50 percent rule in my world

[John Soforic]

In reviewing past threads, I admit being sent into a mild panic over this 50% percent rule of thumb, despite the fact that I am experienced and currently own and operate 41 units... single family and duplexes with one 4-unit. I am an absolute number crunching geek, and while my truck may get messy my accounting is spotless and meticulous. So my point is I know my numbers, track every dime collected and spent on Quickbooks, impose the numbers onto another Excel graph, etc. You get the idea.

Am I correct in assuming we are dealing with a general rule of thumb that applies to the entire country, and as such it may be a broad generality with wide variability? I question whether it applies to Small Town, rural America. The facts are that in my area, taxes are lower, the cost of housing is lower (thus cost of insurance), and I do not hire property management. These local facts lower my overall percent of expenses which end up looking like this...

A common duplex rents for 550 each side (tenants pay utilities)

+13,200 gross rent

-1000 repairs per year (every five years = a $5000 bomb hits the property!)

- 2000 annual taxes

- 500 insurance

- $600 vacancy (5%)

= 9100 net profit before taxes and insurance

So in this example, which is accurate reality in my accounting world, my expenses are 31 percent- not close to 50%. Am I missing something? Or is it just that I can cash flow higher because I live in a rural area with no real appreciation? Even with 10% property management fees my operating expenses would be 41 percent... and I suspect more trouble on the rental side which may account for added expenses.

To be clear, I am not bashing the 50% rule. Why NOT estimate high on expenses?

I love conservative rules that keep me from hurting myself. Real estate to me is a chess game in which one needs to be on the lookout for trouble in all forms. I believe it is a valuable general rule of thumb to keep an investor safe; i.e., it provides a margin of safety. If I misunderstand the concept, please advise. Maybe it's property management that is costing others so much, and adding to the expenses? The purpose of thread is just to clarify it all.

[J Scott]

Originally posted by @John Soforic:

My only question here, is whether it is possible for the 50 percent rule to vary greatly due to locality.

....

-1000 repairs per year (every five years = a $5000 bomb hits the property!)

To your first point above, certainly the answer is yes. But, by greatly, I would say that it's still unlikely that long-term you'll see expense ratios (including rent loss and capex) at less than 40%...and typically not less than 45% based on my experiences, my calculations and my discussions with other investors.

In your example property, you're estimating your expense ratio (inlcuding rent loss and capex) at 31%. If you add in 10-12% for property management, you're in the 41-43% range, which is certainly possible. But, given the numbers you use to support your estimates, my guess is that your actual expense ratio (including rent loss and capex) is actually closer to 50%.

Here's why...

FIRST REASON:

You commented above that your repairs were about $1000/year. You seemed to have lumped several things into repairs, as I didn't see them called out anywhere else. Specifically, it appears that you lumped the following into your $1000/year repair estimate:

- Actual Repairs

- Turnover Costs

- Capex

I think $1000/year is reasonable for any one of those categories, and perhaps 1.5 of those categories long-term. But, I seriously doubt your budget for repairs, turnover and capex is going to be $1000/year or less.

You pointed out that "every five years = a $5000 bomb hits the property!" Yes, that's called capital expenses. These are the big ticket items you'll need to depreciate, and the biggest expenses here are HVAC, roof and water heater. These aren't the only capex expenses you'll face, but they're the most common. In a typical 20 year period, you'll likely replace the HVAC once, the roof once and the water heater twice. I don't know how much you'll pay for those, but my guess is that it's at least $8000 over the 20 years (and potentially a lot more). That's $400/year right there, and that ignores other capex items you'll encounter over the lifetime of a property (siding/trim repairs, concrete issues, major plumbing/electrical upgrades, etc).

My guess is that your actually capex costs over the *long-term* are closer to $500-600 per year. You probably don't believe this right now, but let's have this discussion again after you've held those properties for 30 years.

Then you have turnover. Let's say you have to repaint every two years, get the carpets cleaned (and/or hardwoods refinished) every two years, replace the carpet every 5 years, fix broken cabinets/appliances/plumbing fixtures/light fixtures, etc. If you're doing this for less the $300-400/year, you probably haven't had the property long enough to have a tenant do any serious damage. You're lucky...but eventually your luck will run out.

So, I'm guessing that you're at the $1000/year mark with just capex and turnover, and that doesn't include straight repairs. Things like faucets breaking, toilets running, tubs dripping, windows cracking, etc. Maybe you'll get lucky and that's only half a months rent per year, but again, if you haven't been paying anything for repairs, you either haven't held the properties long enough and/or you've gotten very lucky.

At this point, you're over the $1000/year...probably closer to $1500/year for what you called "repairs"...and if you're not getting very inexpensive labor, you may be a lot higher than that.

And comes the...

SECOND REASON

Your analysis didn't include any of the following:

1. Legal Costs

2. Eviction Issues

3. Utilities

4. Lawn Care/Snow Removal

5. Other Amortized Costs

Let's take them in order:

For #1, I'm talking about dealing with evictions for the most part. Never had an eviction? I can promise you that won't last forever. And when it happens, you have two choices: hire and attorney or deal with the legal red tape yourself. Attorneys cost money and if you try to do it yourself, I'd suggest that you can't discount the opportunity costs, which ultimately translates into money. You *WILL* have attorney costs across 41 units long-term, or you'll be spending enough of your own time that you'll lose plenty of money not doing other income-generating tasks.

For #2, I'm talking about the ramifications of a tenant you need to evict. For one, your 5% vacancy isn't going to cover the times you have a tenant that holds over for 3 months while you're trying to legally get him out. Even if you do get him out quickly, there's a good chance he'll trash you place as retribution (and this will cost more than what you've budgeted for turnover costs, I promise). Tenants you need to evict can end up being your biggest expense in this business, and while you can minimize the chances of it happening, across many unit and many years, you will have this issue at some point, and the amortized costs across all units will likely not be insignificant.

For #3, I'm curious if you leave off all the utilities between tenants? I'm guessing not. And I'm guessing they're not free either.

For #4, do you require your tenants to handle lawn maintenance? How about snow removal? If you are expecting them to do snow removal, I highly recommend that you read #5...

For #5, I'm talking about stuff like liability insurance (which you'll want to have if you're expecting your tenants to do snow removal), CPA costs, advertising costs, etc. These are the little things that you consider "overhead" in your business, but if you didn't have rental properties, you wouldn't incur these expenses. So, realistically, they're a cost associated with having rentals, regardless of whether you choose to amortize them across your holdings or not (from an accounting standpoint, you should not...from an analysis standpoint, I think you're fooling yourself if you don't).

Anyway, my take is that you have a bunch of costs that you either haven't yet experienced (but will) or aren't acknowledging (and should). I could be completely wrong (it certainly wouldn't be the first time), and maybe none of these things above apply to your business, but if that's the case, hopefully others who are reading this will take these things to heart in their businesses.