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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?
This, I think, is Jon's point about zero appreciation. At 4%, money loses half its value every 18 years. So doubling in price every 20 years is effectively zero increase in value.
Originally posted by Matt T.:
This, I think, is Jon's point about zero appreciation. At 4%, money loses half its value every 18 years. So doubling in price every 20 years is effectively zero increase in value.
Exactly. Doubling every 20 years is a 3.53% annual appreciation level - about the same as long term inflation.
That is, houses have no appreciation in real value, but they do in nominal. Appreciation to keep up with inflation may be good enough, however, combined with other things like principal paydown and leverage.
Originally posted by Joe O:
Ahhh, but you're forgetting the beauty of leverage. Sure, if you pay all cash for a house and it only doubles in value after 2 decades, big deal. But what if you only put 20% down (or LESS)? What's your return then???
This has been interesting. The discussion started with estimating expenses on rental properties at 50% of income.
I use this as tool for deciding whether to look further at a property, then use a spreadsheet I modeled from the CCIM APOD. This allows me to take specific differences into account, such as heat.
As for appreciation, rental properties do more than provide appreciation. They provide cash flow, appreciation, tax savings (depreciation), and equity build up as your tenants pay your mortgage. When you add that to leverage, as Mitch Kronowit points out, you can't beat rental properties for long term wealth.
Originally posted by Ann Bellamy:
I use this as tool for deciding whether to look further at a property, then use a spreadsheet I modeled from the CCIM APOD. This allows me to take specific differences into account, such as heat.
As for appreciation, rental properties do more than provide appreciation. They provide cash flow, appreciation, tax savings (depreciation), and equity build up as your tenants pay your mortgage. When you add that to leverage, as Mitch Kronowit points out, you can't beat rental properties for long term wealth.
Glad I'm not the only one confused by the conversation :)
The 50% "rule" has nothing to do with making an appreciation play versus a cash flow play. Those would be more geared towards the 2% rule or the CoC metric. Not sure how we got from a discussion on expenses to a discussion on appreciation as they aren't related in any way.
As to the OP... I use the 50% rule as a conservative estimate. With how low taxes are out here I figure I'm on the safe side of that number. My target market is fairly small so the fixed expenses like taxes, insurance, etc stay pretty consistent. At the end of the day, it generally falls back to a rent as a % of purchase price comparison. Of course with my limited capital, I'm also looking at opportunities to buy equity.
#4 Off Topic Contributor
- Investor
- Round Rock, TX
You get there because the next "logical" step in the analysis is to summarily discount any property that does not "cash flow" when you assume 50% of gross potential rents is consumed by expenses in the long run. I'm with the folks that say this is a nice estimate or rule of thumb and nothing more. To model a project you need a spreadsheet or something to perform the rote calculations, a few key pro forma assumptions like economic vacancy and rent levels, and the timing of major expenses. You can then run these through an IRR calculation that accounts for the time value of money and come up with a figure to base your decision on.
Originally posted by Bryan Hancock:
If your exit strategy includes selling, you're right. If you're a buy and hold forever type, the evaluations are quite a bit simpler.
#4 Off Topic Contributor
- Investor
- Round Rock, TX
How so?
If you buy-and-hold forever you have to make estimates for extremely distant cash flows and what the key variables will be. If your exit isn't until your death or until your basis steps up when you will the property to our heirs that analysis is much more complicated than a short time horizon.
Originally posted by Mitch Kronowit:
Originally posted by Joe O:
Ahhh, but you're forgetting the beauty of leverage. Sure, if you pay all cash for a house and it only doubles in value after 2 decades, big deal. But what if you only put 20% down (or LESS)? What's your return then???
If you're at break-even, or positive cash flow, you essentially don't pay anything for the interest while you're paying down the home...so you're getting a much larger return on investment.
Even with a slight loss this is true in many cases.
Originally posted by Bryan Hancock:
If you buy-and-hold forever you have to make estimates for extremely distant cash flows and what the key variables will be. If your exit isn't until your death or until your basis steps up when you will the property to our heirs that analysis is much more complicated than a short time horizon.
That's why my focus is on properties that cashflow now, and make sure that I maintain enough equity (by buying right) that, if say 10 years from now, selling *should* be an option if I choose to do so if the benefit of keeping for cashflow is no longer there.
#4 Ask About A Real Estate Company Contributor
- Rental Property Investor
- memphis, TN
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#4 Ask About A Real Estate Company Contributor
- Rental Property Investor
- memphis, TN
I do not use the 50% rule for purchasing decisions, but am aware that over time, the annual cost of owning a long-term rental will fluctuate. A lot of the cost depend on what work is done on the property (are you deferring maintenance), management (are you managing or paying a manager) and even the question of leverage which Mitch Kronowit brought up. In the end, I assume between 30% and 40% of gross rents will go to upkeep of the portfolio yearly when I own them outright after 15 years. If I am happy with the numbers on the property, then I purchase it. If not, I don't.
- Chris Clothier
- Podcast Guest on Show #224
Interesting article in the "REI Voice" by Tom Wilson, a multiunit investor. He talks about how different multis are: "there are many more variables and expenses than in 1-4s including utilities, landscaping, contract maintenance, on site maintenance, office management, tenant profile, advertising, government inspections and requirements, and more."
He goes on to say a sellers proforma "should for the most part be disregarded. True expenses are seldom less than 50-60% of gross income," (anything) "otherwise be suspect."
He believes in the future more people will want to rent single family and the best bet is a portfolio of sfhs because more displaced people are used to living in a home, not apartment.
#4 Off Topic Contributor
- Investor
- Round Rock, TX
Originally posted by Joe Smith:
Of course getting both is the goal, but you generally sacrifice one for the other. This is especially true in many primary markets where prices are bid up and supply lags demand.
The ultimate goal should be a growth in equity over time. Many people don’t need that equity to be in the form of cash given how their portfolios are structured and how much money they make from selling their human capital at jobs or other small businesses.
Unfortunately, there are no properties that would fit the 50% rule but there is plenty of money being made. Don't get me wrong, I keep the 50% rule in mind because there is a lot of validity to it but I do my best to find way to mitigate that 50% ie managing the property myself, negotiating deals with contractors, plumbers, and electricians, and perhaps purchasing property that has had the critical and expensive parts updated recently. I basically add what needs to be done in the next 5 years to the PITI to see where Im going to be.
I also have a combination of 15 and 30 year mortgages to balance the cash flow vs. principal pay down. In other words, if I have a property with plenty of equity and a very low 30 yr payment which has tremendous cash flow, I feel like it almost helps balance out the next property if the cash flow is a little tighter but its on a 15 year mortgage.
The catch is that there is literally 0 vacancy and no forclosures in my market so I don't know if anybody will be able to relate to my situation but I have actually found that this is a fairly good market to get started in because while Im not swimming in money, I know I have good renters every month which keeps things very consistent.
I realize Im cutting it a little close but the surplus of renters has enabled me to get into a number of different homes by releveraging the equity from the properties that are on a 15 year mortgages and it has actually worked out fairly well and could now bank roll just about any major occurance. Fingers crossed.
Originally posted by Mitch Kronowit:
Originally posted by Joe O:
Ahhh, but you're forgetting the beauty of leverage. Sure, if you pay all cash for a house and it only doubles in value after 2 decades, big deal. But what if you only put 20% down (or LESS)? What's your return then???
Am I? Or did you forget to finish reading my post? ;)
I agree with you, and appreciation that keeps up with inflation can be plenty.
This has been a good, thought-provoking thread.
One thing that seems to get overlooked in real estate investing, IMO due to the difficulty of estimating it, is risk. In the financial markets, returns are always looked at in relation to the riskiness of the investment. Stocks have their betas and bonds' cash flows are discounted at an appropriate rate to generate a risk-adjusted return.
While we as real estate investors do (or at least should) consider risk when making our investments, it's tough to quantify. For example, exactly how much more or less risky is an investment in a 3 bd 2 ba SFR in city A versus city B? Or a 3 bd vs. 4 bd house, or a multi where utilities are paid by the landlord vs. by the renter. What's the chance that the city will institute an inspection/fee program that clips your cash flow by 5%? What if the neighborhood gets better/worse and impacts your rents and appreciation? What if your state's budget crisis results in higher taxes and higher unemployment? How do we quantify all these idiosyncratic risks?
We can't, really. As a default, I think we often use our intuition in assessing the 1001 risk factors but I've seen investors just ignore them as well. Some compare levered and unlevered returns as apples-to-apples when obviously the risk profile is different.
Return is a two-dimensional number, but the risk aspect seems to fly under radar in non-institutional real estate investing.
Just one more thing to think about when considering what constitutes a good real estate investment.
#4 Off Topic Contributor
- Investor
- Round Rock, TX
Not everyone discounts risk Tom. Many do choose to completely ignore it though. Those that do this repeatedly will go bankrupt in time.
Some on BP measure their success in terms of number of units owned instead of maximal risk-adjusted return on their equity. Others try to minimize taxes at the expense of additional returns on their equity. This is all quite strange to me, but if you post long enough you’ll see this behavior quite a bit.
Just to try and stay on topic, I will address the response regarding self management and controlling expenses. First, this thread was started with who does or doesn't use the 50% rule.
If u self manage, that takes time each month, some months with more time, some with less. Time is money and I personally don't work for free, do u?
I agree that maenaging costs is prudent and can help your bottom line, but rit will not make a huge difference in cost %, I would be amazed if it resulted in a long term difference greAter than 3-5%.
Secondly, as others have also pointed out, this is not an exact science tool, it is a general rule that all should at least use at the stArt for quick evaluations of cash flow, nothing mire.
To those that say that the 50% rule does not exist, I strongly urge you to reconsider, it does exist just as we exist.
Originally posted by Joe O:
I agree with you, and appreciation that keeps up with inflation can be plenty.
Sorry Joe, I didn't mean to discount your post. We're more on the same page than I made it look. I was just getting a little cheesed at all the math experts out there devaluing the effects of appreciation ("It just keeps up with inflation") without mentioning or realizing the true power of wealth creation in long-term real estate investing involves leverage.
The 50% rule is a good basic guideline to follow but I believe that you always have to look at each situation differently. I always consider the 50% rule but go on a case by case basis.
#2 Off Topic Contributor
- Real Estate Investor
- the villages, FL
I do not use the 50%, never have and never will. Too many variables and scenarios for me. Rich
Keep in mind that there is (or can be) more to buying real estate than a simple house on a lot. When I invest I consider the 50% rule because I don't want to over pay for an investment property.
My analysis of a deal though goes far beyond this. I actively look for properties that have a value play of some kind. I know an investor in the Seattle area doing very well investing in apartments in area that you just can't buy for less than a 5-6 cap. The thing is he has already evaluated how rents can be significantly increased sometimes it's as easy as fixing the management, but most of the time he looks at ways of reconfiguring a property to add value. I've seen properties that he has reconfigured that added 30-40% to the gross potential rent on a building. He usually holds for 3-5 years then sells at a nice profit.
The 50% rule is a simple tool that like Jon says can help you avoid over estimating net profits as a property exists today. A property that I buy will not look the same in 10 - 15 years because I will have made my value play.
