Do you calculate Home Insurance, and Property Tax as part as operating expense?

Hey guys, I’m trying to run some numbers to figure out a bid. I like to use Mike’s formula of 50% gross rents as operating expenses, but does this include Insurance and Property tax? Or does this get bundled into principal an interest payment.

For example if I had a duplex with \$1400 gross rents, and a Principal + Interest payment of \$600, am I cash flowing \$100 using Mikes 50% rule? Or do I need to calculate PITI and THEN 50% operating expense afterwards? I hope that made sense. TIA.

The insurance and property tax are operating expenses.
\$1400 gross monthly rent
Divide that by 2 - gives you \$700/mo for operating expenses.
\$700/mo for NOI.
You NOI minus debt service (\$600 here) leaves you with cash flow. You have \$100/mo cash flow in this example using the rule.

Justin is absolutely right.

Mike

You are right as far as you have gone. The next step is to confirm the operating expense numbers. Right now you are estimating your operating overhead at 50% of your scheduled rent.

If this is a real property and not a hypothetical example, how much are the property taxes? Did you call an insurance company and get an estimate on a rental dwelling hazard insurance policy with a large liability rider? How about management fees, advertising costs, legal fees, leasing fees, maintenance and repair, replacement reserve contributions, and vacancy allowance? If any utilities are landlord provided, you need to also add them to your overhead instead of making a utility allowance for vacant periods. How about home owner association fees? Are all of these expenses going to be covered by 50% of the rent?

You need to confirm that 50% of your market rent will actually pay for your operating expenses before you can say that this property will produce a \$100 monthly cash flow.

Hey thanks for the replies everybody. I’m looking to move into this duplex as an owner occupied. What I know right now is:

Gross rents: \$1,400 /mo (could easily get \$750 per unit based on prices in the area)
Principal + Interest: \$689 / mo (\$109k, 30yr fixed, nothing down, Rural Development Loan @ 6.5%)
Property Taxes: \$343 /mo (\$4,118 total in 2007)
Homeowners Insurance: ?
Trash Pickup: \$19 / mo

The state equalized value is \$68,700 which is supposed to be around 50% of total? I know that the person that bought it, bought it in 1993 for \$85k, so they’ve got equity in it, but I’m not sure how motivated they are to sell. I think we can get a deal on this as it’s been on the market for just under a year.

I have no idea on the homeowners insurance, I haven’t checked on that yet. Does it seem to be adding up though, or what do you think?

Dave,

That’s why I use the 50% rule. Over time and over a number of rentals, it’s the most accurate thing going.

Mike

p1nn4cl3,

Here’s how I see your potential deal:

Gross rents: \$1,400
Operating Expenses: \$700
NOI: \$700

Mortgage payment: \$689

Cash flow: \$11 per month or \$5.50 per unit per month

I would say that this is a terrible deal. I certainly wouldn’t operate a duplex for \$11 per month.

Mike

Does it make a difference that we’re going to live there though? I’m not as interested in cash flow on this property as in finding a decent place to live with my girlfriend. I figured this way at least we get someone else to pay for the operating expenses. In a SFH we’d be responsible for all the payments and maintenance and expenses ourselves.

I dunno though, if this doesn’t look good, then we can try to find something even better too. We’re not in a hurry or anything at this point, just trying to find which properties to look at further.

It’s up to you to decide whether living there makes a difference. I am only evaluating the property from the standpoint of it being a rental. If you plan to live there forever, then that’s a different story.

Good Luck,

Mike

What state is this in? The property taxes seem high to me for being about a \$100K property. I’m not saying you will be able to do anything about it; just that it’s more than I expected for that. I’d just be leery that your property tax alone is taking about 1/2 of your operating expenses (considering 50% rule).

I’m all for a person doing all the due diligence they can. My question, however, is how will a person come up with accurate numbers to use? Taxes, insurance, and management fees are easy. However, many of the other numbers are nearly impossible to obtain (other than guessing). Vacancy allowance for example, where are you going to get that number?

It is easy enough to call a couple of professional management companies that have rental properties in the same neighborhood and ask “If I placed my property under your management today, how long would it take for you to put a qualified tenant in place?” For single family dwelling units, I don’t use a percentage rule, I use months. Turnover vacancy will be at least one month most of the time. At a minimum, allow one month vacancy allowance. It the management companies tell me they are experiencing longer vacancies for their managed properties, then I will add another month or two to the vacancy allowance.

That’s why I use the 50% rule. Over time and over a number of rentals, it’s the most accurate thing going.

The problem with the national statistic is that it is reporting the average operating overhead for properties already in service – income producing properties that have already been generating a positive cash flow.

For a property he does not yet own and for which he has no rental income and expense history, p1nn4cl3 can not just start with the 50% rule and state with certainty that his property’s operating overhead will average half of his market rent. That is fine for a beginning estimate, but unless he confirms the big numbers he has no way of knowing if these costs are even in the 50% ballpark.

We might have been able to be more certain in our responses if p1nn4cl3 had told us more about the purchase price and his proposed financing. He only said that the debt service is \$600 per month. Not much help if he is making a large downpayment to get his debt service down. If his property will cost \$500K and rent for \$1400 per month, there is no way that his operating expenses will be under 50% of his rental income, but this property will still have a \$600 monthly debt service after a \$400K downpayment.

If the property cost is \$125K and p1nn4cl3 uses 80% financing, his debt service (at 6%) will also be \$600 per month, but even this property might have an operating overhead greater than \$700 per month. If his property taxes are \$3000 a year, the insurance premium is \$1400 each year, the HOA fee is \$175 per month, projects management costs at 10% of collected rents, and he uses a two month vacancy allowance, his operating overhead is running about 55% and there is no room to take care of all the little things like cleaning, preventive maintenance, advertising, leasing costs, excess damage, and a contribution to a replacement reserve.

The big ticket items in his operating overhead can be confirmed. Property taxes, insurance, HOA fees, and management cost are easily obtained or estimated. The smaller numbers he can estimate or make some allowance for once he knows how much budget he has to work with. My point is that just saying that his operating overhead will be no more than 50% of his rental income does not make it happen for every property.

The unplanned stuff, like tenant damage or repairs, can’t be determined with any degree of accurancy. That is one reason we want the property to generate a comfortable monthly cash flow so there is room to handle the unexpected.

If p1nn4cl3 had started with your 2% rule to qualify the property he is considering purchasing, then he could be fairly confident that his operating overhead will be no more than 50% of his rental income and further research may be unnecessary.

But since he did not give us any clue to his property selection technique, I am guessing that p1nn4cl3 just discovered this property and started qualifying the property with the 50% rule. If that is the case, then he really needs to do more homework.

I am not comfortable with the 50% rule, at least not in Texas.

I have a property ARV \$100k, loan is \$56k. You would think that is good…

PI = \$360
TI = \$370 (high property tax and insurance + flood insurance)

If I rent it at \$900, thats \$450 allowance for TI, repairs, and vacancies.

\$450 - \$370 (TI) = \$80/month for repairs and vancancies, 1 vacancy almost kills the entire year’s allowance for maintenance. I still have not fixed a toilet, sink, A/C went out, and so on.

56% LTV won’t even cash flow.

I usually feel much more comfortable to see PITI + \$200 to \$300 depending on the area and condition. That way I know I have enough for maintenance and repairs. if TI is known, then why not include it with PI.

Then do your analysis on one rental unit at \$700 per month. Only use half of the property tax, insurance, and monthly debt service in your calculations. If half of the duplex won’t cash flow as a rental dwelling unit, then you may not want to subsidize someone else’s housing cost out of your pocket.

Perhaps you could use the results of your analysis to negotiate a lower purchase price which results in a lower debt service which leaves more room to pay a little higher than 50% operating overhead and still cash flow. Over time, as you raise the rent, you should get closer to a 50% operating expense ratio.

You may think that Using the property as your primary residence may change your motivation in purchasing the property. You say you don’t need to make money on the rental unit. Your thinking is that you just need someone helping you to at least break even on the rental unit so your tenant is essentially buying half your property for you with nothing extra coming out of your pocket.

This is fine as long as you will sell the property when you decide to move out. If you don’t sell, then your residence unit becomes a rental unit and just breaking even is not good enough. Eventually, this property becomes a negative cash flow situation. If you get too frustrated with the increased liability, you become a motivated seller.

Better to operate your rental unit as a positive income generator from the beginning. Buy it right, rent it right. Don’t compromise good business practices just because you think you don’t really need the money.

You do have really high property tax in TX. I was looking at \$250K homes in Corpus Christi and found they had approx. \$6500/yr property tax.

I think some common sense has to come into play when you’re evaluating properties. As you said Dave, you can easily find out some of your big expected expenses. If you add all those known expenses up and they’re close to 50% of your gross rents, you’re in trouble because you really don’t have any room for the unknown expenses (repairs, maint., cleaning, advertising, eviction, legal fees, gas to travel to/from unit for repairs and showings, etc). So if there is no way to reduce any of your known expenses, then the rents are too low. In the example listed here, 2% of the purchase price would be \$2180/mo which is obviously significantly higher than what he listed current rent to be. True that with rents at 2% of your purchase price you will probably have plenty of money to cover expenses, but it’s not exactly easy to find deals that meet this criteria.

The 50% rule does not guarantee a positive cash flow if you are simply applying it to your market rents and expecting your net operating income to be no more than half your monthly rental income.

You need to start with something else to qualify a property you want to purchase, such as propertymanager’s 2% rule. If the property will only rent for \$900 per month, then your purchase price should probably be no more than \$45K. At \$45K , the 50% rule has a lot more room to produce a positive cash flow in spite of your high tax and insurance costs.

fadi did not really tell us what the purchase price is/was. He just said the mortgage is \$56K. If the purchase price is \$56K, then a 2% ratio suggests the monthly rent should be \$1120.

Dave,
I was actually referring to p1nn4cl3’s example. My apologies. I should have specified.
Justin

Dave,

I agree with you 100%. Simply using the 50% rule is not enough and I never intended it to be used as the only evaluation of a property. Common sense can not be simply thrown out the window and replaced with the 50% rule and I have never intended that! As you said, you still need to use the 2% rule as a screening tool or just insert some common sense.

If his property will cost \$500K and rent for \$1400 per month, there is no way that his operating expenses will be under 50% of his rental income, but this property will still have a \$600 monthly debt service after a \$400K downpayment.

Your example is the perfect example of what I’m talking about. To me, paying \$500,000 for a property with gross rents of \$1,400 per month is so ridiculous that it is laughable. To think that a person would put down more than 85% of the purchase price to buy down the debt payment is beyond the realm of reality, but I guess that I shouldn’t assume anything. Not only does this property not meet the 2% rule, it doesn’t even come close to 1%! In fact, it’s only .28%! OUCH!

I also agree with you that there can be circumstances and locations where the operating expenses can be unusually high (more than 50% of gross rents). For example, if you buy a condo with high association dues in a flood plain, that could certainly have unusually high expenses. “Normal” rentals would not have HOA dues or flood insurance, both of which would be extraordinary expenses.

Finally, none of the “rules” I use eliminates the need for due diligence. I agree with you 100% that you should look at the expenses that can be determined to see if they pass the sniff test. There are obviously also a bunch of other things to consider such as rental demand in the area; large employers moving into or out of the area; the property being built on a toxic waste dump; having a pig farm for a next door neighbor (one of the properties I looked at), etc, etc, etc.

My only argument in this entire thread is that it is nearly impossible to calculate the actual expenses for most small residential properties. I believe the 50% rule is the most accurate way to calculate those expenses. However, that does not mean that you can check common sense at the door or fail to do basic due diligence.

Mike

OK, your reference to TX taxes and insurance focused me on fadi’s example.

My question is still valid, though. p1nn4cl3 did not tell us his purchase price either, or did I miss it? I see that he is planning to finance \$109K, but we still don’t know how much he is proposing to pay for this property.

If propertymanager applies his 2% rule to the \$1400 market rent, he arrives at a quick and dirty estimate of \$70K as the maximum price p1nn4cl3 should pay for this property to generate an acceptable cash flow. Even if p1nn4cl3 uses an FHA first time homebuyer loan to finance 97% of his purchase, he will probably still have a positive cash flow at this price point.

Dave,
Here it is:
Gross rents: \$1,400 /mo (could easily get \$750 per unit based on prices in the area)
Principal + Interest: \$689 / mo (\$109k, 30yr fixed, nothing down, Rural Development Loan @ 6.5%)
Property Taxes: \$343 /mo (\$4,118 total in 2007)

It was in his follow-up post.