Validate the 50% rule

Validate the 50% rule

Will BarnardPro Member
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Developer · Santa Clarita, CA · Member since 2008 · 15k+ posts · 10k+ votes

It has been agressively stated here on BP that operating expenses average 50% of gross rents. I have posted many times that while that may be true with some properties, it is not accurate or appropriate to use this percentage on all properties (speaking of residential 1-4 units only).

I have stated that when you have gross rents of $400-$700 monthly, it will most likely average out to be in the ballpark of 50%, but as rents increase to amounts above $1000 per month, the ratio or percentage decreases due to a variety of factors (which will not be explained here).

The purpose of this post is to get some viable data from many individuals who have rental units with monthly rental rates in excess of $1,000 (per door) and have at least 3 years of financials. So, if you have property which fits this criteria, Please respond here with the following: (Take all the years you have owned the property(ies) and combine all the amounts listed below, then divide by the number of years to get an accurate annual average):

Gross rents
Actual annual operating expense figures (fixed expenses - taxes, insurance, PM, utilities, etc.)
operating expense reserves (items which do not occur regularly such as repairs, maintenance, vacancy, damage, advertising, legal, etc.) Please include what you have personally experienced with your properties only!
Then list your capital expense reserves (although this is not actually an operating expense, accounting wise, for avoidance of arguments sake, let's include it)
Finally, we can now arrive at your NOI, so post that as well.

Note: If you have multiple properties, combine all the figures as one and note how many properties (actual doors) the figures represent. Once we have had at least 100 doors represented by many posters, I will compile the numbers and see what operating expense ratio was averaged. If we get a rapid number of posts which quickly total more than 100 doors, we can move the figure up to 200 or more before I compile the numbers. The more data entered, the more accurate the average should be. Let's have some fun with this! :lol:

I will post updates here on the figures as we get enough to compile.

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Real Estate Investor · the villages, FL · Member since 2008 · 5k+ posts · 3k+ votes
17y

Merry Christmas to all!! I'm in Cancun and this is not what I wanted to be doing this morning, but I disagee with using this 50% as a catch all %.
Here are 2 things I've found in owning oVER than 1000 residences for rent.
1. There is a distinct difference between low price and higher priced rentals. As rent goes up , % goes down,,period
2. If you own in TX and rent for $1000 per month, JUST your taxes may be 25% per month of your rent, while other states might be 4% per month. (MS)
There are other items that cause a big difference, i.e. age of property, and condition of property. If you stick with newer properties, the % will be less than 50%, imo.
The 50% is ok as a general thing, especially for newbies as a starting point, but there are so many other conditions that will affect the %.

p.s. I currently have 11 properties at $975 or higher. All are less than 5 years old and my % is CONSIDERABLY less than the 50%, fwiw.

See this reply in the discussion

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  • Manhattan, NY · Member since 2008 · 801 posts · 61 votes
    17y

    I've asked her to get me the counts and update the summary.

    One of the notes I made on the first draft of the full report is to explore whether we are really measuring what we think we are.

    The sources she used are all Field Guide members or former members, as such, I questioned whether we were just validating that Field Guide members tended to buy based on the 50% rule of thumb.

    I don't think we could cost effectively do the kind of study it would take to definitively answer that question. But, in the bigger sense for me it may not matter. Simply showing that the 50% rule of thumb is one way to reduce the risk of a negative cash flow investment is sufficient.

  • Los Angeles, CA · Member since 2008 · 557 posts · 70 votes
    17y

    Thanks for posting Taz!

    Originally posted by Taz:
    For those who might still care about this topic...

    Here is the summary of the report:

    ]


  • Real Estate Investor · North Carolina · Member since 2008 · 1k+ posts · 483 votes
    17y

    Great post, Taz -- thanks!

  • Will BarnardPro Member
    Moderator
    OP
    Developer · Santa Clarita, CA · Member since 2008 · 15k+ posts · 10k+ votes
    17y

    Thank you Taz for all of your time and efforts you have put into this. I appreciate it. I will get you my data to add to it as soon as possible.

    As teh rents go up, the EO ratio does trend down but not as significant as I thought it would. It is also higher than what I have personally experienced, but perhaps my business model does play a larger role in that factor.

    Happy New Year to all and let's hope it is a prosperous one! :lol:

  • Manhattan, NY · Member since 2008 · 801 posts · 61 votes
    17y

    For those wishing to dig a little deeper into the data...

    Operating Expense as a Percentage of Potential Rents Study Using Data from the 2007 Calendar Year

  • Investor · Pawleys Island, SC · Member since 2008 · 1k+ posts · 837 votes
    17y

    Throughout this thread there seems to be some varying observations about how the 50% rule is used. I would like to clarify what the denominator is for the 50% expense ratio.

    As I understand the application of the 50% rule from Mike Rossi's postings, he has always said that the denominator is scheduled rent. Mike has always discussed the 50% ratio in the context of a property you are considering acquiring -- a property for which you have no historic experience to draw upon.

    As a pre-acquistion step, I do a projected cash flow analysis. I usually try to use accurate expense numbers for my calculations, and I always use scheduled rents WITH with a vacancy factor to predict my cash flow.

    I believe Mike has always been saying that my analysis should start by assuming that 50% of my scheduled rents will be consumed by operating expenses, and that, by extrapolation, I will only be able to rely upon 50% of my schedule rents for debt service and cash flow. This means to me that if my net operating income is just 50% of my scheduled rents, then the vacancy allowance is already taken into consideration.

    Now, here is my problem with the tabulation parameters for this survey. We are being asked to look at our historical actuals and compute an operating expense ratio against scheduled rents.

    My actuals do not include vacancy as an expense item. Instead, my actual vacancy is reflected in my actual collected rents. To have the vacancy I actually experienced reflected in my operating expense ratio, I would have to use actual collected rents as the denominator in my calculation.

  • Rental Property Investor · Mercer Island, WA · Member since 2008 · 22k+ posts · 14k+ votes
    17y

    Dave, you are correct that Mike uses scheduled rents, and include vacancy losses (and capital expenditures) in the "50%". If you have detailed records, though, you should be able to figure out what your vacancy losses were, and add them to both the expenses (numerator) and rent (denominator) to get the the corresponding ratio.

    That is:

    50% rule ratio = (actual expenses + vacancy losses) / (collected rent + vacancy losses)

  • Attorney · Raleigh, NC · Member since 2008 · 4k+ posts · 1k+ votes
    17y

    Taz that's awesome! Thanks for posting that info! I had always seen the 50% rule generally working for me with a very few abnormalities. Nice to see quantifiable data backing it up.

  • Manhattan, NY · Member since 2008 · 801 posts · 61 votes
    17y

    I'm glad you found it useful, it's what we do.

  • Investor · Westminster, CO · Member since 2009 · 1k+ posts · 1k+ votes
    17y

    I know that it has been a while since there was a post on this thread, like 7 months, but I would like to 'get my head around' this concept.

    So does this concept state, "If the Principle and Interest payment is LESS than fifty percent of the rent, the property will cash flow?"

    Also, I am assuming that we do not count all cash purchases when figuring out if it will cash flow?!?

    Someone mentioned "one hundred bucks a door" as a target profit. Does this include houses that rent for more than $2,000 a month?

    Obviously, as stated before, a house that is 10 years old versus a house that is 80 years old will have a very different Capital Expense over time.

    I am just trying to understand, the oldest house I have was built in 1960. I have not purchased an older home in quite a while.

  • Rental Property Investor · Mercer Island, WA · Member since 2008 · 22k+ posts · 14k+ votes
    17y

    Yep, that's correct.

    This calculation pay's you the same return on your cash as you would pay a lender on the note. So, returns are divided into two parts - the return from the property and the return generated by the cash you put into the property.

    That's really your call. The idea is that a tenant generates the same work regardless of the rent. This applies more at the low end. A tenant in a $300 unit is just as much work, if not more, than a tenant in a $1000 unit. So, you want to make the same profit on both.

    At the high end, though, the type of property required to draw $2000 in rent is often so expensive its not profitable. I have a friend who recently moved here and pays only about $1500 in rent. But the house he's renting would sell for over $400K. His landlord is taking it in the shorts.

    Not necessarily. Rehab expense should be added to the purchase price when figuring your starting point on a property. Once a house is at a good starting point, expenses should be about the same regardless of age. Maintenance is only a small fraction of the total expenses, and much of that's created by the tenants, so the age is only a small factor.

    That said, if you try to use a property that's in poor condition, regardless of age, as a rental, you'll have more maintenance expenses.

  • Investor · Westminster, CO · Member since 2009 · 1k+ posts · 1k+ votes
    17y

    Not necessarily. Just because the house is worth $400,000 today doesn't mean that is what the landlord paid for it. I have a house that is worth around $500,000 and I am getting $2,000 a month rent for it. But I only paid $90,000 for the house, back in 1985.

    This brings up the topic of another couple of threads on here, one about "Appreciation vs. Cash Flow" and "Investing for Appreciation-Where is the Exit", both excellent thoughts the subject.

    Should your friends landlord sell the property and make better cash flow investments? That depends. If he may need to move back into it at a later date, the loss of income is better than having to pay current market price for another home. Then again, he could rent himself, but sometimes a house has more VALUE than just 'cash flow.'

    I am really starting to see the 50% rule as a viable tool in analyzing investments. Although there are many other variables, it is a good rule of thumb, and if I own an investment for 10 years and the expenses stay under 50%, then I feel I have done pretty well.

  • Rental Property Investor · OH · Member since 2008 · 51 posts · 6 votes
    17y

    I'll post my numbers

    Purchase: 21k
    Rehab: 18k
    Rents: 1300 / m
    Mortgage: 0
    Everything is brand new = 0 maintenance

    What is my NOI ?

  • Will BarnardPro Member
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    OP
    Developer · Santa Clarita, CA · Member since 2008 · 15k+ posts · 10k+ votes
    17y

    Your NOI according to the 50% rule is $650 monthly.

    Your note about maintenance expense is $0 may or may not be true for year one, but not for the life of your ownership and therefore, maintenance should be included in your expenses, hence the 50% rule.

  • Rental Property Investor · OH · Member since 2008 · 51 posts · 6 votes
    17y

    650 / month or 7800/yr is a lot of money for expenses. thats why i don't agree with this "rule"

    For 7800 I could completely renovate the place again.

  • Rental Property Investor · Mercer Island, WA · Member since 2008 · 22k+ posts · 14k+ votes
    17y

    You'll have taxes and insurance for sure. No idea what those are, but I'm sure they're not zero.

    Unless you're very lucky, you'll have some vacancies. If nothing else, you may have a short period from when one tenant moves out to another moves in. My last tenant changeover took two months, so that's two months lost rent. Even just two weeks for you is $650.

    When you say everything's new, do you include the roof, furnace, water heater, water lines, gas lines, sewer? Because over time, all those have to be replaced.

    Tenants do wreck places. Even a good tenant can make a serious mess if they're not super neat. A bad tenant can completely wreck the place.

    A lengthy eviction can cost plenty in legal fees and lost rent.

    You'll have utilities, at least for the time its empty.

    If you own 100 units, you'll be dealing with some of this stuff on a continous basis, so you'll be close to the 50% number most months.

    If you own one unit for 10 years, you'll probably average out to this number over the long term. In many months, though, the only expenses you'll have will be the taxes and insurance. Its those killer months when the tenant bails out three days before Christmas, turns the heat completely off and busts all the pipes only to have the temperatures jump to 60 degrees two days later. You don't hear about anything until the Jan rent is late. By that time you have a $2000 water bill and a swimming pool in the basement. Likely? No. Possible, absolutely.

  • Financial Advisor · Tampa Area, FL · Member since 2008 · 956 posts · 214 votes
    17y
    Originally posted by Mike M:

    Not necessarily. Just because the house is worth $400,000 today doesn't mean that is what the landlord paid for it. I have a house that is worth around $500,000 and I am getting $2,000 a month rent for it. But I only paid $90,000 for the house, back in 1985.

    in 1985, $90,000 was about the equivalency of $180,000 today...that's some big $$$$

  • Will BarnardPro Member
    Moderator
    OP
    Developer · Santa Clarita, CA · Member since 2008 · 15k+ posts · 10k+ votes
    17y
    Originally posted by J Mishkin:
    650 / month or 7800/yr is a lot of money for expenses. thats why i don't agree with this "rule"

    For 7800 I could completely renovate the place again.
    I don't always either, rules based off averages are just that, averages, and you could be above average or below on one or all of your investments. Choice and decision of how you calculate it is yours.
  • Real Estate Investor · OH · Member since 2008 · 4k+ posts · 1k+ votes
    16y

    Post your expenses and we'll see. We've had dozens of people make these claims over the past couple of years and EVERY SINGLE ONE of them was proven wrong.

  • Investor · Westminster, CO · Member since 2009 · 1k+ posts · 1k+ votes
    16y

    We have not had a posting here in a while so let's liven it up a bit.

    Let's take the house you live in, I will use mine. It is a 3,000 square foot house that we had custom built in 2005. If we were to rent it, we would get around $2,500 a month. Using the 50% rule, it should cost us $15,000 a year for taxes, insurance, maintenance, etc... 2009 Taxes and insurance were $2,138.76. Let's use 10% for an average vacancy. We have not had any repairs but they will come up. The 50% rule states that we will have $75,000 in taxes, insurance, maintenance, management, vacancies in 5 years. But reality shows it to be $15,000 to $20,000. I can hear some of you now, OH, BUT YOU ARE NOT A TENANT, TENANTS DESTROY PROPERTIES. Maybe, if you have low income rentals. We have a rental in So Cal that is occupied by a young family, he is an attorney, she is an RN, and two young children. The house is BETTER today than when they moved in. Similar numbers, but the 5 year reality is $20,000 in taxes, ins, maint., etc.... So after 5 years, I guess we have $50,000 in "Maint Reserves". Hmm, that is some quality maint money. Five more years, it will be $100,000.

    I have had tenants really destroy a property, and it goes above 50%, but that is the exception, no where near the rule.

    Again, like I stated before, 50% is a very good rule of thumb when judging the return on a potential investment. But I think it is a "worse case scenario". Quality houses with quality tenants managed by competent management firms will keep the expenses under 50%.

  • Investor, Entrepreneur, Educator · Springfield, MO · Member since 2009 · 21k+ posts · 12k+ votes
    16y

    Hi, a rule of thimb approach to just about anything at best gives an estimate. I would never make a buy decission on a "rule of thumb". As Will and Mike M pointed out there are many variables involved. Every property is unique in so many ways that I can only see a rule being applied to like or very similar properties. I really don't think that any rule of thumb should be presented to new investors as the golden rule to investing, instead they should learn to evaluate each deal based on its own merit under generally accepted appraisal methods, which is not rocket science. There are no complicated formulas required in appraising a residential property, it only requires basic math skills as it does in solving any rule of thumb guestimate. What's the purpose? To save a few minutes? There is no doubt in my mind that if someone only uses rules of thumb and rejects deals, that I could acquire many of those deals and profit from them in any investment strategy.

    I have experience with over 1200 low/mod units and I don't see this analysis being valid with properties in a value range of 45K to 75K, rents ranging in the 425 to 800 per month, such figures not being assignable by rent to value. But that is in my area and many factors, as pointed out above, can apply. IMO, Bill .

  • Real Estate Investor · OH · Member since 2008 · 4k+ posts · 1k+ votes
    16y

    You see, NO-ONE has posted any USEFUL data that shows anything other than the fact that the 50% Rule is 100% accurate (because it is).

    Mike M - c'mon - your example is....well...ridiculous. Using GUESSWORK for your personal residence is just that - GUESSWORK and provides ABSOLUTELY no useful information. Listing your ONE rental also provides ABSOLUTELY no useful rental. The 50% Rule say absolutely nothing about one rental over a short period of time. I have SEVERAL rentals that I could point to over a 7 year period that have almost no maintenance and no capital expenses. What does that mean? NOTHING! It just means that the averages haven't caught up with those properties yet. I could also point to individual rentals I own that have had expenses above 50% of gross income. What does that mean? ABSOLUTELY NOTHING! What the 50% Rule does is tell you what the expenses will be over a large number of rentals and/or a long period of time, which is what you need to know if you're going to operate a rental property BUSINESS. It tells you absolutely NOTHING about ONE RENTAL OVER A SHORT PERIOD OF TIME.

    That is worded like something a tenant would put on an application! What does it mean when you say "I have experience with"? Do you own 1200 low/mod units or not? If you have owned that many units over any significant period of time, then you should KNOW what the numbers are. "I don't see this analysis being valid" doesn't sound like you have the data. If you've got useful data - POST THE NUMBERS!

    You see, what we've got here is more amateur guesswork. All the ACTUAL DATA, including Taz's analysis of over 30,000 units across the entire United States says the 50% Rule is accurate. Individuals who have no meaningful experience and can't produce the data are the ONLY ones who argue the point.

    Mike

  • Investor, Entrepreneur, Educator · Springfield, MO · Member since 2009 · 21k+ posts · 12k+ votes
    16y

    Mike, HUD owns the properties, I didn't own 1200. If I posted the figures, which I can not, just guessing it's about 12,000 pages a year. Who could understand them? A commissioner position is a political appointment. There are differences in government accounting compared to GAAP. The 50% rule works because it's so (too) conservative! Why not assume 60% for expenses, I'm sure that would be better, but how many deals would you pass up? No one knows! Bill

  • Real Estate Investor · OH · Member since 2008 · 4k+ posts · 1k+ votes
    16y

    The 50% Rule is NOT CONSERVATIVE - not at all. It is the average expense that a landlord will experience with a large number of units and/or a long period of time. It has been proven by many large studies as well as by Taz's study - WHEN Taz QUITE FRANLY DOUBTED THE 50% RULE BEFORE HE DID THE STUDY (of 30,000+ units).

    Finally, HUD owned properties have absolutely NOTHING to do with the rental business. HUD is NOT a business, they are a government entity. As we all know, government entities TAKE money from taxpayers - they are anything but a business. The one thing HUD specializes in is running drug infested slums - you can see that everywhere in the USA!

  • Investor, Entrepreneur, Educator · Springfield, MO · Member since 2009 · 21k+ posts · 12k+ votes
    16y

    Hi, LOL! Ya gotta know your limitations.

    Obviosuly there is no knowledge of the "Mark to Market" program that PHAs are under. Comparing "Owned Housing" to Market Housing and conversions to private ownership. If you want to become better informed visit the National Housing Association of Real Estate Officials (NAHRO). It's beyound the scop of this thread or site.

    As to the formula being conservative or not seems to me to be a matter of opinion. If your formula works most of the time or all of the time and there is little variance, statistcally it can be said it is conservative approach. So what "Taz" did was validated that 50% worked most or all of the time, based on the comment above because I don't know what "Taz" did in the study!

    A better question might be can the 50% rule be validated in all markets? My opinion would be no. To say validated, to me means, does it work to provide the optimum investment while assuming a reasonable risk in the market. If I only used 65% for example, the number of properties available in my rental market would be very limited and that would reflect an unreasonable degree of risk willing to be accepted to actually be "in the business". If I used 40% I would be saying that I was willing to accept more risk in accepting a property as an investment. Just guessing (IMO a pretty good guess) I'd say that the TAZ study was probably not valid, since it would require a sample size much larger tha was mentioned above to reflect every significant rental market. Properties can be used all over the country, but if they had similar factors, say tax rates above a certain per centage or mean rents above or below a certain level the study would be skewed. So, in my opinion, the question posed can not be answered in terms of all rental markets. Can it be validated in the areas or markets sampled? Probably so, but it looks like the formula was conceived based on an acceptable risk level that can be different from one investor to another. Good luck "proving it"...Bill

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