50% Rule clarification?
Murray Hill, NJ · Member since 2008 · 204 posts · 15 votes
Can someone give me a definitive answer on the 50% rule? I understand the concept, that your expenses should only equal 50% of your gross rent in order to get positive cashflow. But which expenses are included in the 50%? PITI for sure, but how about maintenance, vacancy allowance, property management, and capital improvement? And if the answer is that I should include all of those in the 50%, then why should it be a 50% rule? Why not an 80% rule if we've already accounted for all possible expenses? (I'm assuming the tenant pays all utilities.) I'd be perfectly happy with $200 net profit on $1,000 gross income every single time. Is the other 50% being budgeted just for unknowns and net profit, or am I missing something?
Just to clarify. The 50% rule is an estimate of the probable overhead costs for your rental property. It is also an estimate of the most you can allocate to your debt service and your cash flow.
If 50% of the rent won't cover your debt service (principal and interest) and still give you an acceptable cash flow, then you don't even want to consider buying the property.
If the property passes this first 50% test, then you need to determine whether the other 50% of your rent is sufficient to pay all your costs of ownership and rental operation -- or, in other words, your overhead.
Start by pretending you own the property free and clear. Now, everything you spend to own and operate your rental property is included in your overhead. The overhead cost items include, but are not limited to, advertising, leasing fees, HOA fees, condo association dues, management costs, legal fees, preventive maintenance, vacancy, rent loss, contribution to a replacement reserve account,property taxes, hazard insurance, liability insurance, utilities (at least during vacancies), trash removal, snow removal, cleaning, repairs, postage and any other expense paid by the landlord/owner.
You can get a pretty good idea of the magnitude of your overhead costs with just a little homework to nail down your expected costs for some of the big ticket items like property managment, property taxes, hazard insurance, and association fees, For a single dwelling unit, use one month rent as your vacancy allowance if you are in a strong rental market. For a soft market, you may need to allow up to three months vacancy.
"But which expenses are included in the 50%?"
Everything.
"PITI for sure, but how about maintenance, vacancy allowance, property management, and capital improvement?"
Yes on all except capital improvement. I'm not exactly sure how you're defining that.
"And if the answer is that I should include all of those in the 50%, then why should it be a 50% rule? Why not an 80% rule if we've already accounted for all possible expenses? (I'm assuming the tenant pays all utilities.) I'd be perfectly happy with $200 net profit on $1,000 gross income every single time. Is the other 50% being budgeted just for unknowns and net profit, or am I missing something?"
Because this is "real" estate, not paper investments. In "real" estate, real sh*& happens. That 50% is a buffer in your immortal struggle against God and His sense of humor. Sometimes it's more than enough, sometimes it's not even nearly enough. In the wash, it averages out.
It's just a guideline, nothing more, that works in much of the country for residential and especially for most sfrs. Don't get too uptight about it.
Note that the P&I part of your payment is NOT part of the 50%. 50% is all the expenses in the IRS sense, vacancies, and capital improvements. Expenses would include taxes, insurance, management costs, maintenance costs, legal fees, evictions, tenant damage in excess of deposits, lawn care, snow removal, etc., etc., etc. Utilities would be included, too, since, in theory having utilities included should produce higher rent.
Really. This rule of thumb just says that expenses (plus vacancies and capital improvements) will be 50% of the rent. What's left is the NOI. Then, you have to pay the debt service (P&I) out of that. Did you read T&I where I wrote P&I?
Here's a totally contrived example.
Rent = $1000/month
Expenses = $500/month (includes taxes and insurance)
NOI = $500/month
Debt service = $400 (just the P&I payment)
Cash flow = $100
Not easy at all to find anything around here that cash flows with this much allocated for expenses.
Just to clarify. The 50% rule is an estimate of the probable overhead costs for your rental property. It is also an estimate of the most you can allocate to your debt service and your cash flow.
If 50% of the rent won't cover your debt service (principal and interest) and still give you an acceptable cash flow, then you don't even want to consider buying the property.
If the property passes this first 50% test, then you need to determine whether the other 50% of your rent is sufficient to pay all your costs of ownership and rental operation -- or, in other words, your overhead.
Start by pretending you own the property free and clear. Now, everything you spend to own and operate your rental property is included in your overhead. The overhead cost items include, but are not limited to, advertising, leasing fees, HOA fees, condo association dues, management costs, legal fees, preventive maintenance, vacancy, rent loss, contribution to a replacement reserve account,property taxes, hazard insurance, liability insurance, utilities (at least during vacancies), trash removal, snow removal, cleaning, repairs, postage and any other expense paid by the landlord/owner.
You can get a pretty good idea of the magnitude of your overhead costs with just a little homework to nail down your expected costs for some of the big ticket items like property managment, property taxes, hazard insurance, and association fees, For a single dwelling unit, use one month rent as your vacancy allowance if you are in a strong rental market. For a soft market, you may need to allow up to three months vacancy.
I found that the 50% rule is just a guestimate on the facts. This product is what I use to evaluate a property. There is no easy way to evaluate a property, Use facts and Yes a guestimate of what the taxes will adjust to after the deed is transferred.
I tried numerous times to create an excel spread sheet. Basically what I am saying is I would have been ahead of the curve buy purchasing this program when I first started. I am sure there are other products out there. This is just something I would look at.
http://www.weekendmillionaire.com/store/index.php?main_page=product_info&products_id=13
Dave,
Here's the definitive answer. The 50% rule says that throughout the United States, operating expenses for rentals run 45% to 50% of the gross rents. That's all!
So, as Jon and Dave T said, half (50%) of the gross rents will go to operating expenses (over time) and therefore the rest must pay your debt and any profit you have.
You should always do a good due diligence, but many of the expenses are unknowable (such as the number of evictions for a given unit in a given year, excessive damage done by tenants to a given unit in a given year, lawsuits, etc). That is why I use the 50% rule. It is the most accurate way to calculate operating expenses over a long period of time (which is what matters to your ultimate business success).
Please note that the expenses for a given unit in a given year can be higher or lower than 50%. For example, if a tenant gets mad and does $5,000 worth of damage to one of your rentals, the operating expenses for that unit will be WAY above 50% in that year. Likewise, you can have a property that requires no maintenance; has no vacancies; and basically has nothing more than the fixed expenses in a given year. The expenses in that case will be below 50% in that year. THE KEY POINT IS THAT OVER TIME, IT WILL ALL AVERAGE OUT TO 45% TO 50% OF THE GROSS RENTS!
There are a couple of additional assumptions associated with the 50% rule. One is that you are managing the property in a proper fashion. Obviously, it you screw up the management, your expenses could be much higher. Another assumption is that the rents are market rent for the property. If you buy a million dollar mansion and rent it to your favorite neice for $500 per month, obviously the 50% rule doesn't apply.
Thanks to Mike, Jon, and everyone else for your responses.
One other related question -- I've decided that section 8 rentals are probably a better place for me to begin my investing, since I'm guaranteed at least a portion of the rent each month, and the cost of entry into this market is lower. Do you think that having Section 8 tenants would or should have any bearing on the 50% rule? In other words, does the fact that a large portion of the rent is guaranteed (presumably lowering potential collection costs) make it a little more acceptable to do a deal where the expenses come out to 55 or 60%, or do you feel that it's totally irrelevant?
I think sec. 8 or not your still going to have all the same expenses. My sec8 tenants pay a portion of their rent personally, so you might still have to chase the money anyway.
I have found that if I stick to new or newer properties, my expenses are on the lower end of the estimate. If I get into older properties, the % definitely jumps to the higher end and beyond. I have found my expense #'s are below the 40% on homes purchased over last 2 years, but these are newer homes or completely rehabbed repos before renting. My lease , condition of home and deposit keep tenants from destroying or doing significant damage.
Dave,
Section 8 tenants are no different than other lower income tenants. Additionally, having part of the rent provided by Section 8 isn't that beneficial either. If the tenant pays any significant portion of the rent and doesn't pay, you've still lost all your profit on that property and will need to evict the deadbeat.
So, in answer to your question, whether the tenant is on Section 8 or not is totally irrelevant to the 50% rule.
Mike
One other related question -- I've decided that section 8 rentals are probably a better place for me to begin my investing, since I'm guaranteed at least a portion of the rent each month,
As Mike said, there is nothing "guaranteed" by section 8 payments. Section 8 tenants can get thrown off the program as well.
Also consider the fact that Section 8 tends to take a little longer to get the tenant in the place. A regular tenant can move in as soon as the due diligence on them is done, they are approved, and they hand over the money and sign the lease. A section 8 tenant will wait as section 8 has the property inspected and they are usually a little more stringent in standards than tenants, in my experience. section 8 may take a week or 2 between inspections and reinspections before finally approving the unit.
Does anyone have a source that I can reference the "50% rule." It would be great to have something to have when negotiating with someone. (not that I don't believe everyone here)
Hamp,
Any of the apartment associations have detailed expense data. However, it's not that difficult to figure it out yourself. Make a list of ALL the expenses for property in your area and you'll see that it easily comes up to 45% to 50% of the gross rents.
If you're having trouble, post the numbers for a property in your area and we'll be glad to help.
Good Luck,
Mike
Apartment numbers can be quite different than numbers on SFR's.
It is comparing apples to oranges in my opinion.
Investing in a 100 unit apartment complex is an entirely different investment vehicle than investing in 100 SFR's and the ratios can certainly vary.
Are there any figures available for SFR's? I suspect that expenses would be more than 50% if apartments are 50%, no?
Please remember that these are just guidelines. As the disclaimers always say" you are not guaranteed the same % and results may vary." No POOP Sherlock?
apts to sfrs
old to near new
rehabbed or "as is"
Tx taxes or MX taxes.
Ms ins or dakota
If I take the best of the above against the worst, I can vary OVER 15% between the 2. It is just a guideline. The 10-15% diff will make or break many deals, so please calculate your own and see if bottom line is what you want.
Dave,
In my experiences, SFR units have had lower OE ratios than apartments not higher. With an SFR, you do not have pools to maintain, common areas to maintain, on site maintenance, utilitie expense (except during vacancies which is extremely small figures), etc.
Therefore, on average, you should expect to have a lower OE ratio on a sfr than apart. complex.
That said, averages mean nothing and as Rich mentioned (which is very accurate) you need to calculate the numbers for your investemnt in that area. Rules or guidelines can be helpful during an analysis, but not the foundation of the decision.
As for figures for sfr's, no you will not find them. Why? Because the vast majority of sfr owners/investors do not post or publish publically their operating expenses.
I completely disagree with this. In fact, when we looked at the operating expenses for Will's property in previous posts, they did come out in the 45% to 50% range when all the expenses were considered. We can revisit those examples if necessary. The fact is that EVERY TIME someone has claimed expenses that were significantly below the 45% to 50% range in the past, when we looked at the numbers - they were not!
Will is right that apartment buildings/complexes have some extra expenses, such as common area maintenance, possibly a pool, etc. However, they also have economies of scale that SFHs do not enjoy. For example, you might have 10 units under one roof. That roof will be more expensive to replace than a SFH, but it won't be 10 times more. Insurance for a 10 unit building will be higher than a SFH, but it won't be 10 times higher. I could go on and on, but the bottom like is that it all washes out and the 45% to 50% range is still accurate.
Obviously, every property will not have operating expenses of 45% to 50% in every year. One nasty eviction with tenant damage can increase the expenses to well over 100% in a given year! On the other hand, you can have years where you don't spend a dime in maintenance, utilities, or tenant damage in a given unit and the expenses will be lower than the 45% to 50% rule. The 50% rule says nothing about a specific property in a specific year. If you're buying a brand new house at a huge discount and have an excellent tenant and sell in a year, your expenses should be significantly lower than 45% to 50%. However, if you keep that same property over a 30 year period, the expenses should be in the 45% to 50% range.
Furthermore, I agree with Will that you should always do due diligence on every property. While expenses in a given property won't be much less than the 45% to 50% range over a long period of time, they could certainly be higher in some unique circumstances. An example, would be a town where the major employer just shut down and people are moving away. In this instance, the vacancy expense alone could cause the expenses to well over 50% for decades!
Mike
Mike,
I totally buy in to the 50% rule, and I have no reason not to believe seasoned investors here; its just nice to have a source to reference to-- saying that "well its what they said on some message board" probably is not a very reliable source. Again, I don't disagree with the concept.
Hamp,
Don't think you will find one either.
Buy into the rule or not, it is Very important for all to understand here in this thread that each individual investor needs to have teh knowledge and ability to do the math on each INDIVIDUAL investment they are looking at buying.
Mike can disagree with me all he wants. I will not go there in this post. He has his opinion and experiences and I have mine. I have only chosen to give another point of view on the topic, not just disagree with another poster. It benefits nobody.
It is true apartment buildings have economies of scale (only a few examples listed by Mike), but it is just as true that apartment buildings often have many more expenses such as payroll for onsite PM, onsite maintenance, advertising, marketing, common area maintenance, common area utilities, pools & spas, laundry facility expenses, higher tenant turnover ratio's, higher eviction ratios (bot of which cause higher legal expenses), and this list goes on and on. Therefore, in MY experience, these units rarely have 50% OE, and often have higher. That said, do the math on each property and make the decisions based on that analysis, not any rules you have read in a forum post.