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Updated over 12 years ago, 04/12/2012
Who does not use the 50% rule?
Hello,
Who here does not follow the 50% rule when analyzing/purchasing a property for long term hold? There are a few reasons I can see someone not using it i.e. they are relying on appreciation (not my cup of tea), they look forward to equity build up and loan payoff, or maybe they are seasoned investors that know their maintenance and management keeps at a certain percentage.
I am in Arizona a market that dropped significantly since the boom, and I'm starting to think some investors are buying at FMV simply because they expect appreciation. I don't view it as a wise investment, but hell I could be wrong. I view this as the type of speculation that had everybody and their grandmother buying during the boom. Am I wrong here?
Remember that the 50% rule is a rule of thumb and may be different for each geographic location. In my area, homes that were built before 2000 are considered ancient, therefore, repair costs differ from one area to the next. Our repair costs are probably a little lower than others.
It's a good rule of thumb, but really crunch the numbers to get a realistic expected return.
I don't. I use a spreadsheet that spits out certain numbers. If those numbers are satisfactory, given the type and location of the property, then I'll pursue the purchase.
BTW, the wealthiest investors I've met or read about in California made their money in appreciation, not cash flow. I've said before most of the investors I've heard that don't believe in appreciation either live in flat markets, such as Houston, or simply haven't been in the game very long. Those that began investing in the last 5 years or so have known nothing but a DOWN market. Ask someone who's been in real estate for 15 or more years and ask them about appreciation.
I keep the 50% rule in mind when I am looking at low income rentals. I have several low income houses that I use the cashflow from to purchase properties that I am going to hold for appreciation.
The properties I am buying for appreciation I am mostly looking for mortgage paydown and tax writeoffs. This way when retirement comes around, I can sell my low income rentals and keep my better ones.
I am in Central Illinois where appreciation is not like California so I have to lean a little more heavily towards cashflow. I would love to have the appreciation potential that Mitch has available.
I'm with Ryan and try to stick with the 50% rule on the lower end rentals, here in central Indiana. Appreciation has not done anything for me, but I fall in the "less than 5 years of experience" bucket. I would like to think that appreciation will be a factor in another 10 to 15 years.
Some of my other rentals are newer homes, circa 2003-2005 with decent major components (roof, furnance, etc) and have not come close to needing the 50% rule to make solid cash flow, Yet.
-Jerry
Originally posted by L Gale:
Who here does not follow the 50% rule when analyzing/purchasing a property for long term hold? There are a few reasons I can see someone not using it i.e. they are relying on appreciation (not my cup of tea), they look forward to equity build up and loan payoff, or maybe they are seasoned investors that know their maintenance and management keeps at a certain percentage.
Looking forward to equity build-up and loan pay-off also has nothing to do with the 50% rule.
Here is what you must decide as an individual investor: Are you willing to buy with limited or even negative cash flow for the long-term appreciation and ammortization play? If so, go fo it. If you are trying to build cash flow to live off, then your stratgey can not be the appreciation game, it must be the cash flow game and if so, you would be less wise to ignore the50% rule of thumb.
Originally posted by Mitch Kronowit:
BTW, the wealthiest investors I've met or read about in California made their money in appreciation, not cash flow. I've said before most of the investors I've heard that don't believe in appreciation either live in flat markets, such as Houston, or simply haven't been in the game very long. Those that began investing in the last 5 years or so have known nothing but a DOWN market. Ask someone who's been in real estate for 15 or more years and ask them about appreciation.
They were in at the right time. Appreciation WILL NOT AND CAN NOT return to pre-bust levels for a VERY long time, the financing isn't there, the supply is too great, there are too many delinquent properties that banks just haven't foreclosed on yet, there are too many that banks haven't put on the market, and, in many markets, prices were so far out of line with incomes, it just can't do it again without Option ARMS, etc.
It will be a good 10 years before appreciation in most markets exceeds maybe 3 - 5% annually for more than a year or two (there will be short, sharp blips upward but not sustained, IMHO).
I would agree with that Joe, however, I would also add that this news should not totally turn investors away from appreciation plays.
For instance, Las vegas is a huge depressed market where you can pick up a 3+2 1500 sq. ft. home for around $50k. That is less than 1/2 the cost to build it. Eventually, things will level out and prices will have to get back to at least the cost to build. With that in mind, some areas may in fact have some long-term appreciation plays and some of these areas, like Vegas, also currently provide cash flow so you end up with the best of both worlds . . . IMHO
Originally posted by Mitch Kronowit:
I don't doubt you, but what about the ones that are now flat broke because they bet on appreciation at the wrong time? Do you know any of them? I hate to come off as hating appreciation, but the beginning of my adult life was when the bubble popped so maybe that skewered my thought. Either way it seems like many of you are seasoned investors, and like I said you know what your % is, thus you do not need the 50% rule. Given my timing on getting into investing maybe I can become one of those "wealthiest investors" thanks to bonus appreciation..
I don't use the 50% rule. I think it's value and accuracy is severely overstated by many investors on this forum.
At best it can be used for a fly by evaluation of a property. On any property I'm seriously considering I, like Mitch, run a spreadsheet.
Every property and every region is different. Different taxes, fees, due, utilities, maintenance costs, vacancy, rent rates, and so forth.
Relying on a rule of thumb for something I'm going to sink a large pile of money into is simply too risky when I can spend the 5 minutes to plug the numbers and run a spreadsheet.
Perhaps if you hold a large number of properties in certain regions they average out to 50%, but the properties that I've owned long enough to incur capital costs and average out expenses vary by as much as 30%.
Originally posted by L Gale:
Oh yeah. I know a few people who "bet on the come", i.e., invested like property values would continue going up, up and up, and they got burned real bad when the bubble popped.
I, myself, didn't buy anything between 2002 and 2009. The numbers simply didn't pan out because the values were so high. It wasn't until 2009 that we jumped back into the market and started buying again. No, I'm not an advocate at market timing nor am I very good at it (especially with stocks) but with real estate, the cycles move slower and more predictably, and it's easier to tell when things are ridiculously over-inflated (2005-2006) or irrationally under-valued (now). I believe we're in the latter period and the time to buy has been good for the last few years and will remain so for several more.
We can all agree to meet back here in 10 years (when I plan to take an early retirement) and compare notes. I could very well be wrong and sitting on a bunch of property that hasn't moved anywhere after a decade, but I'm in this to win, not simply make an appearance. That's why I still have a bunch of money in the stock market. Something, somewhere, has to pay off sometime. Either that or we're all screwed. :-)
I consider the 50% rule, but have developed my own tools for analyzing potential deals. Having years of actual numbers in a specific area is helpful when forecasting numbers on a potential investment.
The 50% rule is only a guideline because many things can alter the actual outcome. Obviously if you self manage a property your costs will be different. How a property is metered can change who pays for utilities. Deferred maintenance both before and after purchase can change repair costs. Location can impact costly insurance coverages for earthquakes and floods.
Use the 50% rule as a tool. When you get serious though about a property you really should take the time to know the numbers better.
You'll also want to keep in mind that the 50% rule assumes that you are starting out with "market rents." If you rent at below market rates you may have less vacancy, but you will also have higher expenses in proportion to your rent which over time could easily mean costs are 55-60%.
The 50% rule is an easy way to sort through potential deals. Just don't let it get in the way of doing your due diligence.
The 50% rule is great for doing a (literally) 10-second calculation in your head of whether a property is worth considering further. It shouldn't be used to make a purchase decision, it shouldnt be used as a replacement for due diligence and it shouldn't be considered a pro-forma analysis.
But it's still a great first-pass tool...
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I don't but do, and just like Charles I put a pencil to it for a final decission.
As a lender looking at an application for a NOO, I'd initially look at it with 50%, but then I had to use some other quick judgments as well.
The age, the location (being very familiar with the city helps), type of construction (masonry, wood, siding and amenities involved). From that along with the 50% rule you can get an initial thought as to following through with it and later after the appraisal, fine tune your collateral decission (or holdings).
Just as J mentioned it's usable at first glance.
As you become more familiar with your market, market rents, location, future expansion of the area or perhaps an expected decline in an area, you'll get a better idea of what appreciation to expect.
Someone mentioned speculation, that is not estimating appreciation really, speculation usually hopes for a greater valuation in a short period due to external influences, such as a highway change, a change in zonning, a new market influence such as a large business or public park being located nearby the subject and it generally applies to raw land more than a residence. Anything that can change the highest and best use of a property that can be proven in the market will can yield a rapid change in value, up or down.
The quick ratios 2% and 50% may not be applicable, so you need to know how to drill down the numbers for your pro forma income and appreciation/gains.
I use the 50% rule a majority of the time. However I recently ran into an example where the 50% rule was not aggressive enough. It was with a single family home in Cleveland. While using the 50% rule I showed decent cash flow. WIth the actual numbers the property taxes were just over 25% of the annual cash flow which put the deal in the red.
Use the rules to qualify a property and then do your best due diligence with actual numbers.
Hey Will, could you give me an example of what parts of las vegas you can find homes like this for? Are they $50,000 in decent condition or do they need work? My friend actually just moved out there this week and is wants to start looking at properties to buy and rent as well. Thanks!
"Appreciation WILL NOT AND CAN NOT return to pre-bust levels for a VERY long time."
I agree with this for the most part except for hot core markets.In some of those markets there was a temporary blip and now the markets are starting to increase again at a rapid clip.
The outlining suburban to rural markets is what generally recovers last.In those areas I do believe we are years and years off in some locations from a recovery.
Driving the other day I saw a new homes subdivision sign stuck next to a main road.First one I had seen in 4 YEARS. It was 3/2 ranch's from the low 100's.Height of the market would have seen double that listing price.
So have went from no glimmer of hope in 2009 to seeing some flickers of light in 2012.
Homes in my area had gone from 4/3 at 150,000 to bottom of 68,000 about 6 months ago.Now they are treading at 89,000.It seems to me the banks are holding off shadow inventory until the summer.
The thought is when they release a big chunk on the market the home buyers will be there to gobble up most of the property at decent pricing versus if they released now the banks might have to take multiple reductions to sell.
- Joel Owens
- Podcast Guest on Show #47
As has been said, the 50% "rule" isn't something you follow. You merely estimate/measure your expenses and come up with your own real level of expenses.
Since we are also talking about income vs. appreciation, BTW, they aren't necessarily mutual exclusive, I am moving more and more into the apreciation camp. I have plenty of income properties, some even exceed "the 3% rule" ; ) However, I do believe some areas will substantially beat inflation. Look at Coral Gables, or even Phoenix over the past 12 months. As Will has said, where homes can be bought at way under replacement costs, where population and jobs are growing, where very few new homes have been built in several years, we may see "melt up." I'm working to move into position.
Do you really think we will experience substantial inflation in our economy, but real estate won't participate?
The 50% rule is just a quick and dirty estimate. For any particular property in any particular year its very likely to be wrong. For 20 properties for 20 years, it appears to be likely to be very close.
I can absolutely guarantee you that if you use this rule will do much better than the investor who believe the "cash flow = rent - PITI" lie. That's the absolute best you can do. It might work for some years for some property. But most properties will have SOMETHING that cut's into this "phony cash flow" number.
I have been in the game for a while. I bought my first property in 1987. Of the three residences I bought and sold pre-bubble (last one sold in 1999), NONE had any significant appreciation. If you look at the long term Case-Shiller data, appreciation is a myth. Once you subtract out inflation, there is no appreciation. None. Zip. Nada. Values go up because of inflation.
Now, in any particular area, for any particular short term (i.e, 5-10 years), you may see appreciation, flat prices, or falling prices. If you buy at the right time in an area that proves popular you can make a lot of money. If you buy in the wrong place or at the wrong time, you can lose your shirt. Or worse. Just ask any of the people who are now struggling with an underwater property.
Real estate, whether investment properties (i.e., rentals, nothing else is an "investment") or a residence, does have a savings element. If you buy a house with a 30 year loan and pay off that loan, you own an asset that probably has significant value. Even if you've done nothing in those 30 years (you've been in houses like this, right?), it still has value. The value may well be less than the total amount you've spent, once you properly factor in interest, insurance, taxes, and maintenance. But its still a big, valuable asset. For a lot of folks, that's the biggest contribution to their net worth. Even for a rental owner, it has real value. A free and clear property is likely to generate some cash flow.
The 50% rule is nothing more than a way to realistically consider the downside to owning rentals vs. the "big lie". If you manage a rental yourself and you're lucky and never have any of the big hits like an ugly eviction or a major problem, you'll do better. If you do have those big hits, the 50% rule will look optimistic. But the 50% rule will prepare you for those times when the tenant does move out unexpectedly and you have a month long vacancy and $1000 in make ready costs. Or you have to replace a furnace or water heater.
Originally posted by Jon Holdman:
First off, the 90's were an era of very flat home values. Of course you didn't see much appreciation. And your longest holding couldn't have been more than 12 years (87-99), what I would consider the LOW-end of long-term investing. We normally start buying real estate in our 20's and 30's, then retire in our 50's or 60's. That's a 30-40 year window for realizing appreciation.
Second, looking at the Case-Shiller index for evidence of appreciation is like looking at the S&P 500 index and concluding no single stock ever returns more than 10%. When I buy a piece of property, I'm purchasing one home, not shares in a broader index. In South Orange County, homes that sold brand new in the 70's are now, roughly, worth 20 times more, POST-bubble. Have salaries and wages increased by the same amount since then? If so, I'd be earning around a cool $1 million per year. Hot damn, I'm getting screwed.
There's more to account for the increase in values than simply inflation. Homes just across the street from each other can experience significant differences in values, so imagine how much houses clear across the country can differ.
Originally posted by Will Barnard:
For instance, Las vegas is a huge depressed market where you can pick up a 3+2 1500 sq. ft. home for around $50k. That is less than 1/2 the cost to build it. Eventually, things will level out and prices will have to get back to at least the cost to build. With that in mind, some areas may in fact have some long-term appreciation plays and some of these areas, like Vegas, also currently provide cash flow so you end up with the best of both worlds . . . IMHO
Good point, I keep forgetting about Vegas.
I will also say that the "appreciation" potential with buying right and rehabbing is of course still there, I was simply saying that the "buy at market, do nothing, and wait" method won't work for a while, with the few exceptions such as you mentioned.
Originally posted by Charles Perkins:
The 50% rule is only a guideline because many things can alter the actual outcome. Obviously if you self manage a property your costs will be different. How a property is metered can change who pays for utilities. Deferred maintenance both before and after purchase can change repair costs. Location can impact costly insurance coverages for earthquakes and floods.
Use the 50% rule as a tool. When you get serious though about a property you really should take the time to know the numbers better.
You'll also want to keep in mind that the 50% rule assumes that you are starting out with "market rents." If you rent at below market rates you may have less vacancy, but you will also have higher expenses in proportion to your rent which over time could easily mean costs are 55-60%.
The 50% rule is an easy way to sort through potential deals. Just don't let it get in the way of doing your due diligence.
My duplexes are all newish (post-1980) builds, and overall I average 43 - 48% expense ratios for the lifetime of the time I've owned them, but since putting more money in them at the time I purchased them, my annual the last few years has been closer to 40%, simply because almost anything that can break has already been replaced. Still, being conservative, I use 50% as an initial guideline.
Originally posted by Mitch Kronowit:
Originally posted by Jon Holdman:
First off, the 90's were an era of very flat home values. Of course you didn't see much appreciation. And your longest holding couldn't have been more than 12 years (87-99), what I would consider the LOW-end of long-term investing. We normally start buying real estate in our 20's and 30's, then retire in our 50's or 60's. That's a 30-40 year window for realizing appreciation.
Second, looking at the Case-Shiller index for evidence of appreciation is like looking at the S&P 500 index and concluding no single stock ever returns more than 10%. When I buy a piece of property, I'm purchasing one home, not shares in a broader index. In South Orange County, homes that sold brand new in the 70's are now, roughly, worth 20 times more, POST-bubble. Have salaries and wages increased by the same amount since then? If so, I'd be earning around a cool $1 million per year. Hot damn, I'm getting screwed.
There's more to account for the increase in values than simply inflation. Homes just across the street from each other can experience significant differences in values, so imagine how much houses clear across the country can differ.
In some markets, yes, you're right...but then there's that other problem, which was that incomes weren't keeping up with appreciation, which was one of several reasons for the bubble bursting to begin with.
I for one use a worst case with 55-60% of expenses.
Here you can run long terms with some lucky events - incomelike.
-Uwe
Originally posted by Joe Smith:
My duplexes are all newish (post-1980) builds, and overall I average 43 - 48% expense ratios for the lifetime of the time I've owned them, but since putting more money in them at the time I purchased them, my annual the last few years has been closer to 40%, simply because almost anything that can break has already been replaced. Still, being conservative, I use 50% as an initial guideline.
This makes sense. If you're postponing your capital costs far into the future (which you do when you rehab extensively upon purchase), you should expect total costs well below 50% for many years. Of course, 10 years down the road when you replace the water heater, and 20 years down the road when you replace the roof, HVAC system and exterior paint, you can expect a couple years where total costs will FAR exceed 50%. These average out...*probably* somewhere in the *vicinity* of 50% for many of us on many of our houses... :)
"Appreciation WILL NOT AND CAN NOT return to pre-bust levels for a VERY long time."
I would question this statement. First off, if you mean pre-bust during the boom, then, no, appreciation will probably not return to that level in a long time.
However, if you look at the last 100+ years, I believe there is one constant number that will be returning - houses double in value every 20 years.
I'm 41 now and have 15 properties - all bought in the last 4 years. I'm counting on them doubling over the next 20 years. So when I hit 60, I'll have 20 or 30 houses all paid off and all worth twice what they're worth today. (Well, at least the ones I own today).
To me, if you're looking to hit the historical numbers for appreciation, I don't think you'll be too far off - provided you give it the 20 years.If you're looking for appreciation is the 7 or 8% range, then you better be incredibly good at picking an individual market as the numbers, historically speaking, don't support that kind of logic.