50 % RULE DEFUNCT IN SOUTH DAKOTA...
Real Estate Investor · Cebu, Philippines · Member since 2008 · 297 posts · 5 votes
I am trying and trying to subsribe to the 50 % rule but am unable to do so. I live in a small town most of the year and the Black Hills arent hit as much as the rest of the nation. Houses listed here arent selling low enough to make the 50% rule work. Houses that rent for 550 to 600 sell for 75000 to 100000 I am not sure what to do in this case. Keep praying abviously and keep looking.
Move.
In the stock market, some investors make the mistake of going for stocks that offer the highest dividend yield. The problem is that these are often companies with poor prospects and the dividends start declining soon after the investors buy the stock.
In order to avoid the same mistake with RE, I think it is important to look at demographic trends in combination with the 2% rule. Getting a 2% rent yield in a city or neighborhood in decline is not going to be worth the same as 2% in a growing city.
Regarding the 2% rule, I see those sorts of numbers *on paper* for very low priced properties. But I'm hesitant to actually purchase them, as I'm nervous about expenses.
For instance, say a $10k property rents for $300/month. 50% rule would say expenses are $150/month. After taxes, insurance, etc, there's very little left. But this thing is still going to need a new roof, furnace, etc, eventually.
Does anybody here break maintenance costs down in a way more detailed than the 50% rule? I would think it would be more proportional to the number of square feet and the number of bathrooms than the rent. And couldn't low-end properties be poorly constructed and thus require even higher expenses?
Robert,
That is a great question. I was just wondering that myself. I don't use square footage or anything like that, but I break things down more than the 50% rule, as follows:
-Maintenance and repairs: 20%
-Vacancy, advertising, turnover: 10%
-Property Management: 6%
-Use actual taxes from country records, estimate insurance costs.
Exceptions to this are as follows:
- If the property was built within the last 20 years and appears to be in good condition/well maintained I will use 18% for maintenance.
- If the property appears to be in excellent condition/very well maintained regardless of when it was built I will use 18% for maintenance.
- If the property was a foreclosure or seems to have been poorly maintained, I will use 22% for maintenance.
These are not scientific at all. I am by no means an expert. I also have a family member as my property manager, so he doesn't charge much for labor when he has to make repairs.
I've had one property for 3 years and the actual maintenance costs have been well below 10% of rents. However, I have not yet had to replace a roof, replace any appliances, or paint the exterior. This is a duplex built in 1950 that rents for $1,270.
I'm really interested in hearing what the experts have to say about maintenance costs for multi-unit vs. single family properties or those with higher vs. lower rents for a given square footage.
- MJ
But there a relationship to the 50% rule for SFH's in that the overall expenses have been quoted by several here as more in line with 40%, so if you use the 50% rule and find a property (sfh) that breaks even, then it is worth further investigating as to the profitability of the deal.
When it is worth further scrunity, you then take a good look at those things listed in these last two posts to get a reasonable estimation of what costs you are looking at. If it does not meet the 50% or 40% rule then it is probably not worth the extra time(which is money) and money that it would take to do a good due diligence on all these other things.
Wow, I am gone a couple of months and this thread has been FILLED with bad info. Here is the correct info:
The 50% Rule applies to both apartments and SFHs.
It's done fine so far, because you only have one rental and have only owned it for a very short period of time. If you had 100 of these, you would be LOSING YOUR BUTT!
You won't find many GREAT deals on the MLS. If I only looked for rentals on the MLS and settled for 1% deals, I would have been out of business years ago. You've got to get out of the house and meet people. You're looking for DESPERATE sellers - those sellers that will do ANYTHING to stop their pain. Disgruntled landlords are an excellent source of deals.
Gross rent would be 3% of the total acquisition cost (purchase price + rehab) for a 3% deal.
I agree, if you buy a 2% rental in a city just before the only employer goes out of business, you're in trouble. However, if you buy 1% deals in ANY city, you will lose money. If a rental doesn't make money when you buy it, it's a LOSER.
What do you use for all the expenses you didn't include? Utilities (even if only during vacancies? Legal fees? Evictions? Lawsuits? Damage done by tenants in excess of the security deposit? Advertising? Capital expenses? etc, etc, etc?
You're at 36% without any of these additional expenses (or even taxes)! 20% is too high for maintenance - where did you get that number?
There is no 40% expense number. Jon uses 40% because he does the property management himself and understands that he is EARNING the 10% that would normally be paid to a property manager. 40% + 10% = 50%!
Mike
Do I really need to have a factor for lawsuits? I have a $1M umbrella insurance policy.
Taxes and insurance tend to run around 15-17% of rents in my area, so I guess I'm at 51%-53% even with a low PM fee. I may be being too conservative.
Robert's question is a great one. I wondered about it myself. I figured repair costs will be a function of the cost of constructing the home and not the rent.
I did a quick back-of-the-envelope calculation to estimate it for a few properties and found that the ratio of rent to construction costs does not change that much. I took homes in San Francisco and Dallas in my analysis figuring the cities were so different that I would be able to spot something in the data. It turns out that the higher rents in SFO are related to the higher cost of construction for those homes (not just higher land values) so the repair cost also goes up.
In the end, I came back to Mike's 50% rule as probably the easiest way to evaluate these deals.
As has been said in this thread, I do indeed use 40%. I've investigated, and I know a property manager will cost me 10% of collected rents plus a month to half a month to fill a vacancy. I'm willing to do that work and not charge myself for it. So, I know I am contributing my labor to the deal at no charge. I have a day job and make good income, so I don't need the immediate income. I'm not looking for cash flow from these properties.
So, my math is based on my goal. My goal is to accumulate properties in the Denver area that pay for themselves. I'm willing to contribute labor for management and maintenance, and some cash to get into them, but not on a monthly basis.
I do fully believe the 50% rule applies to SFRs as well as apartments. I made the statement Jim quoted above as further support for this rule, at least as it applies to apartments. I also believe that it takes some number of units to actually hit that number. With an apartment, you're likely to be closer more quickly than with a handful or just one SFR. Rentals are just like slot machines. You play once, and you'll most likely lose, but you might win a little and you might win a lot. You will not hit the 95% or whatever payout the machine is set for. If you play 1000 times, you'll win some, maybe a lot, and lose a lot. You're likely to be closer to that 95%, but could still be far away. If you play a million times, its very likely you'll be close to the 95%.
As far as the 2% rule, I don't use that. I use the calculation for my max price, based on the 50% rule, adjusted for my contribution.
Max price = PV (rate, term, -rent * 0.6) - rehab
Now, my actual calculation is more complex and accounts for purchase, holding, hard money, and refi costs, and any rent I'll collect while I'm working on the refi. But the basic idea is similar.
The full application of the 50% rule along with a $100 cash flow goal would be:
max price = pv (rate, term, -(rent * 0.5-100)-rehab costs.
So, if I stick $500 into that calculation for rent, I get $25,018 for a 6% loan at 30 years. There's the 2% rule.
OTOH, if I use $1000 for the rent, which is more typical for the properties I buy, I get $66,721. That's only 1.5%
If I stick $1000 in my calculation, I get $83,395, or 1.2%. That's pretty close to what I end up at for the permanent loan, though I deduct a BUNCH of costs out of that to get to my actual purchase price.
OTOH, if you stick $300 into the base calculation, you get $8,340 as the max price, and that's before rehab. The trouble is that once you chop the rent in half you're at $150 in NOI. Then you take out $100 for cash flow you're down to a $50 a month payment. That doesn't go very far.
My more liberal calculation gives a max price of $25,018 for $300 in rent. But honestly, I would not do that deal. A $300 rental around here would be a complete dump and would attract a very transient population. It would be a lot more work than a SFR that rents for about $1000. So, why bother?
I don't try to break things down into more detail. I do, however, look for anything that would blow the 50% out of the water. In my $300 example, the management expenses are going to be high. I've looked at buildings where the maintenance was a huge issue, and the owner's APOD showed there were much higher than even 20% (sorry, its been a long time on that one, and I just don't recall.)
I put a bunch of those long term items into rehab. If I'm considering a property, and I see it has a bad furnace, I'll include money in the rehab budget to replace it. Same for roofs, water heaters and other major items. Nevertheless, I know I'll have one of those once in a while. But its included in the 50%.
I like RE investing because it is a true 'meritocracy' -- if you've got the chips you can sit down and play no matter who you are. How you play is totally up to you, too.
However, where you get those chips matters a great deal. If your chips must be generated totally from playing the 'game' then you will 'invest' a whole lot differently than someone who has an outside supply of chips.
No offense to anyone, but from where I sit I see two groups of participants: the 'professionals', and the 'hobbyists'.
I have properties with 1%"Rule" and others with "4% rule" (Is there such a rule?...:) So far, my 1% properties are more like 100% and sometime 110% "rule" but they are long term investment so I don't worry about them that much. From leveraging perspective, they are good. The 4%ers are more like 20%-$25% and here is why:
The way I look at the 50% rule is that it apply if you use the full traditional RE investing with full PITI + The usual expenses of maintenance, management, vacancy, etc. . If you buy a $10,000 house, in Robert's example, obviously the traditional biggest expense of mortgage is not a factor. In this case, I would use 20-25% only.
The good news is that any shortage I have from the 1%er is covered by the 4%ER since real estate is not my primary income.
I would highly recommend any of you who have non-performing cash flow properties to arm yourself with some low cost /low income SFRs that can be used as hedge against negative cash flow.
Oh, and by the way Mark, the only thing that separates the "Professional" from the "Hobbyists" is the source of your income. In this case, I am a proud "hobbyist"
Eddie, The "50% rule" has nothing whatsoever to do with financing. It covers the operating expenses (IRS definition), capital expense (also and IRS definition), and vacancy. It simply says these three items will be about 50% of the gross scheduled rent, leaving the other 50% of the gross schedule rent as your NOI. The taxes and insurance part of the PITI payment are included in the 50%, but the P&I payment is not.
Another way of looking at this rule is that the P&I payment needs to be less than 50% of the gross scheduled rent in order to be at least break even.
That professional/hobbyist dividing line applies in stock investing, too. The usual names, though are "investor" and "trader". An investor is someone who sticks in the money they earn somewhere else as a way to "put their money to work". A trader is someone who's actively trying to work the market to make a living. Applied to real estate, I would agree with you there are people who try to do some sort of real estate business (wholesaling, fix and flipping, developing, property management, real estate brokering) to make a living and people who hold real estate as a long term investment (rentals). Despite what the gurus tell us, all those "real estate businesses" are jobs, just like many other jobs. As long as you turn the crank, the money falls out. Stop turning, the money stops. Investments continue to spit out money (if they're good investments) or not (if they're bad investments) whether you put in any effort or not. Owning rental real estate is an investment where all these other things, including the property management and maintenance I do on my properties, are jobs.
Jon, Although I agree with you on the 50% rule definition, it seems to me that the IRS rules, If I understand it correctly, are for the purpose of defining deductions. It is sort of an umbrella rule that help them and us to generally estimate taxes. However, with regard to our real world, I think that it is (Thankfully for us with regard to the IRS) by far too stringent. Using that definition would mean that almost any 1% rule property is losing investment (using an average $100,000 property with $1,000 monthly rent). I would only use the loan interest in that calculation because any other expense is either loan payback that goes back to the property or "necessary evil" such as taxes, maintenance, etc. I don't think however that this is the case. You may not make money, but if I had to use the 50% rule the way the IRS defines it I would loose and loose big. So far, in my case it is not so.
Your equating professionals / Hobbyists with Investors /traders is right on the... money.
Regarding what you call job in managing your properties, not every work is a job however, if you relate to your work as the manager of your properties as a job, than you should pay yourself a salary or percentage of your rent as if you did should you decide to hire a PM.
In this case, you would be a professional manager and a real estate investor... :wink:
Nothing wrong with being a 'proud hobbyist', Eddie.
But isn't it sort of the same difference between being DGA and non-DGA?
And to take it a step further, wouldn't you dislike it if the DGA allowed 'hobbyist directors' to compete for employment by bidding down pay scales and benefits?
But back to my previous point, what I like about REI is that it is a true meritocracy: both hobbyists and professionals are welcome to enter the arena.
So who will be still around and prosperous in twenty years? Well if it's me then I'M BUYING DRINKS ALL AROUND.
Mark, BiggerPockets has 40,000 members. An offer like yours can get expensive. Assuming 25% of the members survive in this business and take up your offer, and assuming a beer costs $4 today and an interest rate of 7% and inflation of 4%, your offer has a present value of about $22,000. If you wish, you can pay me half of that right now and I will "insure" you against the beer costs in 20 years.
I agree that lots of non-professionals may be satisfied with a lower return and hence bid property prices up. But I suspect regular BP members are a bit too sophisticated for that.
I define job to mean anything that you get "paid" to do and don't get paid if you don't do it. Exactly how you get paid doesn't matter. Could be hourly or salaried like most regular jobs. But also could be commissioned, like RE agents, car salesman and many other salesman. My day job is in high tech, and I'm purely hourly. Other employees are hourly. Still others, in sales especially, are commissioned. Wholesaling is commissioned sales. For all practical purposes, its identical to being a RE agent.
If I don't do the PM job or the maintenance job, I have to pay someone else to do it. So my "pay" in those cases is money I don't have to spend and more of the gross rents I can keep.
But these are all jobs. If you don't do them you don't get paid.
The IRS doesn't define anything about this other than what's an expense (which can be deducted all at once in the year its incurred) and what's a capital item (which must be capitalized and depreciated (deducted) over multiple years). They don't define the 50% rule, or anything like it. They don't care about estimates, only actuals. Now I'm sure they have guidelines, and if your expenses and depreciation are outside their guidelines, they will look more closely.
I will argue a 1% property is almost guaranteed to be a money loser. A 1% property has gross rents of 12% of the purchase price. Expenses, capital, and vacancy eats 50%, leaving you NOI of 6%. If you have a 6% interest only loan, you're break even. If its at a higher rate or amortized, you're cash flow negative.
OK, you stick in a down payment, and make it cash flow positive. But that's really the return on your cash, not the property.
OK, you do the maintenance and mangement, and get the 50% down to 40%. Now NOI is 7.2%. With 6% toward interest and ignoring the principle payments like they do in calculating "total return" on a commercial deal, you're EARNING 1.2% by doing that work.
All this completely neglects the fact if you buy right you'll have some nice equity right off the bat. Apply Rich's strategy of paying it off in 20 (or, my goal, 15) years and you have a really nice chunk of change down the road with nothing out of pocket along the way. That's my personal goal, and why I'm willing to forgo any immediate cash flow and do the management and maintenance myself.
p.s. Since NC Mark is in the rental business, he's probably a cheapskate like the rest of us. I doubt if he's buying any $4 beers - probably more in the line of a 50 cent imported Chinese beer! LOL! I figure his beer tab will only be about $200 if he loses.
I'm trying to break things down for a BP Benchmark House.
Property value: $50,000
Gross Rent (mo.): $1,000
LONG-TERM REPAIRS (includes annual maintenance)
roof: $4,750 over 25 year period.
exterior paint: $3,000 over 10 years.
interior paint: $1,400 over 4 years.
carpet: $1,500 over 4 years.
appliances (5 of them): $3,500 over 20 years.
replace kitchen: $10,000 every 20 years.
replace bathrooms: $8,000 every 20 years.
TOTAL PER MONTH: $191. (fixed, not a percent of rent or value)
RECONCILE TO 50% RULE
property taxes: $83
insurance: $33
property management: $80
vacancy: $70
utilties during vacancy: $4
legal fees, evictions, etc: $17
repairs due to tenant use: $50
long-term repairs: $191
MONTHLY TOTAL EXPENSES: $528 (52.8% of GR)
These numbers are pulled out of my head, not based upon actual experience. I'd like to hear what experienced people think. If I'm going to be looking at properties in low-rent areas I feel I need a more detailed handle on expenses than the 50% rule gives me.
There's no way in the world that I would put $700 (each) appliances in a $50,000 rental! UGH!
The insurance seems low. Be sure you're using a cost for landlord insurance, not homeowners.
I'm with Mike on the appliances. Even if you do buy new ones, they're not $3500. Not sure what five you mean, but none of mine get washers and dryers. A used fridge, DW and range is more like $500, maybe even less.
Find out what PM's actually charge. Around here $80/month would not cover it. Long term with your numbers, I'd budget $120.
You've left out vacancy.
I would not spend those numbers on kitchens and bath. At the worst, you're talking about new cabinets and countertops. I can do that in a typical house for $3000 including labor. More likely you would need to replace the countertops and would be able to charge a tenant for messing them up. Similar for bath. A new vanity and toilet are $300 at Home Depot. Those are both easy DIY projects. If you pay someone, another $100-200 for labor. $5-7 a foot for tile installed.
You've left out furnace and water heater. Depending on the age, sewer lines may be an issue.
However, breaking it down to this level of detail does not give you a more accurate estimate. You have more numbers and more detail, but not necessarily more accuracy. All these are just predictions. Reality will be whatever its going to be and won't align with your estimates whether you do this level of detail or just a single number.
Thanks for the feedback. I believe the 50% rule is good enough for mid-range properties, but I'm still unconvinced it works well in other cases.
For example, the "benchmark house" magically transported to downtown Palo Alto, CA, would now rent for five times as much, but I doubt repair expenses would go up five times. Similarly, moving the house to a not-so-good part of Memphis might draw half the rent, but is unlikely to have one half the repair cost.
Cash flow is funny thing, Robert. I have two guest unit on my property here in Studio City CA. I rent one for $995 and the other for $1,160 (Had to lower it recently due to ridicules competition from MFs). The first one is a tiny little studio (420 sq/ft) the other one is a loft (720 Sq/ft) both together pay about half of my mortgage. I have two rental SFRs in Texas, both are 3/2 One pays as much as my tiny studio here in Cali, and it is 1,100 Sq/ft, the other is just shy of 1,600 sq/ft and rents for 1,050 which is less then my loft rental here in Cali. Both houses by the way cost me just over $100K each. The houses I own in Birmingham cost a fraction of that and rent between $550 and $686. I'd be very surprised if anyone can cash flow in California today even after the prices drop (I'm sure Will Barnard would dispute it...) I would also argue that there are very few places in the country where you can buy a middle range SFR investment and cash flow at 2%.