Is simply applying the 50% rule running the numbers? In other words, can I simply calculate what my P&I will be and as long as it's 50% or less of the expected rent, then the deal has potential? Can this replace other, more in depth methods of running the numbers such as calculating the cap rate and CCR?
Also, how does a down payment play into the rule? It seems that in a small down payment scenario, the numbers might not work, but they would work in a higher down payment scenario since the monthly debt service would be lower. Why would the latter higher down payment scenario get the green light, but the former lower down payment scenario get the red light since the down payment is still an expense that comes out of the investor's pocket? It seems like it should play into there somehow, but I'm not sure how since I haven't read anything that mentions where the down payment comes into play with the 50% rule.
A bigtime ditto for what everyone has opined. . .
. . .and here is my further, 0.02:
It is a screening tool, and helps me to ball park what the property is really worth.
I use it as a benchmark against a bloated and ridiculous asking price, as well as lowball cap rates.
Also, I bump it to 55-65% when Im researching distressed and C-level properties, and 40-50% for AAA properties.
Remember we are buying real estate not for the view, or how pretty it is. We are buying for the pure math of passive revenue generation and CASHFLOW.
If you overpay for a property that you dig into your pocket each month to afford. . . it doesnt get better, even with appreciation.
Bottom line:
Use it as a benchmark to answer the question: ". . .will I make money when escrow closes?"
Tevis
ok, just wanted to get into this question. 1. what do you mean 50% rule when talking about commercial? I am assuming you mean commercial because your talking about cap rate.
The 50% rule is a "rule of thumb" used as a screening tool when evaluating the cash flow a property.
It holds that, averaged over the long term (several years), 50% of the gross income will go towards paying the non-cost of capital expenses. Some months will be less than 50%, some will be more (much more), but it will average 50%.
Some obvious expenses are repairs, taxes, insurance, advertising, management fees, etc. Some not so obvious expenses are the cost of vacancy, legal fees, etc. The 50% can be adjusted for your particular circumstance. For example, if you are going to self-manage, subtract the ~10% manangement cost and go with the "40% rule". If taxes are particularly high in your area, add 5% more and go with the "55% rule". It is just a tool.
After taking 50% off the top of the gross income (rents), you will then have an adjusted gross. Take your cost of capital (mortgage (PI only) out of the adjusted gross. What's left is your average cash flow for the property.
No..all of this said, there are many people on BP with a great deal more experience than I have on explaining this - and I know they will have no problems gently pointing out my errors ;).
Hi,
The down payment is not accounted for in the 50% rule, neither is who pays for utilities. To me, a better name would be the '50% Rule of Thumb.' I don't view it as a replacement for any of the other in depth calculations I make before making an offer, but as a starting point. If it 'passes' the 50% rule, I then look closer.
As far as the down payment goes, one of the other criteria we've been looking at is how long until we might have our money back, including closing costs. This is related to the cap rate, just a different way of looking at the numbers. Obviously the sooner we have our money back the better, but in our market I like to see 3-4 years with our 25% down payment. For this calculation I use the total rent it is currently collecting, PITI, average utility info, and a monthly 'budget' for smaller repairs. For larger repairs, I look at my monthly expected net income, and figure out how long it would take to recoup that expense- for example our first house needs a paint job, that expense will take us about a year to recoup, which adds a year on to the time it takes to get our money back out of the deal.
I have seen some 50% rule modifications on here, for example figuring on 60% for your expenses and 40% for debt service and profit when you are paying for utilities. As far as the down payment goes, maybe it'd be better to look at how the property would perform with NO down payment and 100% financing- if the numbers can still work then you have a deal!
Kelly
I think you've already had some pretty accurate review of the "50% rule of thumb", I personally use it as a quick check of "do I even need to bother" and to keep me from shaving some expenses here and there to justify the deal.
For the down payment I like to use Cash on Cash return, that gives you a % that your actual cash in the deal is earning. COC is (annual total cashflow)/(cash in the deal) so if you have a $1000 down payment and are getting $100/mo in cash flow that might be an ok deal to you and your COC there is 120%.
I feel that you have to evaluate a deal with multiple methods to figure out what you are really earning, obviously if you somehow obtained 100% financing you would be making a phenomenal return on what you have in the deal, but that doesn't necessarily mean you're making money over the long term and vice versa.
Brian W. you had it right at the start. If your PI is less than 50% you have a good chance the other half won't exceed 50% IF you don't have large capital expenses early on.
The only way down payment comes into play is to adjust PI.
Separate your operating expenses then try to estimate your capital expenses for a more accurate estimate once you start looking further.
A bigtime ditto for what everyone has opined. . .
. . .and here is my further, 0.02:
It is a screening tool, and helps me to ball park what the property is really worth.
I use it as a benchmark against a bloated and ridiculous asking price, as well as lowball cap rates.
Also, I bump it to 55-65% when Im researching distressed and C-level properties, and 40-50% for AAA properties.
Remember we are buying real estate not for the view, or how pretty it is. We are buying for the pure math of passive revenue generation and CASHFLOW.
If you overpay for a property that you dig into your pocket each month to afford. . . it doesnt get better, even with appreciation.
Bottom line:
Use it as a benchmark to answer the question: ". . .will I make money when escrow closes?"
Tevis