The hardest part of real estate investing is analyzing potential real estate deals.
Some things are pretty easy to predict – like rental income. Other things can be very hard to estimate – such as your expenses.
Not every owner operates the same. Some defer maintenance and don’t do basic repairs. Others over-improve a property and have really high expenses.
To make it even more challenging, some properties require more maintenance than others. Things like age, property type, and location all play a major factor in determining the expense ratio.
Bonus: Learn how to find great deals, online, easily, and for free
Good luck figuring out what they are actually spending to maintain their property.
The 50% Rule – Making Assumptions About Rental Property Expenses
In order to analyze the property, you will need to make assumptions about your expenses. That’s where the 50% rule comes in:
The 50% rule is just a simple assumption that 50% of your rental income will go toward operating expenses. Principal and interest payments are excluded from operating expenses as well as capital expenditures but includes most other expenses you will incur.
50% may seem like a lot, or it may not. It’s a broad assumption so it may be accurate or not depending on your particular property.
The best way to verify this rule is to own some property and keep track of your expenses. If you don’t own any, try to work with someone who does.
If you own 3 other rental properties that are all triplexes in one city and they all were built in the 1930’s, you can probably make accurate assumptions about a fourth triplex in the same city built that was in 1936.
On the other hand, it may not work on a townhouse built in 1989. That’s why we have the 50% rule as a starting point.
What’s Included in the 50% Rule
The 50% rule includes all operating expenses which include (but are not limited to):
I have a simplified calculator you can use to estimate your expenses and potential cash flow. This is fundamentally the same one that I use, except mine, is tailored in some specific ways for my strategies.
Breakdown of Expenses in the 50% Rule
Here is a rough breakdown of expenses. Your percentages may be different, so use these only as a guide.
Total – Between 42-48%. Operating expenses. To be conservative, it can be rounded up to 50%.
WHAT’s NOT INCLUDED
It’s important to know that principal and interest payments are not included.
When You Should Use the 50% Rule
Just like other ‘rules’, this one is just an assumption made to help analyze and screen properties.
There may be dozens or even hundreds of potential deals, and you need to be able to quickly sort these deals into good and bad ones.
You should never use this rule in place of actual historical expenses on any property.
Really, if you have no expense history or experience in rentals, then use this rule as a conservative estimate. Still, I would always get actual expenses from the property you are looking at.
If their expenses are higher than 50% of rent, you need to understand why. Perhaps rents are really low, or major repairs were recently made.
If the expenses are really low, you can assume there is deferred maintenance to be done or perhaps the seller is misstating their actual costs.
Break the Rule and Reduce Your Costs
Now that we know how the 50% rule works let’s figure out how to manipulate your costs to keep them low.
Increase Rents But Keep Fixed Costs the Same
Let’s say you have a 2 unit building. Your roof costs $6,000 to replace once every 20 years. That’s $300/year or $150 per unit per year. If each unit is generating $1,000 per month, you need to save 1.25% of rents each year toward this roof.
Let’s say you can add a 3rd unit to the attic or basement.
Once you add a 3rd unit, the roof still costs $6,000 to replace. That’s now $100 per unit per year or 0.83% of rent. Certain fixed costs will not change as you stuff more units into the same building, thus reducing your expenses as a percent of the rent.
Save Money on Property Management
You should include property management expenses into your calculations because of course some day you won’t want to manage all of your properties yourself.
Fortunately, you have some free time and are looking to maximize your income. Let’s look at 2 ways to leverage your free time to increase your income.
Property Management Play #1
Build the cost in but save the money by doing it yourself then use that savings to buy more property.
If you are able to find $100,000 properties that generate $2,000 in income, then doing your own property management will save you 200-240/month. Let’s just say $2,800 per year.
I’m also going to say that you are saving enough cash to buy 1 property per year with a $20,000 down payment.
So in year one you save $2,800 in fees on one property, in year two you save $5,600 on two properties, and so on. By the 5th year, you will have saved enough to buy one additional property.
So, you will have 6 properties instead of 5. By managing your own property, you have increased your assets by 20% in 5 years.
Basically, you are leveraging your time into more property.
Property Management Play #2
This one isn’t quite as cool as play #1, but it still works if you are planning to manage your own properties for a few years.
Nearly every year that you own a property, rents will tend to increase. If you find a good deal on a property now, even if it wouldn’t exactly meet the 50% rule (its expenses are too high just say), in 4 to 6 years of rent increases, rents may be high enough to justify a professional property manager.
It’s not the preferred method, but it’s important to remember that rents tend to increase as well as property value. If there is a solid deal that is borderline, you may still want to get it knowing the numbers will be solid in a couple years.
THE 50% RULE IS RIDICULOUS, BUT YOU SHOULD STILL USE IT
The 50% rule is ridiculous and really doesn’t work if you think about it logically for a second. I can easily think of a number of situations where this ‘rule’ completely fails. Let’s go over a few:
You find a very small single-family residence that meets the 50% rule and 2% rule criteria. It costs $75,000, is renting for $1,500 and it’s actual expenses are around $750 per month. Wow, what a perfect property to buy! So, you buy it.
You realize it is small and you decide to do some remodeling and add a bedroom. It costs you $25,000 and raises the rent to $2,000. Wow, this is really a property of our dreams!
But, what about the 50% rule? Since rents went up by $500, our costs should increase by at least $250/month (not counting principal and interest remember). Of course, some additional maintenance expenses will be incurred over time, but do you really believe a bedroom adds such a significant amount of monthly expenses? Of course not.
You purchase a 2 family property for $200,000 that is currently receiving $800 per side ($1,600 total). It’s performing well and the 50% rule applies and each month $800 is going toward expenses (or savings for capital improvements). You decide to remodel the property by refinishing the floors, removing some old carpets, and throwing in some granite counter-tops, allowing you to now receive $1,000 per month.
Again, it’s very unlikely that these improvements will cause an increase in expenses by $200.
You purchased a 2 unit building and are able to convert the attic or basement into a 3rd unit. The new unit will generate $1,000 per month in rent, so expenses should increase by $500, right?
In this scenario, you will incur increased expenses as a third kitchen, bathroom, floors etc will all require maintenance. But, there are some fixed costs that won’t change, such as roof, foundation, siding, and more that will actually cause your expense ratio to decrease.
As I mentioned above, by putting more units into a space, your fixed costs won’t change so your cost per unit decrease.
The 2%/50% rule relationship
The 2% rule and the 50% rule are closely related and often used together. (read more about the 2% rule.)
The 50% rule is used to estimate expenses as a percent of rent; The 2% rule is a screening tool suggesting that monthly rents should be around 2% of the sale price. (Also see how this all relates to the gross rent multiplier.)
Think about it – expenses are related to rents; rents are related to property values; so expenses have a relationship with property value as well.
Since these topics are so interrelated, it’s essential to read and learn about all of them.