Operating Expenses Estimate Too High?
Investor · Phoenixville, PA · Member since 2008 · 257 posts · 18 votes
When I find a promising multi-unit rental property, I usually assume that 50% of the gross rents is what I'll have after operating expenses to pay my mortgage. The listing sheets have a breakdown of the operating expenses; should I go by what they have or assume it's 50%? I don't want to overestimate the expenses too much.
It always baffles me to see someone with CCIM or some other high-brow designation after their name passing off some crapola underwriting example for a complex. These people should be immediately stripped of their designation IMO. I am all for them working on the behalf of their clients and trying to get top dollar for the asset, but outright bsing on the financials is borderline fraudulent in my book.
I'm not sure I completely followed your post Jeffrey, but the cash outlay for a brand new building and an old, dilapidated building will happen in different years. My point was that using the "50% rule" shows that the property with the immediately-replaceable roof has the same value as the property with the roof that doesn't need to be replaced for 15 years.
If, however, you plug this data into a real-world cash flow model using discounting you will see that one project is worth more than the other. A crude model where all discounting is done in year 0 can't account for this fact. This is precisely what the 50% rule does.
Again...I don't have a problem with it being used to screen properties. Err on the side of caution. It is inaccurate though and shouldn't be used as the end-all-be-all modeling technique. Capex and expenses vary based on project. Use the actual data and some common sense to build a more accurate model so that you will get more accurate data to make a decision about the project.
The post originally asked about OPERATING EXPENSES as well, which shouldn't really include capex anyway...unless you want to treat set-asides as an operating expense. If you do this you should also count the yields for the cash set aside to be accurate with the underwriting.
I think it is fair to say that the 50% rule is a much better guideline than 45% because (a) it is easier to use in mental calculations, (b) it is more conservative and (c) it seems to have worked for so many successful BP investors.
I consider myself fairly financially sophisticated but I would not second-guess the numbers that numerous investors have claimed from real experience managing MFDs because I do not have real-world experience managing a portfolio of apartment complexes.
It isn't a question of the "45% rule" versus the "50% rule." It is a question of whether or not it is a RULE. Operating expenses and actual overall expenses are two different things. Capital expense timing matters a lot when your equity is weighted at 18% plus. A capex in year 15 is a lot different than a capex in year 0.
Again...the X% rule is useful for screening and is not an exact figure. Do a lot of due diligence and underwrite the transaction according to when expenses actually consume cash. Doing anything other than this will give you poor results. Garbage in...garbage out.
RIDICULOUS! Almost every rule has exceptions.
The 50% Rule doesn't say ANYTHING about the value of a property - NOTHING! The 50% Rule simply says that over a long period of time and/or a large number of rentals - the operating expenses (including vacancy and capital expenses) will run 45% to 50% of the gross rents. That's it.
Who talks that way? I don't "underwrite transactions" - I am NOT a loan officer or bank employee! I do evaluate properties that I'm thinking about buying, but I definitely do NOT "underwrite transactions".
Semantics aside, as I've said MANY times before, I agree 100% that a person should do proper due diligence.
That vast majority of the newbies on BP are buying SFHs or very small multis. Unfortunately, the vast majority of owners of SFHs and small multis don't have a clue as to their operating expenses and certainly don't have them down on paper. It is IMPOSSIBLE to use actual data to evaluate most of these properties because the actual data doesn't exist!
EXACTLY!
It sounds to me like MikeOH and Bryan are arguing the same point, but their actually talking about two different things, and both things are tremendously important.
I think Mike's point (and if it's not, I apologize) is that the "50% Rule" is a great tool for a first-pass approximation of whether an investment is likely to be a good deal. While I'm think Mike would agree that there are deals that pass the 50% Rule but in real life aren't very good deals and there are also deals that don't pass the 50% Rule but in real life are good deals. This is because the 50% Rule is meant to apply over a large number of units and locations, and is not meant specifically to do a detailed analysis on a single unit.
Bryan believes the number that should be used to do the analysis is 45%, not 50%, but I don't think that's his major point (and ultimately, his major point is more important than whether it's 45% or 50%)...
Bryan's point (and my guess is that Mike would agree) is that you *must* do complete due diligence on a property before purchasing it, because you don't know if the OE is going to be 45% or 50% (or even 35% or 70%). And the only way to figure it out is to get data, data, data.
Perhaps we can all agree that having a simple to use rule of thumb like the "50% Rule" is great to do a first-pass approximately of a deal, but that nothing replacing a full due diligence and financial analysis before actually purchasing.
As for Bryan's other point about analyzing discounted cash flow (what some people refer to as net present value or NPV analysis), this is something that is tremendously important if you're going to be investing on a larger scale, and it's sad that more investors (in my experience) don't have any clue about NPV and its implications.
I think I'll write a BP blog post on the subject, but suffice it to say, anyone reading this thread that doesn't understand NPV should do some research on the subject...
I always require tax returns and actual income / expense vacancy for 2-3 years and do comparisons to get an idea of trends. Is the expense low because of deferred maintenance? Is it high because owners were catching up on deferred maintenance to either sell or improve vacancy rate? Are utilities included in the rent? There are many variables in the income expense ratio calculations that can affect the actual number. Many good investments don't fit the rules of thumb! These "rules" are just for a first glance and even if they are out of whack, you find the property desirable and potentially something you would want in your portfolio, dig into it. It takes time, effort and due diligence to get the good ones! Of course for the SFR investor, you may not have the tax returns or income/expense info, but this is what you need to create from current, realistic or actual costs and income projections.
Bill
Not according to you Mike. You use a blanket 50% and shun everyone's comments that disagree with you. I have seen this across countless threads that poked holes in the "rule." A rule isn't a rule if it doesn't apply in the vast majority of distressed situations...which applies to most purchases analyzed on BP.
Fine...In the long run we are all dead too. I tend to like to analyze real world data on real world projects and not use rules of thumb when I analyze my investments.
Plenty of people Mike. "Underwriting transactions" doesn't have to be bank parlance. You underwrite projects that are done with discretionary funds of others when you syndicate transactions. I am sure you are too close-minded and dogmatic to use anything other than your standard parlance though.
You have also attacked people that don't agree with you and point out things that don't fit properly in your tidy little lollipops and gummibears fantasy-world 50% blanket assumption model. The first sign of someone disagreeing with you is met with words like "WRONG" or phrases like "WE HAVE BEEN OVER THIS A THOUSAND TIMES" or some such. Take some time to read and think about what the other person is saying before you summarily dismiss their thought(s).
Fair enough...But I have found tens of people on here that "underwrite" large commercial transactions too.
The actual data DO exist, but you won't ever be able to come up with them reliably. The vast majority of SFRs operate in a loss position from a cash flow standpoint with standard leverage ratios. People generally care more about tax benefits and appreciation with SFRs. It is much harder to get real-world cash flow with SFRs, which I am sure you would agree with.
Mike...I am not trying to pick a fight with you. I just want you to read people's posts and to internalize what they are saying before you go on the attack about things. Several people have made very pertinent points across several posts, all of which you have steamrolled over and summarily dismissed. This does a disservice to newbies reading the threads.
My point is that the 50% Rule is applied to a first-pass analysis (just like you describe below how you do it), and ultimately that analysis will indicate that the property is worth pursuing (PASS) or not worth pursuing (FAIL).
But, as Bryan pointed out, it's starting to feel like you just want to argue about this -- and I only participate in pointless arguments on the Politics forum -- so I'm done here...
I agree and that is because the vast majority of SFHs are owned by mom and pop owners who didn't understand the operating expenses when they bought the property. A person can certainly have a positive cash flow with SFHs if they properly evaluate property before they buy and purchase at the right price.
I don't agree. I own both and I don't find getting real world cash flow to be more difficult in one or the other. The key is to understand the operating expenses and BUY AT THE RIGHT PRICE - regardless of the number of units.
J Scott,
I'm not trying to be argumentative, I'm trying to be accurate. I can NOT agree with things that I know are false because the financial lives of newbies lie in the balance. What we say here DOES MATTER.
For example, we've had people on here (many claiming to be experienced investors) who have claimed that the expenses were ITI (interest, taxes, and insurance), 25%, 30%, 35%, 40%, 45% and everything in between. Should I, in the interest of being agreeable, nod my head and agree that expenses are limited to ITI, 30%, 35%, etc? NO! The real world data shows that operating expenses over a large number of units and/or a long time period are 45% to 50% (The 50% Rule). That is the number that matters if you're running a rental business. Whether or not anyone follows the 50% Rule is their decision, but I won't pretend that I believe something else just to get along.
Perhaps the difference between Mike and Bryan could be as simple as their roles in the RE industry.
Mike is an investor who invests his own money and he needs to be conservative in his assumptions and he would rather assume 50% and then discover that it is actually 45% than the other way around.
Bryan, based on what I can tell, helps other people to invest in the RE sector and can afford to be somewhat more aggressive / precise in his projections.
One of Warren Buffett's many wise sayings is "I would rather be approximately right than precisely wrong." In that spirit, perhaps we can all agree that the 50% rule is about as good as any that is out there for screening properties.
Let me chime in here, as I usually do.
First off, doesn't the 50% rule state "50% of MARKET rent will be your expenses?" If your rents are too low, then it will be more than 50%. If your rents are HIGH, then will be less than 50%. An example is a rental I have in Los Angeles County. The tenant just moved out, paying $1,295.00 a month. My new property manager states that it easily will rent for $1,695.00 a month. My expenses will not magically increase by nearly $2,500 a year just because I raise the rents $400 or more a month. My taxes and insurance will stay the same and this is the first vacancy for the house in 24 years. So even a one month vacancy in 288 months equals a vacancy rate of 0.3 percent.
The Reverend MikeOH has a very visible AGENDA of making sure investors, especially noob investors, over estimate their rental expenses. While I have investments that will be closer to 30% in expenses, over a 10 year period, I also have investments that will be at 60% over a 10 year period. As I have stated before, there is NO DIRECT correlation between the "rent collected" and the "expenses." BUT, the actuarial facts will prove that the real estate expenses will equal 45-50% of the rent collected, after all is said and done.
Another question that comes up often is what is the difference between "Capital Improvement" and "Maintenance/Repair" and does Capital Improvement play into the 50% rule? Also, if there is damage that your insurance pays for, is that an expense?
So preach on MikeOH, we love ya!!
And Bryan, I love reading your posts. You are one of the most eloquent posters on BP.
The bottom line is, WE ARE ALL MAKING MONEY, we just do it different ways!!
Would you care to explain how these two statements make sense. You've admitted several times now that your own personal portfolio has expenses that average about 50% (including just yesterday in another thread). You then post that actuarial facts PROVE that expenses are 45% to 50%. Then you say that I have an agenda to see that noobies overestimate their expenses, when I'm saying that expenses are 45% to 50%! That sounds like doubletalk to me!
I don't know J Scott. I don't see how Mike M could agree with me that the expenses are 45% to 50% and then accuse me of having an agenda to make sure that investors, especially newbies, overestimate their expenses. That just doesn't make sense. If he agrees that the actual expenses are 45% to 50% (and he admitted that his are), then it seems to me that my agenda is to ensure that investors, especially newbies, understand the REAL expenses as opposed to over-estimating them.
Cool! We've got this one settled! At least until someone else finds that original 2007 posted question!
Bill
MikeOH
I apologize for agreeing with you.
Mike M
Assuming all possibilities are equally likely (again, the real number is just as likely to be 47.34534% as 49.234234%), then there is a near certain chance that the actual number is below 50% (it could be 49.9999999%, but near certain it is below 50% just because there is a 1 in an infinite chance that it's exactly 50%).
Assuming we agree so far...
If there is a near certain chance that the number is below 50%, and if the 50% Rule uses 50% as the OE, then by transitivity, there is a near certain chance that the 50% Rule is overestimating the actual expenses.
So, as you can see, Mike was agreeing that the number is 45-50%, and it seems likely that if you use 50%, you're overestimating...
Can we all be friends now? :D
J
Another thing to ask is this, "Is is better to OVER estimate your expenses or UNDER estimate your expenses?"
@Mike
The operating expenses are NOT 45-50%. If you include CAPITAL expenses with operating expenses they will come out to 45% plus or minus 2% on the average deal over the long run.
Notice that this does not apply to deals that are in distress with above-market (high vacancy) or below-market rents as you have conceded.
Since you are so hell-bent on being precise I am going to nit pick your stuff to death. OPERATING expenses do not include things that are CAPITALIZED. Consequently, your 50% figure is WRONG!
Further, it is clear that observations for units in tertiary markets can have far in excess of 50%. Consequently, your 50% "operating expenses" figure is WRONG.
Further, timing of capital items MATTER when you do a discounted cash flow analysis. Consequently, your 50% "operating expenses" figure is WRONG when you account for the time value of money.
Ergo, you are WRONG. 50% is a good back-of-the-envelope SCREEN test and is not what should be used to evaluate (since the word underwrite ruffles your feathers) projects.
And yeah...some people have negative cash flow banking on appreciation in certain markets. Just because this doesn't fit your investment strategy doesn't make it WRONG. It just means that it is different. There are a ton of people buying Google shares or Apple shares instead of utility stocks and nobody is calling them dumb. If someone has a steady job, business, or income source they are perfectly justified in taking more risks with their investments.
And for the record I invest my own money AND the money of others in real estate deals. I own a sizable portfolio of properties and I am working on investing in some large projects with other people's money in addition to the handful of projects I have already participated in with the money of others. I certainly wouldn't call these investors dumb because they are buying in markets with little or no cash flow because they are concentrating on upside from appreciation. Is this how I would invest my own funds?...no. Does that make it WRONG....no.
OTHER PEOPLE HAVE DIFFERENT GOALS AND OBJECTIVES THAN YOU DO MIKE. Read that three times, take a deep breath, internalize, and sound out goosfraba before you post again.
That is ABSOLUTELY WRONG! Post the numbers! Provide a link! I just read one of the NAA studies last night AND YOU ARE WRONG! When capital expenses are included (as is with the case in the 50% Rule, the expenses are 45% to 50%. You don't even need to read the entire survey to determine that - it's in the executive summary in the first few paragraphs. In addition, Taz's study of 30,000+ units showed the expenses in every rent category in the range of 45% to 50%! Finally, EVERY SINGLE PERSON that has claimed otherwise here and has produced data has been proven wrong. Post the numbers!
It's absolutely true that cap expenses are not technically an operating expense - AS I'VE SAID HUNDREDS OF TIMES BEFORE! However, for the purpose of the 50% Rule, they ARE included, whether you approve or not.
Agreed, as I've also said HUNDREDS OF TIMES! Speculation is a valid business model.
Who are you arguing with? I agree that speculation is a valid business plan (again - as I've said hundreds of times before).
Mike...You are the one that started arguing to begin with. You wanted to pick a fight over 45% and 50% when BOTH are valid numbers for certain projects. You obviously don't read my posts and just throw whatever random canned response out there that you want to complain about so it isn't worth the effort anymore.
I tried to look up the data last night and the site made me log in to view it. It doesn't matter what I say...you will just believe what you want to anyway so I am done with this "debate." Believe whatever you want to.
Your "rule" is good for ONLY a screen test. Real data should be used to evaluate the project. This is what I originally posted and IT IS THE TRUTH. You go on analyzing your deals with some arbitrary ratio and I will go on analyzing my deal with real numbers. The end. The money shows up in my account each month so that is all that matters to me.
Lets take it down a notch, please.
Hey Jon, you can see by my avatar picture, I took it down a little more than just a 'notch." :lol: