and a waste of my time.
For those who want to look at a very narrow vision of one person's rental property business, they can go with your thought Mike. Not everyone must operate a RE business in the fashion that you do. Just another wonderful aspect of RE, we can all make $ in a variety of differnt vehicles, methods, strategies, etc.

I have seen a few ask for data. So here is some of mine. Evaluating 6 properties over a 10 year period, I have experienced an expense of 35%. That does not include depreciation (non cash) or mortgage (principle and interest).

It also does not include capital expenditures. This is really what I was missing. New capital expenditures come through with depreciation, but are not reflected in the 35% above. I will do a quick review of the capital expenditures over the same period to see if it totals 15%. It may not reach the 15% number, but I'm sure it will be over 5%.

So, I guess I should say that you have converted me to the 50% rule. I would tend to agree that a rule of thumb expense rate of 45 - 50%, which would include any over time capital expenditures, is probably accurate.

Of course, for the purpose of investment evaluation we also need to consider gain from appreciation (???) and cash flow after tax. Appreciation is probably irrelevant to me since I tend to buy and hold (It is relevant, however to my kids).

But I think the tax effect is relevant to all. If you don't have to pay them to the state or feds, its real dollars. I think that anyone earning over $50,000 with their day job will benefit to some degree. Someone with even break even cash flow using the 50% expense rule will most likely come out with a positive cash flow after tax.

So, the follow on question would be what simple metrics would you use to evaluate a property after tax (let's say using a 25%, 35%, or 45% state and fed marginal rate)?

The one in aurora(I think ) was on Dallas ave. HORRIBLE investment. My worst ever...

Of course, for the purpose of investment evaluation we also need to consider gain from appreciation (???)

I consider appreciation to be icing on the cake. At any rate, I don't know how to predict the appreciation for the next few years. Will appreciation be a historic 3% to 5%? If I had predicted that in 2005 or 2006, how would I be doing so far? With an unprecedented runup in prices, what will prices do in the future? I guess the bottom line is that I agree with you Oscar, the appreciation is really irrelevant to me. And, with our country broke and spewing out new entitlements every day, I doubt if the kids will see a penny from my business either. By then, I'm sure that the government will have found a way to take every penny! OUCH!

Mike

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