When an investor decides to buy a rental property, there are usually scores of choices. But how do you know if you are choosing the most beneficial property? The last thing that you want to do is to buy a new investment property only to find out that it does not cash flow, and it is continuously sucking the profits from your other investments.
There are several methods to gauge the money-making potential of a rental property. This article will show you how to analyze the listing initially. Rather than completing an in-depth financial analysis of all available properties, the 50% rule will help you to weed out the duds so you can focus on the promising opportunities.
The 50% rule is a rule of thumb to do a very-quick first-pass analysis of a single-family investment (rental) property. The law states that — on average — the total expenses associated with operating an SFH investment will be about 50% of the gross rents. The costs included in the 50% are things like: taxes, insurance, repairs, property management, administrative, legal, turn-over costs, eviction costs, etc. All the ongoing annual expenses associated with maintaining the investment.
Identifying profitable investment properties is the key to success in the housing market. Real estate investors who can consistently find positive cash flow properties can expect a sizable return on their investment every single time they buy a property. Mastering the ability to zero-in on rental property cash flow is a must. So what is the most effective approach to investing for cash flow? And what are some of the methods that you can use to assess the cash flow of an income property accurately? In this article, we will introduce you to the 50% rule and show you how to use it when real estate investing for cash flow.
A thorough deal analyzer is crucial to the success of any real estate investor, but a quick system that acts as the initial evaluation for potential properties is helpful too. With calculations like the 50% rule, investors can assess a deal with limited information, and determine whether the property is worth more time and effort. Keep reading to learn how the real estate 50% rule works, and add this calculation to your tool kit today.
The 50 percent rule is one way to estimate what the expenses will be on rental properties. The 50 percent rule states that the expenses on a rental property will be 50 percent of the rents. The 50 percent rule does not account for any mortgage expenses. One of the biggest mistakes new rental property owners make is underestimating the expenses on rental properties.
This rule is widely used on many online forums and by many investors, but I do not think it is something that should be used by all landlords on every property. I do not like rules that assume all properties are the same and perform the same. I prefer to run the numbers on each property to make sure everything is accounted for, and the potential returns are as accurate as possible.
Real estate investors use several rules of thumb when evaluating potential rental properties to buy. The 50% rule can provide a ballpark estimate of a rental property's expenses and can help you make more informed real estate investing decisions.
The 50% rule is one of the most common formulas that investors use to analyze a potential deal quickly. However, like any rule of thumb, it does have its shortcomings.
This article is for anyone who wants to learn more about what the 50% rule is and how to apply it to your own deals.
Specifically, we're going to cover the following:
- The basics of the 50% rule
- Why it's an important rule of thumb
- How to use it to determine the cash flow
- A personal example showing that while useful, the 50% rule is not foolproof
What Is the 50% Rule in Real Estate?
As you would expect, finding profitable investment properties starts with figuring out how to estimate cash flow. Generally speaking, the best way to calculate cash flow accurately is to carry out a thorough investment property analysis. But when you are in the midst of the property search, you can't afford to analyze each investment property in detail. This is where the 50% rule comes in. In simple terms, this is a convenient tool that gives you ballpark estimates of each property's cash flow. Using it allows you to narrow the search down to high potential real estate investments.
The premise of the 50% rule is relatively simple. This method posits that rental property expenses will make up 50% of the gross income. Such costs include everything from property taxes and insurance to repairs and maintenance expenses. Below is a brief example that illustrates how to estimate real estate cash flow with the 50% rule.
The 50% rule is a guideline used by real estate investors to estimate the profitability of a given rental unit. As the name suggests, the rule involves subtracting 50 percent of a property's monthly rental income when calculating its potential profits. According to the rule, 50 percent of the rental income should be designated to expenses and therefore not considered when comparing potential gains against the monthly mortgage or loan repayments.
The purpose of the 50% rule is to help investors make quick, informed decisions about rental properties.
One of the most common mistakes property owners make when searching for deals is underestimating the cost of expenses. This can lead to lower profit margins, or in some cases, an unsuccessful agreement altogether. Essentially, investors will incorporate the 50% rule into their initial review of a deal as a way to protect against unexpected costs and expenses.
It is essential to keep in mind that the 50% rule should only be used as a screening tool. You still need to carry out an in-depth real estate analysis to assess cash flow properly. With this in mind, here is how you should use the 50% rule when you're looking at different potential real estate investments.
The 50% rule is based on the total rents that a property generates. Here is an example of how it works and the typical allocation of the expenses:
Property Address: 1343 Country Boulevard
Purchase Price: $250,000
Rental Units: 4
Rent Per unit: $ 850
Total Monthly Gross Rent: $ 3,400
Vacancy Loss 10%
Property Taxes 10%
Property Insurance 10%
Owner Paid Utilities 5%
Capital Expenses 5%
Total Expenses 50%
Total Estimated Monthly Expenses: $ 1,700
Estimated Net Operating Income: $1,700
The 50% Rule says that you should estimate your operating expenses to be 50% of gross income (sometimes referred to as an expense ratio of 50%). This rule is simply based on real estate investor experience over time.
So if a rental property makes $30,000 per year in gross rents, you should assume that $15,000 of that will go towards expenses, NOT including the mortgage payment.
- Expenses include:
- Property Insurance
- Property Taxes
- Property Management
- Remember, even if you are self-managing, it is best practice to always include a property manager in your calculations so that you can hire a professional PM if you'd ever like to. The rental property will continue to be profitable. You don't want to buy yourself another job.
- Reserve Funds/Capital Expenditures
The 50% rule says that real estate investors should anticipate that a property's operating expenses should be roughly 50% of its gross income. This does not include any mortgage payment (if applicable) but includes property taxes, insurance, vacancy losses, repairs, maintenance expenses, and owner-paid utilities.
How Is The 50% Rule Works?
The 50 percent rule states the expenses (not including mortgages expense) on a rental will be 50 percent of the rent.
Many investors use this rule to judge the profitability on a rental and only this rule. However, I think using a blanket rule like this is not the best way to analyze a rental property. I also do not like the 1% rule. Here is an example of what the 50 percent rule would say the expenses are on one of my properties.
Rental property number 4
Rent: $1,600 a month
Mortgage payment: $740 (without taxes and insurance)
According to the 50 percent rule I make about $60 a month on this property. However, I make much more than that. If I were to use my cash flow calculator, it shows I am making over $350 a month on this property. What is the difference? On the cash flow calculator, it figures all of the expenses; it does not use a blanket rule. Here are the expenses on this property using my calculator:
Property Management: $128
Total: $501 a month
The difference between my estimates and the 50 percent rule is $300 a month or $3,600 a year. Are my expenses really this low or am I just making stuff up? I analyzed my rentals last year, and my expenses were almost exactly what I had estimated them to be. I have had rental properties since 2010, and my estimated expenses have been very close to what the actual expenses have been. This was not just a one-year anomaly.
The 50% rule works by taking the total monthly rental income and dividing it in half. This is to account for potential expenses associated with owning the property, like repairs, taxes, property management and more. Investors do not need to know the exact costs to utilize the rule; in fact, the reason this calculation is so popular is that it allows investors to estimate potential deals quickly and on limited information.
One thing to note is that the 50% rule does not classify mortgage or loan payments as "expenses". Instead, loan payments should be compared to the remaining half of the rental income to determine whether or not to move forward with a property.
How to Make Money Using the 50% Rule in Real Estate?
The best way to utilize the 50% rule is to consider it an appetizer with a more thorough, full-course analysis to follow. If a property passes the test, calculate other metrics before moving forward. The 50% rule should never be used as a final say when deciding to invest; however, it can be used when determining when not to invest. For example, if you run the numbers on a property and your mortgage far exceeds half of the rental income, the deal (or your loan) may not be the best option.
As you already know, it is crucial to mind your due diligence before taking on an investment opportunity. If you want to use the 50% rule to make money, then understand it should go hand in hand with a healthy rental property calculator. Be sure to ask the previous landlord questions, research the market area, and evaluate all aspects of a property when it comes time actually to invest. In the meantime, use the 50% deal to quickly analyze potential options and whether or not they are worth a second look.
The calculation is straightforward. For example, if a property could generate $2,000 in monthly rent, this means that $1,000 will be needed for the rental property expenses I discussed. This means that you can expect to receive $1,000 in net operating income from the property.
Of course, if you have a mortgage on the property, be sure to include the monthly mortgage payment in your cash flow calculation. As a final thought, keep in mind that the 50% rule is just a guideline. Your property's expenses aren't likely to be exactly 50% in a real-world situation, but it does usually provide a good estimate.
Why Is The 50% Rule Important?
When analyzing deals, it's important to do so quickly; otherwise, someone else may pick up the agreement before you've even had a chance to make an offer on it. Deal analysis (or underwriting, for the fancy folks out there) is critical to every deal and will determine whether or not you should proceed with the deal.
An analysis is not something you rush through or skimp on. Therefore, the million-dollar question becomes "how can we do a full-fledged deal analysis and do so quickly?"
We use ballpark estimates to determine if the deal is even worth looking at in more detail.
The 50% rule is a ballpark estimate - a place to start your analysis based solely on assumptions that have yet to be verified.
Just as the 1% rule (if an investment property's monthly rent is approximately 1% of the total purchase price, it will likely cash flow) allows you to do some very quick, back of the napkin calculations, the 50% rule is the same; it allows for some rapid and dirty math to see if a deal potentially makes sense.
Luckily for you, the 50% rule is quite versatile. It can, and should, be used for any residential real estate investing (single-family rentals, condos/townhomes, and multi-family properties).
So if you're doing deal analysis for your very first property or your 100th, you can take advantage of this handy little trick.
What is Not Included in the 50% Rule?
There are some expenses, however, that are not included in this formula which has a dramatic impact on whether a property can cash flow or not. They include:
- Property Manager Expenses
- Home Owner Association Fees
- Mortgage Payments
These items not required to own an investment property. If an investor prefers to self-manage his rentals, he should not have to automatically factor in that expense. In addition, not all properties are part of an association, so these expenses should be added in on a per-property basis. Though many, if not most, investment properties carry a mortgage, the terms and payments vary and are factored into the equation after the 50% rule has been applied.
Using the above example, we will now factor in the average cost of a property manager (10% of gross income) and typical loan costs. Notice how it will affect the analysis:
- Estimated Net Operating Income: $ 1,700
- Less Property Management (10%) $ 340
- Home Owner Association Fees None
- Purchase Price: $250,000
- Down Payment: 20%
- Amount Financed: $200,000
- Term: 30 Years
- Interest Rate: 5.5%
- Payment: $ 1,136
- Monthly NOI (Pre-Tax) $ 224
What initially looked like a good investment, has shifted dramatically after factoring in the cost of the mortgage. Experienced investors expect their rental properties to earn them a minimum of $100 each month per unit. Since our sample property has four units, it should be able to provide the owner with a monthly pre-tax income of at least $400. If this property were self-managed, then it would be an investment candidate with a monthly net operating income of $ 564.00 or $141 per unit.
What Other Reasons Make The 50% Rule Inaccurate?
Another problem with the 50 percent rule is it uses the rent to determine the expenses. When I bought my fourth rental property in 2012, it rented for $1,300 a month. The rents have gone up over the last three years to $1,600 a month, and it may rent for more than that if I were to get a new tenant. Look at how much the expenses changed because my rent increased.
- With $1,300 a month in rent, the 50 percent rule says my expenses are $650 a month
- With $1,600 a month in rent, the 50 percent rule says my costs are $800 a month.
Did my expenses really go up by $150 a month because the rent is higher? It could be argued that because the rent is higher, my vacancy expenses would be higher because when a month's rent is missed, I will lose more money. I agree with that but here is how much my vacancy costs would increase using different vacancy rates.
- 5 percent vacancy: Expense would increase from $65 to $80 a month
- 10 percent vacancy: Expense would increase from $130 to $160 a month
- 15 percent vacancy: Expense would increase from $185 to $240 a month
Even with 15 percent of the rents accounting for vacancies the increase would only be $75 a month, not $150 a month. With a 5 percent vacancy allowance, the extra cost is only $15 a month. Maybe the other expenses would be higher with the higher rent? My property taxes have gone up slightly, but less than $10 a month, my insurance has not increased, my maintenance has not increased, but my property management has. If we look at property management, the increase is about $22 a month. On specific properties it is possible that the expenses would increase $150 a month when the rent changes if many other things change as well. It is also possible that the costs would not change much at all, which is the problem with the 50 percent rule. It is a blanket rule that does not account for the different expenses that different properties will have.