50% rule and 2% rule

[Sean Schellenger]

When we build new homes or do a major renovation to an existing structure in the city of philadelphia, we are able to get a ten year tax abatement. I am trying to figure out how much of that 50% goes towards taxes for most investors. I know it varies depending on the area....

Im looking for feedback from those who use the 50% and 2% rule. Should I be adjusting the number's slightly based on the fact that my tax expense is 0? If so, who much??

[Vikram C.]

Sean, this is a late response to your question. Here are some things to consider:

1. Properties are valued based on their future cash flow. If you try to sell your property nine or ten years after you build it, the buyer is not going to give you a higher price because you had a tax abatement in the initial years. Therefore, it makes sense to value the property using the 50% rule for expenses and then add the value of the ten year tax abatement to that value. Also, remember that the 50% rule is a generalization and I have seen properties with a higher expense ratio.

2. The actual amount of taxes will vary from state to state. On the whole, if you buy a property for ten times its NOI, and the NOI is half of GSI, then you are buying the property for five times GSI. If the property tax is 1% of the property price, then this works out to 5% of GSI which is 10% of NOI. If the property tax is 3% of GSI, then this works out to a fairly big 30% of NOI. If you do not account for this in your valuation metric, as many investors in Texas seem to be doing, you are paying more for the property than you think you are paying. If I was buying a property subject to a 3% property tax, I would definitely consider making my expense assumptions higher by around 10% compared to buying a similar property in a lower-tax state with similar expenses.

In your particular case, you will be saving 1% to 2% per year of the property price for about ten years. I would not be willing to pay more than, say, five years' tax savings for that privilege.

Note for newbies:

GSI = Gross Scheduled Income. This is average rent multiplied by number of units multiplied by 12 months. Assume no vacancy.

NOI = Net Operating Income. This is the net profit of the business excluding debt service costs.