The 50% rule - explained (AGAIN!)

[David Morrow]

Twice today I've seen posts that demonstrate a gross misunderstanding of the 50% rule, so I thought it would behoove me to start yet another thread explaining this concept to my fellow knowledge-seekers.

The misconception I've seen is encapsulated in a statement similar to:
"I'm working on a deal that meets the 50% rule . . ."

The rule does NOT state that your property is good IF its expenses are 50% or less of gross revenues. The pitfalls associated with this misunderstanding are legion.

Rather, the rule encourages you to ASSUME that half of your gross revenue WILL be eaten up by operating expenses when averaged over time. In other words, when sizing up a deal, you should cut the gross income by half, make sure there's enough left to cover you debt service (principle and interest ONLY, since taxes and insurance are included in the expenses for which you've adjusted), THEN see what's left over as cash flow.

And, AGAIN, this is only a quick and dirty rule. Some markets have higher taxes, some have higher vacancy, and some properties have expensive deferred maintenance - all of which will drive your operating costs higher. Then some will have trouble-free tenants, maintenance free mechanicals, perfect structures, and great insulation - all of which allow you to pocket more loot.

For more no-nonsense knowledge, read this great article: http://www.biggerpockets.com/renewsblog/2013/07/13/annoying-misconceptions-newbies-love/

[Mike McKinzie]

Let me make a correction to David's post. It is a mis-conception to state that "50% of your gross income will be needed for expenses," over the long haul.

The 50% "rule" states that "50% of your "ANNUAL FAIR MARKET RENT" will be your expenses. Your expenses include vacancies, management, property taxes, insurance, repairs, legal/HOA costs, etc.... It does NOT include PRINCIPLE and INTEREST on a mortgage loan.

For example, let's say that your FAIR MARKET RENT is $1,000 a month. Over time, your annual expenses will be around $6,000. You cannot lower your expenses by lowering the amount of rent your charge. Just because you lower the rent to $900, it doesn't mean that you will lower your expenses to $5,400 annually. And if on the rare occasion you get lucky and can get $1,100 in rent, your expenses will be only 50% of the FAIR MARKET RENT of $12,000.

In the same vain, if you have a vacancy and collect only $11,000 in one year, your expenses don't go lower to $5,500, they will still be $6,000. But the $1,000 in lost rent is categorized into your "expenses" for the year (but not on your taxes) to arrive at the 50% number.

Some time ago, there was a posting of one years numbers for 1.1 MILLION apartment units. There were all kinds of numbers, from vacancies to the coins collected from the pay laundry rooms. So I spent about an hour collating all the numbers, all the FAIR MARKET SCHEDULED income, the ACTUAL INCOME, the ACTUAL EXPENSES including vacancies, everything. Then I divided the FAIR MARKET SCHEDULED income by all the expenses and the number came to....................49.98%.

Therefore, when figuring out the 50% "rule" or "guideline," the first number you need, AND THE MOST IMPORTANT, is FAIR MARKET RENT.

And the 'sister' to the 50% guideline is, "If the Principle and Interest" payment is LESS than 50% of the Market Rent, everything else being equal, it should be an investment that makes money. Whether or not it achieves the Cap Rate you are seeking is another set of calculations.