How do I verify 50% rule?

Question

My goal is to purchase a multi-family and owner-occupy one unit. This will be my first home purchase. I've been using the 50% rule up until now to get an idea of what the CoCR would be, but I'm seeing some huge differences in property taxes zipcode to zipcode. E.g., one lists ~$6k for property taxes, while another lists ~$2k. That comes out to ~$300/mo difference in monthly operating expenses. How do I account for that?

I think the 50% rule is supposed to take property taxes already from some other posts I've seen (https://www.biggerpockets.com/forums/52/topics/163...). I figured I could just do a breakdown on per property on items such as property tax, property management (10%), vacancy rate (based on city averages).

I'm getting stuck on how to estimate capital expenses though. One approach I was considering is taking the full cost for replacing the furnace, roof, etc. and calculate a monthly cost.

Is there another way I could estimate this? Is this worth the time?

Ned Carey · Answer

@Benny Ng the 50% rule is a crude rule of thumb. It is helpful in quickly screenwriting deals. But you need to understand the rule. it says

Over a portfolio of properties, over a period of time, your expenses including vacancy and capital expenses will be about 50%

Shorter term or for a specific property the number can be less or more.

The ideal way to calculate capital expenses is make a chart of all items in the property that can wear out. Figure how much to replace each item. Figure how many years of usable life left. Divide the replacement price by the number of useful years left and that is how much to put aside for that item.

Example; a water heater is $600 installed. It will last 10 years. That water heater is costing you $60 a year if new. However if it only has 3 years life left you better plan on allocating $180 a year for that item.

That is a lot of work but that is the proper way to do it. I figure $1,500 a year for both repairs and capital expense on a townhouse in Baltimore. If I don't spend that much in repairs it goes towards future capital expenses.

Michael T. · Answer

@Benny Ng the 50% rule is not necessarily a rule but a guideline to be used.

Every market, every purchase, every SFR or multi-unit is going to be different, however, if the initial analysis passes the 50% rule and you're making money well then you can continue on.

Once it passes the 50% rule you can dive in deeper to taxes, capex, etc.

Ned Carey · Answer

@Benny Ng

Do you typically calculate similar capital expenses from comparable units, even if the age of the items differ?   Do you calculate it to hit the replacement date on the item, like in your water heater example?

All my units are row houses (townhouses) in Baltimore built in about 1935 though 1955. I just use the $1500 number for everything.  We are buying so inexpensively and the cash flow is so good is doesn't have to be that accurate.  We know our model works.

No I do not make up a chart like I described .  This is the professional way to do it but I bet perhaps 1% of SFH landlords do it. I bet most multi family landlords don't do it. I learned it from someone who worked for a large property management company. They managed the HOA I lived in at the time. He said when an HOA does an annual budget and have a line for reserves, that is not just a  random number for a rainy day, that is carefully calculated as I described.  large professional organizations do it. That average landlord managing themselves do no.

I will add to my original comment. You did not mention the size of multi family you are talking about.  Large mutifamily buildings can run anywhere from 40% to 60% expense ratio.  Member here @Joel Owens here has mentioned that in large part has to do with whether the landlord is paying for utilities.

If you are buying a significant property there is normally a due diligence period. During this period you get copies of actual expenses from the landlord including tax returns.  You then use verifiable expenses to analyze the property.

Russell Brazil · Answer

Its just a rule of thumb. Some properties may have operating expenses much high, others spot on, others much lower.

Any individual property should be fully analyzed and underwritten to give a good idea how thay particular property will perform.

Justin R. · Answer

You underwrite the deal.......Which is what you should be doing on every investment opportunity.

Brian Ploszay · Answer

A side note when buying a multi-family:  I find most brokers who estimate expenses in their marketing materials are frequently off.  So don't trust any information as accurate.  Verify yourself and add back expenses that are not mentioned in their sales analysis.

Benny Ng · Answer

Thank you all for the information. It has really cleared that up for me. I'll make my next step by diving deeper into per-property basis expenses for my analysis!

Benny Ng · Answer

@Ned Carey I see, that makes sense. It sounds like my next step would be to start itemizing these capital expenses. I was getting worried that my quick calculations would make some of these properties in the higher-tax area seem more profitable than comparable ones in lower-tax areas.

Do you typically calculate similar capital expenses from comparable units, even if the age of the items differ?

Do you calculate it to hit the replacement date on the item, like in your water heater example?

How do I verify 50% rule?

Most Popular Reply

Over a portfolio of properties, over a period of time, your expenses including vacancy and capital expenses will be about 50%