Clarification of the 50% rule

Anybody who’s been here and done some reading has read all about the 45-50% rule (I’ll use the commonly used 50% figure herein just for simplicity), as follows:

[color=blue]Gross rents minus debt sevice (principal and interest only) minus 50% of rents (for operating expenses) = NOI…This simple formula can be used to help determine if a rental property should cash flow…[/color]

My question revolves around the fact that property taxes and insurance, which are contained in the 50% figure for operating expenses, are also known figures (even though they fluctuate slightly year to year), just as the debt service is a known figure…

Given this, is there a percentage to use just for “other operating expenses” for the following?:

[color=blue]Gross rents minus debt service minus property taxes minus insurance minus other operating expenses = NOI?..If this percentage is determined, it should help to narrow down the unknown (that pesky little 50%) somewhat…[/color]

I read Mike’s (propertymanager) book, loved it, and highly recommend it, and I guess I’m kind of waiting for an answer from you, Mike, more so than others, to see if you ever found this figure?..I know the 45-50% rule comes from actual numbers based on real life national experience as opposed to the gurus who don’t include a lot of the actual expenses landlords incur…

It just makes sense to me that since the taxes and ins. are known numbers and could be backed out separately, just as the debt service is, that somebody should have been able to have determined a separate percentage for the “other operating expenses”…

I look forward to everybody’s comments…

John

John,

Gross rents minus debt service minus operating expenses = cash flow (not NOI).

NOI = Gross rents minus operating expenses.

Cash flow = NOI - Debt Service

I’m sure that’s what you meant to say.

As for your question…you are correct that taxes and insurance are known quantities for a given property in a given year. Therefore, if you want to determine a percentage to use for “other operating expenses”, you would simply need to do the math.

For example, let’s say that the gross rents are \$1,000 per month. Let’s also assume that the taxes are \$100 per month and the insurance is \$50 per month.

Using the 50% rule, the operating expenses would be 50% of the gross rents, or \$500 per month. If the taxes and insurance are \$150 per month, they account for 15% of gross rents. Therefore, all the other expenses would be 35% of the gross rents. I honestly don’t know how this is helpful, but that is how you would calculate it. That does NOT mean that taxes and insurance would be 15% across the country. In some areas, taxes are sky high. In other areas, property taxes may be very low. In some areas (especially hurricane prone areas), insurance may be crazy. In other areas, insurance may be low. The individual expense numbers vary from one market to another. However, the total operating expense figure (45% to 50% of gross rents) is prevalent throughout the United States.

Gross rents minus debt service minus property taxes minus insurance minus other operating expenses = NOI?...If this percentage is determined, it should help to narrow down the unknown (that pesky little 50%) somewhat...

Gross rents minus property taxes minus insurance minus the other operating expenses = NOI. Calculating NOI does not involve debt service.

Hope this helps.

Mike

Some further clarification: The 50% rule does not include fees paid to a management company, correct? If so, is 50% + management fees a good way to eyeball Op expenses?

Thanks,
Cameron

Cam,

The 50% operating expenses includes ALL the operating expense, including management. Basically, the only thing it does not include is the debt (mortgage).

Mike

And when you manage it yourself that 10% +/- that would be figured into the 50% for a management fee goes into YOUR pocket not the pocket of someone else. Same goes for many other fees like cleanout, light rehab, etc. You do the work yourself and you pay yourself. If there are 8 slices of pie I want all 8 or as many as I can get.

When you get to the point that you can’t handle all of your units and you need to pay someone to do some things I suppose taking a small bite of pie is better than not getting any pie. But while you still have a small enough operation to take the whole pie, go for it.

the 50% rule is nothing more than a “rule of thumb” or top down estimate. your actual cost can be significantly higher or lower depending on a wide range of factors. in the end, you need to dig into the numbers to make intelligent buying decisions.

Thanks, all, for your remarks. I greatly appreciate the time put into answering basic questions.

If you are buying a property where the utilities are included into the rent, then I would add this to the process. I think this method is more accurate then just using the 50% rule when utilities are included. I am open to others opinions but this seems more accurate then simply taking the rent by 50%.

SFH for \$50,000 with \$2,400 a year in utility usuage.

\$ 1,000 rent

• 200 for utilities (monthly average for the year).

``````  800 total rent excluding utilities
``````
• 400 (50% rule)

``````  400 Net income
``````
• 350 Mortgage (7.5% for 30 years)

\$ 50 Profit per month for the SFH

See this thread regarding issues with owner paid utilities: http://www.reiclub.com/forums/index.php/topic,32135.0.html

Right…I had the terminology wrong but understand the concept…

I was actually scratching my head as I was writing the post trying to put into words exactly what I meant…I’ve made a lot of money investing in real estate over the past decade +, but have never sat down and run numbers the way that I’ve seen here and also read about in your book…I’ve always “gone with my gut” and fortunately it’s worked out for me (more so due to extreme appreciation than with the 50% rule) but I guess the law of averages always could have caught up with me, and maybe was/is due to by continuing the same way…This is why the formulas/numbers that I’ve read about here really struck a note with me and made me start analyzing them!

So when I looked at the 50% rule including taxes and ins., I was wondering if there was a standard % that could be taken out of the 50% to arrive at a “new” % to use after taking out debt service, taxes, and ins…In other words, not by simple math of backing out my own actual figures, but numbers based on the national averages over time that represent the taxes and ins. that constitute that portion of the 50%…

I guess I could have shortened by post by asking if anybody had a breakdown for the 50%, since it includes so many different expenses, but the scenario is actually that over time, on a national average, 50% for the “group” of expenses is what you should expect, but as aak5454 said, you have to determine if any of your actual numbers (for example, taxes, flood ins, or whatever) are out of the norm and therefore would throw off the 50% figure…

Thanks for all your replies (Mike and others)…

I plead guilty to paralysis by analysis…

:biggrinparty (closest I could find to a dunce cap)

How do you guys recover your initial investment costs such as down payments, repairs…etc. for the rentals?

I assume you guys are investing for the future and not depending on the cashflow, so how do you finance your operations if my assumption stands?

Not depending on the cashflow? Investing for the future? Not me. The cash flow better come in each month or I’d be looking awfully thin. For me, this is a business. I MUST make money or my wife will be mighty unhappy. She has gotten accustomed to inside living, having a nice car, and going on the occassional vacation.

I normally don’t put any money down, so that doesn’t really apply so far. I try to do the initial rehab with cash from my cash flow. On occassion, I have paid cash for deals and then refinanced to get all my money back. I’m doing that right now. I have a doublewide on a full acre and permanent foundation that I’m just finishing. Everything was paid in cash and I’ll hopefully be ready to get my money back in the next few weeks (of course at 50% LTV or less).

Mike

Actually, this highlights a couple things about different approaches. Property manager comes from a “Cash Flow Today” model. It is an excellent model, because it gets you dirt cheap into properties, gives you strong cash flow, and if you do sell in the future than any appreciation is simply juicy gravy. You never have to worry about negative cash flow, and the cash flow is a great stream to finance future investments. It is an extremely conservative approach, which works well.

There are other approaches where purchasing a property is more a goal of buying with zero cash flow now, but being able to ride property values for future appreciation. For instance, you may find a place that has poor management, rents and vacancies are way below market, and within a couple of months you can significantly improve gross rents and make the initial numbers look rediculous. In that case, the initial numbers were bad - compared to what property manager likes to see, but by being creative and a good manager you can turn the numbers all around.

I had a situation where I was able to double gross rents inside of 6 months. It started as a mild negative cash flow, but ended up being a huge cash cow. I sold in it 12 months at a huge profit.

But you have to understand what you are talking about. When you buy landlord properties - whether apartments or SFR or whatever, there are several issues you should consider. One is Cash Flow. Most new investors badly overestimate cash flow. Now is the 50% Rule sacrosant? For property manager it is. For me and others, no.

Many investors, myself included, also consider future appreciation and are willing to trade immediate low cash flow for future long term gain. The main thing is you don’t want negative cash flow.

It depends on my goals for a particular property. If it is an older structure, with lower income tenants, then 50% is a very good number. If it is a newer property, with a higher level of tenants, then you might find long term that 40% is fine for your area. I know of some very successful investors who use 35%, but they know what they are doing, are working with properties and tenants.

So it depends on what your intentions and exit strategy is for a particular investment. Are you a buy and hold until you die, living off the CF? Then you should be a firm adherent to property manager’s approach. Are you someone who is investing for 3-5 years then planning on reselling? THen you should balance the current cash flow against the potential higher values.

I am semi-retired now, only own two properties (one in Texas and one in Las Vegas) and live in Ecuador, but when I was active I did a mix. I bought to hold some, looking for strong CF, and bought some to rehab and flip. Both strategies worked well for me. The key was I knew what i was going to do with each property when I bought it.

Cash Flow is one part of the question. Sometimes it is the most important part. It depends on what you are doing.

The reason I asked is because to aquire rental houses at deep discounts, you may have to spend money on rehab, marketing costs…etc. Now, even with cash flow you will not be recovering your initial investment costs unless you refinance to pull that money out.

This also mean when you are starting your buy and hold career, you are not depending on that income to live on. Only when you reach 10 to 20 doors could you contemplate living off your income, even then, it is not a lucrative living (that is of course relative to one’s current income).

Now, there is always the argument to sell your old properties and buy newer ones every few years, unless you are buying apts. But once you at at that stage, you should have enough liquidity and income to do whatever you like.

Now personally I don’t like to count on appreciation. Over the long run, appreciation is guaranteed since house prices and inflation will always cause prices to go up but you will always hit market swings. This too is dependent on where you live of course. Florida, California, Detroit, Phoenix…etc.

when you do rehab to a house to rent, do you figure that into the purchase price 30k house + 10k rehab = 40k purchase price?

also, how do you figure in closing costs for rules of thumb for rentals?

As far as I’m concerned any money that gets put in for rehab up front should be considered part of the purchase price instead of part of normal expenses. If the price doesn’t make sense to you including the rehab costs you need to bargain it down more.

I agree with that. I consider it part of the “down payment” since I use my own cash.

I always agree very closely with Salverston post. It really depends on what your goal is. I have 32 units, and sure I could live off the income if I managed them my self; however, I earn many, many multiples working in my chosen professional. For me, real estate is part of a larger, diversified investment portfolio versus for others its a source of income. That’s a big difference, but at tehe end of the day, a dollar is a dollar and I want rental sto be cash neutral (or very close to it) from day one.

This specific group of posts are probably the most important that i’ve read in all my time here. Thanks so much guys. I love hearing different approaches to REI, especially from people with well thought out opinions who don’t disagree and belittle eachother. This thread alone has made me really reconsider what my own personal goals are. I guess it’s time for me to figure out which school of thought I belong to.

It seems the more diversified you are in your investing (rentals for cash flow, rentals for appreciation, flips, wholesaling, etc.) the higher chance that you have of doing well in upswings and downswings of the housing market.

Property manager 's approach to cash flow is great (I am using some of his formulas as a guide right now), but I am starting to actually understand different methods for accumulating wealth.

ex- Using propertymanagers theories for purchasing you could accumulate endless rental houses AND use a property manager to maintain them by sacrificing cash flow in return for long term appreciation. The extra free time I save myself by not managing properties (something I dont think I will be good at) can be spent finding deals (something I think I am good at)

my current plan- buy rehabs using cash that when completed will cost under 70% of ARV. Have new appraisal and then refinance the property (take 75% out) leaving me with a few grand more than I started with, 25% equity in a home, and a rental property that is slowly paying itself off WHILE it appreciates in value.

Although I won’t be making any assured (I know rent is not assured, but for lack of a better word I am using it anyway) monthly income this way I could supplement my income by selling rental properties that have appreciated significantly from when the purchase was first made. Since they cost me nothing to begin with (assuming everything was done right) I would be able to endlessly buy property. Couple this with my being in a great housing market for rehabs and appreciation and I think I am ready to go.

One reason I’m writing this is to explain my plan to myself. Another is to make sure I am not overlooking something huge. This is where you experts come in… Thanks as always…I think I have my business plan.

I’ll take a sure thing every time. I’m not betting on appreciation during the middle of a bust that followed the biggest real estate boom in history.

Mike

Is the estimate for vacancies factored into gross rent or the 50% rule?

I guess what I am trying to ask is what does Gross Rent equal.
Does Gross rent = Gross Scheduled income - Vacancies
or does Gross rent = Gross Scheduled Income
and the 50% includes the vacancy estimate?

Thanks!