The 50% rule is wrong!

[Kirk B]

Or is it just incomplete?

House 1:
Units: 2
Gross Rents: $1,000
NOI: $500
CF: $100*2 units = $200/m
P+i=$300/m
Max Offer @ 7% i = $45,092.27

House 2:
Units: 2
Gross Rents: $1,000
NOI: $500
CF: $100*2 units = $200/m
P+i=$300/m
Max Offer @ 7% i = $45,092.27

They are both fully rented/rentable.

House 1 is a much larger house in a worse neighborhood (think "hood" not "warzone"), and in decent shape. Painted wood or vinyl siding, hardwood floors, decent kitchen and bath, decent moldings, sound structure, and seperate utilities.

House 2 is ugly and in bad shape but in a very nice blue collar area. Crappy asphalt or abestos siding, crooked uneven floors with old hardwoods, baths with 12x12 self adhesive vinyl flooring and claw foot tubs, kitchens with about 5 SF of total countertop space, ok moulding, some walls are paneled over, ceiling height may be low in some areas.

Which house is better?



Long story short: The 50% rule does not adequately address property condition and location. Here is an example: two houses with equal rent, one is in bad neighborhood but good condition, while the other is in a better neighborhood but bad condition. Which house is a better deal? Which would you buy?


I hope that this thread stimulates debate over how to properly incorporate property condition into the 50% rule.

[J Scott]

Originally posted by John Hostetler:

Sure, I'm sure it's old to you, but it sure would be nice if someone could simply answer the question of why a 4-plex (or an entire stable of 4-plexes) renting for $4,000 has higher expenses over time than a similar 4-plex(s) renting for $1,800?

The answer is simple supply and demand...

People need to stop thinking of it as "a certain rent will generate a certain amount of expenses."

It's actually the other way around: A certain amount of expenses will ultimately determine an equilibrium point in market rents.

Let me put it another way...

Let's say I buy a rental in an area where there are no rentals. I charge $3,000/month for the rental (making a fantastic profit), and given that I own 100% of the rental properties in the area, I'll probably find a renter (there is no competition). Then, along comes another landlord who buys a property in the same area. He determines that he doesn't need to be as greedy as I am, and can make a great profit renting at $2800/month, so he does. All the renters flock to him.

As each new landlord and property enters the market, the rent is going to continue to drop -- more supply is causing less demand, and the new landlords don't care about making exorbitant profits, just making decent cashflow and keeping their properties filled.

Add a couple hundred more landlords and a couple thousand more properties in the area, and the rental rates will drop to the lowest point where the typical landlord and typical properties can make a small but sufficient cashflow and return on their investment.

This is the equilibrium point for rents in the area (what is known as "market rent").

Now, if you do the math backwards, you can easily determine that to make a small but reasonable profit on a typical rental with typical financing, you need to set your rental rates (gross income) at about twice the operating expenses. Or in other words, at market rent, operating expenses will tend to be somewhere around 50% of gross income.

I'm not saying it's 50% on the nose. It may be 45%, it may be 55%, and in some cases, it may be much higher or lower based on a specific investment or market. Here are some things that might affect the actual OE:

- A market where supply and demand haven't reached equilibrium because there aren't enough rentals or because of rent control.

- An investor that picks up a great deal and rents it far below market.

- Interest rates at excessively low or high points (when the cost of capital is lower, it takes less income to generate the same cashflow and/or return and vice-versa).

That said, given the law of supply and demand, and given the basic math behind determining cashflow, market rent (the equilibrium point) will tend to run somewhere in the 45-55% range in most markets and at most times.