50% rule

[Jim McMillen]

noob here.....Can someone explain the 50% rule, 2.5% rule.....I can't seem to find a definition for it.

Thanks.

Jim

[John Santos]

Michael & Andy & John
Thanks for the valuable insights.
In order to buy far away from where you live i.e. in my case PA or deep down in South Jersey may be better bets. However for a new real estate investor, buying too far is a challenge especially keeping current job and taking care of 2 small kids.
Any suggestions on how to buy at a far distance and yet manage successfully?
Regards
Anand

[Mike M.]

Andy
Funny you should say so. I am a PA investor with THREE small kids and a J-O-B :) I'd encourage you to look to build relationships with people who can help you and build your TEAM. Trying to do it all yourself is unwise and unprofitable. Remember good investors don't just leverage money; we also leverage TIME (of which you and I have little) using other people's time and talents.

[Jeffrey Nowakowski]

The 2% rule sounds like a fantasy in most areas and obiously the lower interest rate enviroment kind of make it a moot rule.

I love hearing what investors in other areas experience.

[Ty Golera]

I don't think the 2% rule can be applied in major metro areas like L.A., San Francisco, NY metro (includes central NJ) as vacancies do not last long on a good property in a good area. These areas are more for appreciation than for cash flow. If you get both, it is a bonus.
Remember that HOA is always a hidden expense that can skyrocket substantially if you don't check their reserves, how long it has been since the roof was replaced, possible special assessments for sewer lines / water utilities (especially for rural properties with private utility companies)

I am a novice and almost made the mistake of investing in a condo in the Phoenix market with $300 cash flow after PITI, mgmt fee, & HOA. It does not meet the 2% rule for NET expenses.

[Steve Wilcox]

I have a question about the real use of the 50% rule as taxs are WAY different in parts of the country or even local markets

I am looking at 3 and 4 plexs in areas like Newark NJ and seeing tax rats of 4-5k per year, and the essentially same units in Elizabeth, NJ have taxs more like 10-12k per year.

While the rental income is only marginally different obviously the 50% rule can not be correct for both of these given the huge difference in tax rate.

Is there any similar rule of thumb we can use that does not lump taxs in. Expenses like maintenance, repair reserves, advertising, ect should be fairly standard regardless of the area, but taxs are way to variable to fit into the formula

[Ibrahim Hughes]

Originally posted by Steve Wilcox:
I have a question about the real use of the 50% rule as taxs are WAY different in parts of the country or even local markets

I am looking at 3 and 4 plexs in areas like Newark NJ and seeing tax rats of 4-5k per year, and the essentially same units in Elizabeth, NJ have taxs more like 10-12k per year.

While the rental income is only marginally different obviously the 50% rule can not be correct for both of these given the huge difference in tax rate.

Is there any similar rule of thumb we can use that does not lump taxs in. Expenses like maintenance, repair reserves, advertising, ect should be fairly standard regardless of the area, but taxs are way to variable to fit into the formula

Steve Wilcox - where are you looking in Elizabeth with taxes that high? In my experience taxes on the south side of Elizabeth (between the Port and Elizabeth Ave/Uptown area are about as high as what you would find in North Newark ($5-7k). Maybe a little higher in North Elizabeth (bordering Linden, Union and Roselle Park). And definitely with new construction. But newer construction with expired tax abatements in Newark are in the $10-12k range as well. Basically imo taxes are only marginally higher in Elizabeth. Unless I'm missing something.

[Ankit Duggal]

According to the IREM standard, real estate taxes account for 10.5% of gross potential income in the northern New Jersey area. So maybe you can utilize a 40% ratio instead of the 50% ratio.

[Will Barnard]

Originally posted by Ankit Duggal:
According to the IREM standard, real estate taxes account for 10.5% of gross potential income in the northern New Jersey area. So maybe you can utilize a 40% ratio instead of the 50% ratio.

This would not be accurate. If taxes were extrodinarily higher in one area, then that means the expenses are higher, not lower, thus the 50% rule would have to be increased above 50%, not down to 40%

[Steve Wilcox]

Ibrahim S, I am looking in the Elmora section (which I do not think is a comparable product to most of newark) but taxs on most SFH in that area are around 7-9K and on 2 family or more are 9+. I am curious how the same rule could be applicable, and how it needs to be adjusted to represent taxs in the different area.

[Will Barnard]

Originally posted by Steve Wilcox:
Ibrahim S, I am looking in the Elmora section (which I do not think is a comparable product to most of newark) but taxs on most SFH in that area are around 7-9K and on 2 family or more are 9+. I am curious how the same rule could be applicable, and how it needs to be adjusted to represent taxs in the different area.

Take the average tax rate and your local tax rate and calculate the difference. If the average tax rate was say 1.5% of value, and your tax rate was 3%, then you have an addional 1.5%. Now take that extra actual annual tax amount difference and calculate what % of the gross rents it covers. It should not be more than a couple % points and add that to the 50% rule. So, if your tax rate was abnormally higher than the average, your new rule for your area might be the 53% rule (as an example, this is not an accurate calculation)

[Ankit Duggal]

The goal of my percentage number was to provide an expense percentage net of property tax rates in order to have standard comparative tool that an investor when comparing one or more assets quickly. The investor would have to bring in the tax numbers into the calculation on an individualistic basis to help the make comparison truly valid in an opportunity cost scenario.

[Will Barnard]

I think you are attempting to be too perfect with your calculation by using this rule of thumb. It was never intended to be a perfect/accurate calculation.

Keep in mind that the rule is based on owning many units over a long period of time and as such, you may have 42% costs on one door, 58% on another, but over the average and long haul, they average close to 50%, not exactly.

I would also point out that in areas where property taxes are higher (like TX), some or all of that cost is offset by other items such as lower costs on other items, better rent per cost of door, etc.

[Clayton Mitchell]

Quick question. As a hopeful for the real estate market in the near future, is it a good idea to put your net cash flow toward principal on the mortgage?

[J Scott]

Originally posted by @Clayton Mitchell:

Quick question. As a hopeful for the real estate market in the near future, is it a good idea to put your net cash flow toward principal on the mortgage?

Depends on two things:

1.  What the interest rate on your mortgage is; and

2.  What your other alternatives are with that money.

If you take $1000 and pay down the principle of a mortgage at 5%, then you are essentially earning 5% return on your $1000.  If you could be using that $1000 to invest in something that earns 10%, then you've probably made a bad decision.  If the $1000 would otherwise sit in a savings account earning .75% interest, then you've probably made a good decision.

[Clayton Mitchell]

Thank you I Scott!

[Olani Oshuntuyi]

Lots of great info on here, lots of opinions, just trying to figure out if I'm being cautious enough with my numbers, since I don't meet the 2% rule, but still feel good about the cash flow...

I'm in the process of buying a fully rehabbed 4-plex in chicago for about $350k which will yield gross rents of at least $4600. I'm estimating a cash flow of 1500 - 2000 since it is newly rehabbed, and I will self manage it..

This will be my first time buying a multi, obviously it doesn't meet the 2% rule, wondering if my estimates are not conservative enough, your thoughts?

[J Scott]

Originally posted by @Olani Oshuntuyi: 
I'm estimating a cash flow of 1500 - 2000 since it is newly rehabbed, and I will self manage it..

50% rule assumes a long-term hold of a property, so whether it's newly rehabbed or completely run-down, it shouldn't matter.  Keep in mind that while it's newly rehabbed now, in 20 years, it won't be.  Even if your plan is to sell before you sink any major cash into the property, consider that your buyer will likely discount their offer based on the pro-rated life-span of the capital items.  You can't escape the cost of depreciation by buying a property fully renovated, despite a lot of landlords on here thinking they can.

[Neil Quinn]

For those that own a primary residence yet, but live in a high CoL area, is this an exception you make to your investing?

I hate renting, but in my area rents are about 0.6% of home value.  Debating if it makes sense to buy primary residence first, or focus on investing first.

[Ned Carey]

Despite Realtor ads, a home is not necessarily you best investment. Real estate tends to go up with inflation but so do rents.  Real estate has high transaction costs.  so if yuo are going to ilive in a home only 2-3 years you are probably better off renting. If you are going to live in a home for 10+ years you are probably better off buying. 

However that may depend on your market. What is the cost of owning vs the cost of renting? A mistake many people make is buying the most house they can afford. Much better financially to buy a much less expensive house and use the savings for reserves and investing. 

[George Jan]

Hi! 

@J Scott

@Will Barnard

From the property listings I've seen, expenses that go toward both the actual and pro-forma NOI calculation are vacancies, collection losses, property taxes, insurance, maintenance, legal and accounting (if any). Those are operating expenses, not the expenses that are capitalized (major capex, renting/renewal commissions etc) nor interest. That makes NOI equal to EBITDA in business. Therefore EBITDA margin would then be roughly 50% of gross revenues, too.

However, some other posts say that the 50% rule includes capex (averaged out over a long period since capex is lumpy) as well. Is that correct? How about rental/renewal commissions also amortized over time? 

If they are all included then NOI is really EBIT and only interest (and income taxes) are excluded.

I know the 50% rule is just a rule of thumb, but it is used a lot for quick deal evaluation so it's important to know what exactly goes into those expenses. 

Thanks!

George

[Will Barnard]

@George Jan

The original 50% rule states that it covers all expenses, both vacancy/loss to rent, operating, and capital expenditures one could generally expect. As stated, it was/is a rule of thumb and a "back of the napkin" calculation. Those units with owner paid utilities or those in higher turnover/crime areas will typically sway higher than the average.

That all said, I don't use the 50% rule for much as it is a nationwide generalization and as we savvy investors are aware, real estate market conditions differ dramatically location to location, and from then to now.

[J Scott]

Originally posted by @George Jan:

Hi! 

@J Scott

@Will Barnard

From the property listings I've seen, expenses that go toward both the actual and pro-forma NOI calculation are vacancies, collection losses, property taxes, insurance, maintenance, legal and accounting (if any). Those are operating expenses, not the expenses that are capitalized (major capex, renting/renewal commissions etc) nor interest. That makes NOI equal to EBITDA in business. Therefore EBITDA margin would then be roughly 50% of gross revenues, too.

However, some other posts say that the 50% rule includes capex (averaged out over a long period since capex is lumpy) as well. Is that correct? How about rental/renewal commissions also amortized over time? 

If they are all included then NOI is really EBIT and only interest (and income taxes) are excluded.

I know the 50% rule is just a rule of thumb, but it is used a lot for quick deal evaluation so it's important to know what exactly goes into those expenses. 

Thanks!

George

First, the 50% rule is NOT an accounting function nor is it anything other than a rule of thumb...

That said, the way I interpret and use the rule of thumb -- and most investors I know would agreed -- is as follows:

"On average, across a large number of units, a long time period and a large geographic sample, somewhere around 50% of gross income will be used for operating expenses, vacancy/rent loss and CapEx."

Now, "around 50%" to me means "45-55%," and it assumes property management expenses (not self managed). 

This 50% calculation doesn't include taxes, depreciation (though depending on your goal with the calculation, I guess you could consider that analogous to CapEx in some respects), or debt service (amortization/interest).

[George Jan]

@Will Barnard

@J Scott

Thanks guys. I know it's an extreme approximation and varies not only region to region and city to city, but also property to property. Nevertheless, it can be useful, up to a point, so I wanted to know whether capex is included or not since I've seen some disagreements. Even now, WIll said capex was included and J said it wasn't. And capex seems to be about 8-10% for apartment buildings and often more so for SFHs so it's a big deal whether it's in or not. 

[Will Barnard]

Originally posted by @George Jan:

@Will Barnard

@J Scott

Thanks guys. I know it's an extreme approximation and varies not only region to region and city to city, but also property to property. Nevertheless, it can be useful, up to a point, so I wanted to know whether capex is included or not since I've seen some disagreements. Even now, WIll said capex was included and J said it wasn't. And capex seems to be about 8-10% for apartment buildings and often more so for SFHs so it's a big deal whether it's in or not. 

I think you mis-read J's post, he did state in his last post that Capex WAS included in the rule of thumb.

[George Jan]

@Will Barnard, 

@J Scott

Got it! Thanks much for taking the time to answer!