50% rule

60 Replies

My question is this. If I use the 50 percent rule in my market. Most of these properties qualify easy. Do I make an offer then ask for actuals?  There's many properties I want to pull the trigger on. Any advise?

Thanks 

Tony V

What type of properties are you thinking about doing? Single family homes won't be able to provide the actual expenses nor would most of them do so.  At some point you just have to jump in and give it a try. There is a reason we are always learning landlords.

Every house we have bought has been better than the first. 

@Brent Coombs when it comes to expenses in analysis. I've seen a lot of people saying first analyze 50% rule. In CT most pass this rule easy. My issue is I need facts. Do I make an offer off the 50% rule? Then get actuals. 

@Tony Velez , I am still not sure by what you mean by "In CT most pass this rule easy". I guess you mean that most properties there don't cost more to service (mortgage, insurance, vacancy allowance, cap ex, maintenance, management, tax) than half of the gross rent. That makes sense, because that is why the rule was made up in the first place. (Yes, it's "made up"). But no-one can prove in advance whether a particular property might fall on one side of the line or the other (40% ~ 60%) in any given year.

GENERALLY, multi family properties might have lower cap ex per door when it comes to roof replacement for example, but hopefully you will have worked that out. I agree with @Elizabeth Colegrove: "At some point you just have to jump in and give it a try". Cheers...

Updated about 6 years ago

Edit: thanks to @Will Barnard, I realized that Mortgage (P&i) should not have been included in my 50% expenses Rule summary, but would be taken off the OTHER 50% remaining income.

@Tony Velez

The 50% guideline is simply a statistical observation: looking at a sample of rental properties, over time the operating costs run approximately 50% of the gross revenue. {When looking at smaller multifamily (i.e <16-20 units) with central heating, the operating costs are likely to run closer to 60%)

The 50% "guideline" is a quick, in-your-head, means of performing triage on a property and deciding whether it warrants further examination.   It most certainly is not a method of analysis on which you would base a purchase decision - for that you want to breakout your favourite slide-rule, or spreadsheet, and carry out a full discounted cash-flow analysis of the property over a projected hold period.

If not already in your library, I would suggest picking-up a copy of @Frank Gallinelli's "What Every Real Estate Investor Needs to Know About Cash Flow" and working your way through it as a starting point to property analysis.

My best apartment building is running at 36%. 40% will throw off great CF. 50% works but you have to work for it. Anything over 50% is not a CF play but an IRR play.

Makes sense?

@Tony Velez I do 3 levels of analysis. 

Level 1: the "are we remotely close to offer price" analysis  

  • Take the gross potential income and allocate 50% - 60% (exact percentage is determined by property age, amenities, and current condition) of it towards expenses 
  • Then take NOI and divide by cap rate which gives us the high-level valuation
  • This takes 5 - 10 min to do 
  • side note: another way to do this is knowing the average expenses per unit per year for that property time in that market then allocating that towards expenses instead of the 50% - 60% 

Level 2: the "ok, let's get serious and specific" analysis  

  • If after doing Level 1 it makes sense to continue then Level 2 is done 
  • In Level 2, you use property and market specific information to run your analysis
  • Some (but not all) things to consider for the specific market/property: taxes and how they are evaluated, vacancy trends, what's currently being billed to residents vs. what could be billed to residents (i.e. water), etc. 
  • Basically every expense line item on your analysis spreadsheet will be filled out based on the market/property 
  • This might take days or even weeks to do depending on your level of familiarity with the market, submarket and property and the responsiveness of the seller/seller's rep  

Level 3: the "time to verify" analysis  

  • After you get it under contract you move to Level 3 where you verify your assumptions during due diligence
  • You verify all the line items in your analysis spreadsheet by looking at leases, water bills, bank statements, etc. 
  • You'll update your assumptions if/when things don't match up then determine how to approach it with seller 
Originally posted by @Joe Fairless :

Then take NOI and divide by cap rate which gives us the high-level valuation

  • This takes 5 - 10 min to do 

Where are you getting this NOI?

And where are you getting the cap rate?  And what are you doing with them besides wasting time?  

@Bob Bowling I got this information from the pro forma. I'm practicing how to analyze deals the proper way. It's not wasting time to me. Practice makes perfect 

@bob 

@Bob BowlingI get the NOI from the gross potential income minus the projected 50% - 60% expenses. This is for the initial analysis.

I get the cap rate from comps. One good resource is REIS. 

And I don't understand your last question. It appears to be rhetorical so I won't answer. 

@Joe Fairless - So, as part of your underwriting, are you pricing out the exit? If so - how? I am assuming that the answer is "yes", because without pricing out the exit you couldn't underwrite the investment IRR projection. And, naturally, I assume that you do indeed underwrite to the IRR...

How does this work in your case?

What about you, @John Cohen ?

Originally posted by @Joe Fairless :

@bob 

@Bob BowlingI get the NOI from the gross potential income minus the projected 50% - 60% expenses. This is for the initial analysis.

I get the cap rate from comps. One good resource is REIS. 

And I don't understand your last question. It appears to be rhetorical so I won't answer. 

To get a NOI you need operating expenses. 50% rule is for determining cash flow. It includes capital expenses so it would overstate your expenses and give you a crapitalized value at best. You will not find NOI defined as 50% of gross rents.

To the third part let's assume you have done the work and have a NOI that is not a wild *** guess. Let's say you have two properties and one has a NOI of $25,000 and the other is $27,500. Market cap rate is 10%.

This is your Step 1 level of analysis.  How do you decide on an action to analyze further based on this information?  Other than to determine a market value this seems to be a complete waste of time.

@Ben Leybovich pricing out an exit depends on type of deal and time of hold. Value-add deals with short-term (12-36 month) sales it is more important to understand cap rates in the market. Long-term (5-10 year holds) it is not as important to guess on cap rate, because a lot can change in market conditions for that holding period. I also assume a higher cap rate (generally 50 basis points) higher then my going in cap. This gives me protection when I underwrite. Each deal will be deal by deal specific, always keep that in-mind. 

@Bob Bowling 50% of gross rent, minus vacancy, will give you a quick and dirty NOI. This is for a quick evaluation. If the market cap gives a purchase price significantly below the asking price, you make a call to the broker or owner and see the motivation and why they are selling.

This leads to @Joe Fairless next point is it worth digging deeper.

@John Cohen That's exactly what I am driving at, John. I am essentially challenging the concept of straight forward pricing of multifamily via capitalized NOI, specifically because of what you said - things change and fluctuate. I think this is @Bob Bowling's point - stated somewhat sharply, as always...:)

Personally, I take issue with long-term holds not needing to be priced out to the exit. I figure, unless you have 1 guy, who is all in with you for 100 years, stroking all of your equity checks at the acquisition, it is important to know when and how the capital will flow out...

My investors ask me first - how much will I make? Then they ask - is that CCR or IRR? Then they ask - how long will it take? And then they ask - how much you need? In that order...

Therefore, pricing out the exit is imperative for me on any hold time-frame as a matter of funding a deal. no exit = no IRR underwriting, which my guys want and are too sophisticated to invest without.

Now - obviously you can't base the exit on today's NOI nor Cap Rate. So, my question to you and @Joe Fairless is exactly that: do you price out exits, and if so - how. And if your investors don't require that you do, my question is - how do you, as the sponsor, get comfortable around the idea of taking money without a clearly underwritten path to get it out. This is very much a sticking point for me, and I'm just trying to compare notes here...

Thanks, guys!

Originally posted by @Tony Velez :

@Bob Bowling I got this information from the pro forma. I'm practicing how to analyze deals the proper way. It's not wasting time to me. Practice makes perfect 

 If you're doing it incorrectly you are wasting time.  I was speaking to Joe though and you can see that do I g it correctly eliminate 33% of his steps!  How's that for efficiency?

Originally posted by @John Cohen :

@Bob Bowling 50% of gross rent, minus vacancy, will give you a quick and dirty NOI. This is for a quick evaluation. If the market cap gives a purchase price significantly below the asking price, you make a call to the broker or owner and see the motivation and why they are selling.

This leads to @Joe Fairless next point is it worth digging deeper.

 Rookie mistake looking at asking price.  

But let's assume we're rookies and give me two realistic examples of how one would make you move to step 2 and the other would make you stop at step 1.

Now if your answer is going to be based on "asking" price then don't bother.  An experienced investor will quickly educate the seller as to market value.

@Bob Bowling I didn't say anything about asking price being the gauge of the offer. I just said its a quick way to look at things. Asking price means nothing to me, thats why I said next step would be to make the call. You aways have to educate the broker/owner, but that doesn't mean you have a shot at the deal. I think you would agree with me, there are inexperience and other buyers out there that overpay all the time. 

Originally posted by @John Cohen :

@Bob Bowling I didn't say anything about asking price being the gauge of the offer. I just said its a quick way to look at things. Asking price means nothing to me, thats why I said next step would be to make the call. You aways have to educate the broker/owner, but that doesn't mean you have a shot at the deal. I think you would agree with me, there are inexperience and other buyers out there that overpay all the time. 

 My question is still how is level one useful?  I am saying it is a complete waste of time.  Can you show me how it could be used to determine whether to go to level 2?

Are you advocating for level 1 or should we wait for Joe?