When is the 50% rule inaccurate?

Question

I realize the 50% rule is supposed to be a "rule of thumb" that helps you weed out potential properties before more fully analyzing properties that pass it.  My question is, when is the 50% rule fail?

For example, if I'm interested in purchasing a multi-family property built within the past 3 years, do I alter the rule at all.  I know that long term the 50% rule applies, but CapX costs shouldn't be a factor for a decade or more.  At what rate do you factor these in.  Of course you want to be accounting for these expenditures down the road, but it seems that any income generated is better used to fund more property purchases than to get socked away waiting for the eventual wear and tear of the property that likely won't happen for years to come.

In short, when does the 50% rule fail for properties that are still good deals, if ever?

Kimberly T. · Answer

For me, I've never used the 50% rule.  Property taxes and insurance premiums vary way to much in different states for it to make sense to me to use it.

If you're asking about what kind of rule of thumb to use to determine if a property is worth further investigation, I personally use the GRM (gross rent multiplier) rule of thumb, because that's what I was taught.  That rule is: I don't look at a property whose price is more than 10 times the gross rent.  So if the gross annual rent is $30,000 then I won't bother with it if the price is over $300,000.  Of course, that's just a rule of thumb, you still have to know what the real break even point is in your particular market.  You can adjust it according to your market (8x rent, 11x rent, etc.).  But it's an approximation that's really easy to calculate to determine if something is worth more time.

Now, as for buying a newer building, you can absolutely adjust your Cap X and repair budgets accordingly, but that goes deeper than the 50% rule.  The 50% rule (or GRM or any other rule of thumb) shouldn't be used to actually analyze a specific deal, because each property is different.  I actually spend some time figuring out exactly what we should budget for each property's Cap X and repairs based on the property's specific amenities, condition, etc.

Josh Michel · Answer

At this moment or in life?  I'm a young-ish guy looking to buy and hold as far as life.  I'm on lunch as far as at the moment.

Rich Weese · Answer

I loved both replies by Joe Villanueve, and laughed out loud at the first one. I have like a million posts on here and half of those (generalizing) have been discounting the 50% or 1%  applications that many want to use. I'm old and made very good living in RE and NEVER used either of these methods. I just don't know how I did it? (being facetious)

I would list this as maybe # 100 in my methods of evaluating RE deals. I appreciate the fact that others may find it helpful to their processing. I just don't need it. Experience does help make those methods even less interesting to me.

Now to your actual opening question. "When does the 50% "rule" fail?" If that is your only measuring stick, my answer is Always. Just my $.02 worth and I'm sure I have longer, well thought out replies in some of my other million posts..

Rich

Joe Villeneuve · Answer

I just use the rule of analysis.  Fudge is for ice cream.

Just take the rental comps in the area and subtract the following in this order:

1 - Desired cash flow to you.  (Notice I pay myself first)2 - Taxes and Insurance (actual...not guesses...and it's not hard to find.  This is the 21st century and the internet is our best friend and research partner).3 - 10% of the rent for a property manager...even if you plan on starting out doing your own PM.  What if down the road you can't, or don't want to do it...and you didn't analyze for it?.4 - 5% for CAPEX/MISC/etc...if you don't have a good way (this isn't by the way) to cover these items.5 - What's left is the max monthly payment you can make.  Revers engineer from this number to the maximum loan amount this max monthly payment will cover.  There are any number of free apps on google to do this.6 - Make your offer based on #6 above.7 - Buy/rehab property if you get it...ot,8 - Walk away if you don't get it.  Notice I didn't say negotiate if you don't get it.  You never negotiate against yourself, and if you raise your offer to get the property over the number you generated at #6...you are negotiating against yourself...and are about to lose.

Steve Olafson · Answer

Most experienced multi family investors don't use the 50% rule at all.  I use a model that is based on expenses/unit/year.

The categories are basically:

• Insurance
• Taxes
• maintenance costs
• advertising
• management
• salaries
• turnover
• administrative overhead
• utilities
• Contract services (landscaping and such)

You can bucket them however you want but you should have all of these in the calculation.  On top of this you will need to figure in $250-300 per unit per year for the capital improvements.  Perhaps you don't need them now, but you will have them at the ready when you do.

Once you calculate a number for your area, you can use that number repeatedly as your rule of thumb.  The biggest things that vary property to property are insurance, taxes, and utilities.  So you will want to get actual quotes/numbers on these items while you are under contract.

Joel Owens · Answer

It's a decision you have to make.

Lenders will require a certain amount of reserves on a loan that you may feel adequate or not enough for your personal comfort level.

The choice to plow additional cash into purchasing properties rather than holding for excess reserves is your decision based on interest rates, what cycle the market is in, etc.

If great deals abound then for me I want to try to get as many as possible while in the initial cycle recovery. If the market is tapped out and values are high I want to hold the cash rather than overpaying or look at a different asset class in a recovery cycle.

Joe Fairless · Answer

@josh

@Josh Michelif you're buying brand new multifamily construction then it would be high depending on the amenities. That would likely be around 40% - 45%.

On the other end of things, the 50% might not be enough. I've seen (and have) properties that are higher than 50% expenses, at least initially.

Steve Olafson · Answer

You can lump turnover into the maintenance bucket if you want for simplicity.  Different models will have different numbers.

If you hire a contractor to do all your maintenance, you will pay more.  If you hire a management company that charges you for maintenance and they mark up the costs, you will pay more.

If you do the work yourself or figure out a way to get the work done in-house, you would likely pay less.

This is why I said experienced investors use this model.  Because they have already been doing it and know what it will cost them.

I have a maintenance person that handles all my properties.  He is paid by the hour and works full time.

You need to figure this out for yourself.  There is data out there that tells you what the averages are for expenses in a given location.  I have not had to reference that in a long time since the projects that I work on are all local.  You might be able to get some of this data from the local apartment sales specialists.  Most of those agents have that data at their fingertips.  Be careful here though as they want to sell properties for as much as they can.  They tend to use numbers on the low side.

Josh Michel · Answer

@Steve

Not to highjack my own thread, but your breakdown leads me to another question I've never been truly sure how to factor in.  Certain of those expenses I know cold, taxes, management, utilities, etc.  Others, like maintenance costs I haven't figured out how best to work into my numbers.  It seems I'm always overestimating them, which I do to be cautious, but I find that a baseline is really difficult to locate.  How in your experience do you go about estimating that number?  To a lesser extent I have the same question about turnover.

When is the 50% rule inaccurate?

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