Strict definition of 50% rule?

Question

Really thought I would have an easier time finding a consistent definition of this by googling.

Can someone lay out for me what of the following goes into the expense part of the 50% ratio?:

[/u]Hard, real costs (eg $$$ being paid out)[u]
Principal Payment
Interest Payment
Property Insurance Payment
Property taxes
Mortgage Insurance
Management fees
Marketing fees
Remodeling expenses
Repair expenses

[u]soft costs: real but not $$$ paid out):
Vacancy adjustment

Additionally, should I be pretty happy if my rental property rents at twice PITI?

Example:  (Principal, interest, insurance + taxes)  X 2 = Rental price that tenant has signed up to pay ?

Jon Holdman · Answer

The "50% number" includes three things:

1) expenses per the IRS definition - money you spend in one year that can be deducted in that year.  Things like property managment, insurance of all sorts, taxes, maintennace, legal costs, CPA costs, tenant damage above security deposits, lawn care, snow removal, etc.
2) capital - money you spend in one year but that has to be depreciated.  Things like roof and furnaces.  Note that we're talking about the cash you spend on this item, not the depreciaion from it that goes on your taxes
3) vacancy - money you never manage to collect.  May be actual or economic.  Actual is  rent not collected because the place is vacant.  Economic is a discount you give (e.g., half month free for move in) or an ongoing discount (e.g., pricing your unit below market rents.)

Principle and Interest payments are NOT included in the 50%.

This is also a long term average.  Any property in any particular year will vary, possible widely.  The total for 20 properties for 20 years will be pretty close.

Property management is a significant componet.  If you self manage and do it for free, your income will be higher.  But realize you are earning part of the income by being a PM (and, often, handyman.)

Mike McKinzie · Answer

The other side of this is, "50% of Market Rent," NOT "50% of collected rent."  So if the "Market Rent" is $1,000/month, you start with $12,000 to get your 50% Expense ratio, even if you only collected $10,000 or $11,000 for the year due to vacancies or economic incentives, ie Move In Discounts, or renting below market.  Luckily, I have rented above market when the tenant was desperate to move in, but I still use the market rent for my ratio.

It has been shown on BP many times, that taking huge numbers of rentals, into the Millions of units, expenses will be 50%.  I think Brian posted a survey of a little over 1,000,000 apartment units and expenses came to 49.98%.  But also remember this, if 50% is the average, half will be OVER 50% and half will be under 50%, excluding all the exactly 50% units.

On the whole, higher priced rentals, those that rent for more than $1,500 a month, the expense ratio goes down a bit.  Very cheap, especially older rentals, can go over 50% quite often.  But even those that go under are still close, in the 45% to 47% range for expenses.  The main reason for this is that typical repair bills, say unclogging a toilet, will be a different percent of a $500 rental vs a $2,000 rental.

Nathan Emmert · Answer

The 50% rule isn't telling you how good of an investment you're making, it's simply helping you determine NOI.

The 2% rule is what people generally use to determine a good investment, per their definition.  That definition is generally cash flowing $100/unit at a $500/unit rent point.

Debt servicing will vastly impact your CoC return, but it doesn't change your expenses outside of debt servicing.  The 50% rule addresses those expenses, they are completely independent functions.

Nathan Emmert · Answer

The 50% is all expenses except your principle and interest mortgage payment.  Your taxes and insurance are built into the 50%.

If your rents are twice PITI... AND the property achieves 50% expenses over the long term... a property rented at 2x PITI would cash flow.  Whether that cash flow is enough to make you happy will be decided based on your personal goals and the amount of cash you put into the property as a down payment and rehab cost.

My goal is 1.5% of purchase price in rents.  Given a 25% down payment, that metric achieves a 15+% CoC return using the 50% rule and assuming 5% fixed for 30 years.  Given today's rates at closer to 4.5%, the CoC is actually closer to 18% but I haven't adjusted my metric.

Steve Babiak · Answer

The 2% rule works for a very limited range of rents ~ $500 give or take; of course, if your rent is higher and you get 2% of purchase price, that's outstanding.

Erik Kubec · Answer

@Brian Hoyt that is what I had thought.  The purchase price was $130k with 25% down.  I put about $8k into it and did a chunk of the work myself.

When I look at the 2% rule--or even using Nathan Emmert's 1.5% rule, it does not look so hot: it's 1%.  Actually, less if you add in the rehab cost.

James H. · Answer

And that is a very good return on a nicer home IMO. By self managing you are earning about another 150 a month. So that's almost 300/month for very little work. I'd take a deal like that all day long.

J Scott · Answer

You got it.  That said, a few things to keep in mind:

-  This is a long-term projection.  Short-term could be much different.  For example, for the next 6 years you could be averging $250/month, then have to replace a roof and lose $6000 for one month.

-  This includes property management.  If you do your own, you'll make more money.

-  Your mileage may vary.  Depending on the location, property type, property age, etc, your expenses could be more or less than 50%, though 45-55% is likely.

Erik Kubec · Answer

Thanks everyone--I think I get it:

My rental agreement states that the tenant will pay $1300 / month + utilities.

My Principal and Interest payment = $486.80.

So $650- $486.80 = $163.20.

I guess the $163.20 is my predicted cash flow based on the rule of thumb that %50 of my total rents will go to expenses.

Jon Holdman · Answer

The "50%" doesn't include debt service because if debt service is included its wrong.  The debt service gets added on on top of this 50%.

This is just an empirical rule derived from several large studies of apartment complexes.  Its handy as a gross estimate of NOI, nothing more:

"Expenses" (includes capital and vacancy) = 50% of gross scheduled market rent
NOI = rent - "expenses"
Debt service = depends on you and your financing
Cash flow = NOI - debt service.

Its that simple.

Yes, it would be lovely if you could include all expense, capital, vacancy AND debt service and have them only total to 50% of the rents.  Unfortunately, this isn't reality.

If you pay cash, cash flow = 50% of rent.

If you by an expensive house (say, $100K for a house that rents for $500), then the debt service alone may be more than the rent.

Strict definition of 50% rule?

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