50% rule = golden rule??

General Real Estate Investing
1

I’ve been looking for my first deal.
Planning to buy and hold until the market improves. (I’m really interested in rehabbing/flipping) So I’ll be landlording for a little while.

I’ve found several properties that seem to be a really good deal, but they fall a bit short of the 50% rule. If the rule were 65-35 I think I’d have two properties by now and if I pushed it to 70-30, I’d have found several I think.

Do experienced investors stick to the 50-50 rule all the time? Would it be a bad idea for me to take a chance on something that falls short?

Thanks for the advice…

2

Neg,

The 50% Rule is nothing more than a restatement of the data that throughout the United States, operating expenses run 45% to 50% of gross rents. You can use 65-35, 70-30, or even 90-10 - whatever you like. However, that isn’t going to change the REALITY of your expenses. Paying too much and not having positive cash flow is the number one reason that the vast majority of new landlords fail.

To answer your question, why don’t you tally up the typical expenses for your area as a percentage of gross rents.

Taxes
Insurance
Management
Maintenance
Vacancy
Advertising
Entity Maintenance
Legal Fees
Evictions (court costs and setout fees)
Capital Expenses (not technically an operating expense)
Damage done by the tenants in excess of the security deposit
Utilities paid by the owner (at least during vacancies)
Lawsuits

Just put the expenses next to each category and see what it adds up to.

Mike

3

Neg - I am in a similiar situation. I am looking for my first deal. The difference is that I am planning to hold it for the long term (not only until the market improves). Right now I am stiking to the 50% rule.

There is another thread around Home Warranty in this forum. In there, Bluemoon said he usually includes a clause that the tenant will be responsible for the first $300 in repairs. I would imagine that this would help hold your expenses down as most repairs would be done by the tenant. It still wouldn’t take care of other expenses like vacancy, advertising, etc…

The other thing to consider is that property management is also included as an expense. If you are planning to do it yourself you can actually save another 10% - the rest of the expenses would run approximately 40%. The risk here is that you may end up having to work (do the property management) without being paid for it. It may be ok for your first deal because you would be basically learning…

Having said that you need to decide for yourself if you want to take the extra risk of buying a property that doesn’t fit the 50% rule. The way I see it, this is a risky business. The 50% rule helps you analyze the deal and reduce your risks (not eliminate them - you may still end up belly up even if you follow the 50% rule). If you decide to go ahead in a deal that doesn’t fit the 50%, than you need to understand what are the added risks and feel comfortable with them…

So back to your deals - are you sure you can’t improve one of the 65%-35% deals you found to be closer to the 50-50? It may be worth a shot… :O)

Good luck!

4

Neg,
I think you have to have a specific criteria for the properties you purchase. That includes everything from the type of property to the amount of profit. I think this “roadmap” will help to keep up us from talking ourselves into buying property that doesn’t fit our ultimate goal. Like propertymanager said, The 50% rule provides a good guideline that includes the unexpected and sometimes difficult to estimate costs of operating expenses. I think you’ll find that the 50% rule is very accurate. Good luck.

5

If I were you I’d STICK TO IT!!! Being a newbie, take it from people like propertymanager who’ve been there, done that. ESPECIALLY for your first deal, you want to be making money monthly, it will just make the learning process that much harder if you aren’t making money in spite of the unexpected.

I know you’re excited and you want to take action, but hang in there till you get that first real DEAL, it will make your life a whole lot easier, and you won’t become one of the failed first time landlords.

6

Neg,

The “50% rule” is a rule of thumb. It is not an absolute number for every property. In the absence of actual operating expense numbers for a property you might consider adding to your rental holdings, use 50% of gross rents to estimate your operating costs. If the other 50% of gross rents leaves enough left over to pay your debt service and leave you enough cash flow, then you may want to take a closer look at this property.

When you take the closer look, you will do a detailed cash flow analysis. Get actual amounts for all the operating costs you are likely to have for that property. This means you will have to do some homework.

Get quotes from the insurance company for rental dwelling policy. Look up the property tax record and see what the current property taxes are. Ask the tax assessor’s office if the property is scheduled for a reassessment anytime soon, especially if transfer of title triggers a reassessment.

Talk to property management companies about management costs and market rents for that property. Ask about their experience with the vacancy rate and eviction rate for similar properties the company manages in the same neighborhood. Is there an HOA and what is the monthly assessment?

What is the age of the property? Are major systems (such as roof, HVAC) and appliances at or near the end of their life cycle? What is the age and condition of carpet and vinyl? What is the replacement cost for each of these things? How much will you need to contribute to a replacement reserve each month to handle the replacement costs when they come up.

Once you get real numbers or accurate estimates for your operating expenses, then you can make an informed purchase decision.

7

Dave - after all this analysis do you typically find properties with expenses below 50% of rents? Just curious to understand your real life experience… Thank you for your post… Have a nice evening!

8

Sometimes lower, sometimes higher. Property taxes, hazard insurance premiums, and HOA fees are the most likely items that push operating costs above 50%, especially if the rental market is soft and market rents are low.

It is the detailed cash flow analysis that tells me if a property I am considering for my rental portfolio will be a positive income generator and whether the income is sufficient to sustain the property. If the detailed cash flow analysis keeps me from making investment mistakes.

Once I have purchased a property, it is another story. Even if the operating expenses started out lower than 50% for a specific property in the current rental market, they don’t always stay lower. Over time, expenses go up. Large property tax increases due to reassessment is not uncommon. Some resort area properties have seen hazard insurance premiums quadruple in recent years. When rental increases can’t maintain pace with the operating expense increase, then you reach or even exceed 50%.

In two rental markets I am in, the soft rental market has made vacancies longer and has forced me to lower my rents to fill vacancies. I have waived rent increases in extremely soft rental markets to reduce turnover, but my operating costs still increase. This year my operating costs are running closer to 54% of collected rents.

I can’t control some costs, but I can manage the impact of other costs. Maintaining my property in top condition and making all repairs in timely manner helps keep small problems from escalating into big repair bills. Regular and routine property inspections help. Good landlord tenant relations, multiyear lease options, and keeping my rents below the top of the market all help reduce turnover and my vacancy rate.

9
This year my operating costs are running closer to 54% of collected rents.

Wow Dave, you sure know how to throw a wet blanket on things. I’ve just about been tarred and feathered on many occassions for daring to say that throughout the United States, operating expenses run 45% to 50%, and then you say that yours are running 54%!!!

Over time, expenses go up.

What? I’ve never read that from any of those “gurus”. The standard guru line is that you can buy a negative cash flowing property today because rents to up over time. I’ve never heard the “gurus” say that expenses go up!

In two rental markets I am in, the soft rental market has made vacancies longer and has forced me to lower my rents to fill vacancies.

What? What? Expenses can go up and rents can go down? Are you sure that you don’t have that backwards??? That doesn’t sound like a lot of fun.

In all seriousness, DAVE IS 100% RIGHT! Things aren’t always rosey like the gurus portray. If you’re in this business over time, the rental market will be good and the rental market will be bad. THAT IS WHY IT IS ABSOLUTELY CRITICAL THAT YOU BUY AT A BIG DISCOUNT! You’ve got to be able to survive is all the different market conditions if you’re in this business for the long haul.

Mike

10

I bought a 4 unit property 9 years ago and have never been able to raise the rent at all on any of the units. I didn’t buy at a deep enough discount so my cash flow has always been considerably lower($75 per unit) compared to my other long term holdings. I average between $125-$150 on my other units so don’t count on rent increases ever. This is a building that is only 15 years old so expenses are still fairly low and tenants pay all utilities. Buy low or you will not survive. If you can’t get it low, walk, there are PLENTY of deals out there right now that cashflow nicely.

11

I have had the same experience. In 1986, I bought a bank REO in OH for $34K with 80% financing and $450 monthly rent, my cash flow was around $55 per month. I thought, no problem, rents will increase over time and improve my cash flow.

I was younger then, relatively inexperienced with only a couple of other rental properties. Mike’s book was not written yet, and I had no mentor looking over my shoulder. The prevailing guru thinking at the time was, “If the cash flow is only $50 per month, buy 99 more. Then your cash flow will be $5000 per month.”

I owned that property until 2001 when I sold it to my tenant. I was never able to increase the rents because the market would not bear it. Fortunately, property taxes and hazard insurance premiums stayed fairly stable so my cash flow was consistenly around $50 per month. And it stayed that way for the entire 15 years I owned the property.

By the time I sold the property, I had used all 15 years of cash flow for major repairs (mainly roof replacement and some structural stuff). I did make a little profit from appreciation but by the time I paid the realtor’s commission and some closing costs, I was breakeven or maybe just a little ahead. Thank goodness I bought at a good enough price to begin with, or this property would have been a losing proposition.

Since Mike (propertymanager) is an OH investor, I bet he can also relate to my experience. I bet his knowledge came from the school of hard knocks and only through his experience has he developed the investment criteria he uses today. I know this is true in my case.

12

[[…Do experienced investors stick to the 50-50 rule all the time?..]]]

I never buy by the 50% rule. It’s not possible in my area. If I get $100,000 off the price and make a huge down payment, I consider myself lucky if the rent will pay the mortgage.

However, I can assure you that over time, your expenses ARE going to run about 50%. So if you are not going to buy by the 50% rule, you’d better be darn sure you know what the expenses are going to be and where the money is coming from to pay for it.

I always buy for the property’s potential for appreciation. I’m in a market where appreciation can be counted on— when we are on the up-cycle. That makes real estate in my area a long term game. There’s some “wait” in the hold and wait.

There are a lot of expenses with rentals that are completely out of the landlord’s control, and that means they are difficult to budget for.

The county raises taxes without my permission, the insurance company raises my rates without consulting me.

I have a house in one neighborhood, where the owners were able to fight off the city’s plan to charge us each $30,000 for a new sewer system. OK good, but the city then started to bill us $30 a month for “storm water management”. That’s coincidentily exactly the same amount they charge each month for a sewer fee. And believe me, no one asked me if I wanted to pay it and I am getting exactly nothing in return. The nearst storm drain is miles away, and my rain water isn’t getting anywhere near it.

Tenants move out when it is inconvenient. Sometimes it takes a long time to find a replacement tenant.

You can cut down on tenant damage by careful screening, but occassionally a bad one sneaks through, or a good one goes bad, and damage can cost thousands of dollars.

Remember, your income is coming from someone who is incapable of balancing their own checkbook. Sometimes tenants are late and sometimes they just stop paying. It takes awhile to get them out. During that time, your expenses go up and your income goes down.

13

Sorry I haven’t followed up on my thread until now.
Family vacation, then family medical problems.

Thank you all for the info. I truly appreciate all the advice and info you have shared. I was forced to take a long break from deal hunting this summer, but I’m getting back into it now.

Thanks again!