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/