can someone please explain this 50% rule to me? 82 posts by 18 users

Posted: 06/28/2008 at 04:12AM

For example: because of the tax rates here, we can expect to generally pay in rents about 1% of the home value. this includes insurances, taxes, interest, etc. SO - a working example:

That's exactly the way it is in my area also (and in many areas of the country). Rents generally run about 1% of the home value here. However, your statement that this includes insurance, taxes, interest, etc is meaningless. There isn't necessarily any correlation between what the tenant pays in rent and what the landlord pays in insurance, taxes, interest, debt, etc. That's why the vast majority of newbies fail in this business. They take in less money than they pay out.

If I buy a $100k house for $70k (assuming i can get in at 70% value), and I can rent at $1k a month, how would $500 of that each month go to operating expenses?

What you pay for a house has ABSOLUTELY NOTHING to do with the operating expenses. In your example, it would make absolutely no difference whether you paid $70,000 for the house or only $10 for the house - the operating expenses would be exactly the same! Operating expenses include everything you spend to operate the business, but do not include the mortgage (principal and interest).

The 50% rule simply reflects the fact that throughout the United States, operating expenses run 45% to 50% of the gross rents. That includes taxes, insurance, vacancies, advertising, utilities paid by the owner, management, maintenance, entity maintenance, legal fees, evictions, damage done by the tenants in excess of the security deposit, capital expenses, lawsuits, etc, etc, etc. (I could go on and on). Some of these expenses don't occur on a regular basis (such as excessive tenant damage), yet the effect on the bottom line is still profound.

What type of business are you in? Whatever it is, you should still have operating expenses and the principle is the same (although the numbers may be different).

Mike

Posted: 06/28/2008 at 08:34AM

The pay yourself part comes out of the 50% expense portion. Typically to hire a property manager it would cost you 10% of gross monthly rents, so by managing the property that would be the money you pay yourself.

In your example if you had a $420 mortgage payment then your businesses + cash flow would be $80/month and you would be paying yourself $100/month (10% of $1000). So the total you would be making from the property would be $180/month. The $100 isn't counted as cash flow because it is not passive income, you are actually working for that money. In essence it's earned income it's just that the government doesn't see it that way unless your business is paying you a management fee.

-Michael

Posted: 06/28/2008 at 08:59AM

Taxes and insurance are part of the expenses. They're usually included in your mortgage payment, though. When doing this math, you have to separate the P&I (principle and interest) part of the payment from the T&I (taxes and insurance) part of the payment.

If you're going to manage them yourself, you can earn for yourself the part of the 50% that goes to property management. So, in that case, we can assume expenses of 40% of rent.

Rent: $1000
Expenses: $400 (40% of rent, this is money out the door)
NOI: $600
P&I Payment: $420
Cash flow: $180 (cash in your pocket)

Now, the payment you make to the mortgage company might be $520 to cover the full PITI payment.

Taxes are a different question. Easier to look on an annual basis.

Income: $12,000 (rent)
Expenses: $4,800
Interest: $4,800 (only the interest part of the P&I payment, just a round number for the example)
Depreciation: $2,000 (value of improvements / 27.5)
Taxable Income: $400 (12,000-4,800-4,800-2,000)
Tax: $112 (at 28% marginal rate)

So, the income isn't totally tax free, but very close.

Posted: 06/30/2008 at 08:26PM

Hmmm...you might be a good landlord, but let me recommend that you don't go into animal training...I don't think you'd be as successful... :)

Posted: 07/02/2008 at 10:18AM

Keep in mind that this 50% rule is a quick, " back of the napkin" calculation of the expenses and NOI (net operating income) and should not be the final decision maker to move forward or back out of a deal. There are many other criteria to consider including the fact that different properties, locations, etc. have different operating expenses.

I have seen many deals in which the investment did not hit the 50% rule, but was a good deal and others that met the rule and were poor deals.

Many members here have posted numbers from deals they are working on, only to have the 50% rule gurus calculate their deal and tell them there deal was very bad. Use what ever calculations you choose for your criteria, but keep in mind that there are many claculations & considerations to observe before moving forward on any deal.

It is true that sellers and particularly seller's agents, will make the numbers look as good as possible, attempting to hide or leave out expenses and inflate the gross incomes. It is your job to see through that and to derive a true and accurate financial analysis.

Posted: 07/02/2008 at 05:43PM

Keep in mind that this 50% rule is a quick, " back of the napkin" calculation of the expenses and NOI (net operating income) and should not be the final decision maker to move forward or back out of a deal.

Ridiculous! Where are you going to find accurate numbers for SFHs or small multis? As I recall, you don't include all the expenses in your calculations, which is why you come out less than 50%. Pretending that expenses don't exist doesn't make them go away.

I have seen many deals in which the investment did not hit the 50% rule, but was a good deal and others that met the rule and were poor deals.

Clearly, you don't know what you're talking about. There is absolutely NOTHING for a deal to " hit" with the 50% rule. The 50% rule simply reflects the fact that throughout the United States, operating expenses run 45% to 50% of the gross rents. That's it!

Mike

Posted: 07/02/2008 at 11:28PM

Hi Nationwide
Jus curious to know how the 50%-rule-deal and not-a-50%-rule-deal are bad and good respectively. Can you give a couple examples? I want to understand the math better.

Again, we can go back and forth forever about the 50% rule. It really has no real world foundation. In the real world, you need to calculate each investment on the numbers it is producing, not assume the OE is 50% or any other % for that matter. Mike will argue that in the real world, sellers do not ever provide accurate numbers on expenses. While that may be true, it does not mean that you can not figure them out on your own. It takes the know-how and experience, but it is not rocket science.

Posted: 07/03/2008 at 05:39AM

Aside from all the arguing, (which is very entertaining, so please don't stop! ) let's face it - the 50% rule is a good basic guideline to use when you are quickly running the numbers on a number of properties to decide whether to spend time trying to buy them. If you do use that rule, you will seldom find yourself in a bad position, unless of course there is that trend Nationwide mentioned where the rents are plummeting. If you are lucky, and/or control your expenses as much as possible, you reduce that 50% in reality and greatly benefit! But at least you were conservative. I think the reason Mike is adament about his guidelines and policies is that they have worked so well for him over the years, and he wants to share that reality with others so they won't unecessarily get into bad deals.

Posted: 07/03/2008 at 07:48PM

First, I absolutely agree that the 50% rule is a valuable tool for doing an initial assessment of a deal...

But, that said, the statement above is just plain incorrect.

Mike -

You'd probably agree that across the hundreds of thousands of SFH investments across the U.S., the average purchase price for those properties is around market value for their location (in fact, you'd probably agree with this almost by definition).

If I then said to you, " Mike, since you own a lot of rentals, your average purchase price for each of those is probably around market value for the location in which you bought."

Would you agree with that statement?

Of course not! Because you're not an average investor and you don't make average investments. You ensure through your techniques that the properties you purchase are well below market value. Regardless of what the " typical" or " average" investor does, you do better

So, what's to say that an investor who is specifically focused on minimizing expenses can't do the same thing? Or even that an investor can't do the same thing without even realizing it. For example, let's say that I focused my investing on areas that met the following criteria:

- Taxes disproportionately low
- Insurance rates below national average
- Only new or fairly new homes
- Had close contacts in the contractor business, who provided me great rates
- Ensured all multi-unit properties were submetered
- Had a brother-in-law who was an RE attorney

If those accurately reflected my criteria and my situation, I think I could safely say that my OE would be less than the national average, regardless of how many houses I owned.

The average is a wonderful thing to model against, but luckily not all of us (or the things we do) will trend towards it... :)

Again, that said, if you don't have any reason to believe you're not average, the 50% rule is a great one...

Posted: 07/04/2008 at 06:23AM

Jason,

While I agree in theory that a person could search the country for an area where all the expenses are below average and you could have an uncle who would do your legal work for free, that still isn't going to reduce your operating expenses significantly - in fact probably not much, if any, below the 45% to 50% range. That's because the fixed part of the expenses normally won't vary that much.

Nationwidepi appears to be in the business of selling retail properties to newbies with the claim that his expenses are mysteriously low. Let's look at a deal from his website and see how his " deal" looks.

$155,000 Duplex - Currently appraised for $165,000.
Includes builder warranty and is guaranteed to have a minimum of one year lease contracts in each unit prior to investor's 1st months expenses.

Rental Income is $875-$925 per side/per month (we listed the low end)

Gross rents $1750
Taxes $222
Insurance $82
Management $140 (Original placement fees paid for, no other charges)
Repairs $0 (It is new with builder warranty)
Utilities $0 (Tenants pay all as wriiten in contract)
Maintenance $0 (Tenants pay all as written in contract)
Vacancy $0 (we have a variety of new tenants to choose from)
Vacancy $105 (Lets put 6% in there anyways to satisfy you)
Administration Costs $0 (Management handles everything for their 8% monthly fee)
Total Expenses $549 (should be $540 assuming the 6% vacancy reduce management fees, which is why I take vacancy out first as it Does affect the OE)
NOI = $1210
Debt Service = $906
Cash Flow with vacancy assumption = $304 ($152 per door)

So, with stated expenses of $549 per year, his expenses are already 31% of gross rents! However, he left out the majority of the expense categories. Lets start with maintenance. HE LISTS ZERO FOR MAINTENANCE. He does that because he's selling these properties to newbies and has a home warranty. However, what happens after the first year? Oops, the newbie WILL have maintenance expense. In fact, even during the first year, the newbie will have maintenance expense because the majority of maintenance is caused by tenants, not by the age of things. Most landlords will see routine maintenance expenses at about 8-10% of gross rents, but since Nationwide claims to be exceptional, let's just say 8%. Now he's up to 39%! As I've said dozens of times, capital expenses are not technically operating expenses, but they still have to be accounted for and are about 5% of gross rents. Now, he's at 44%. What happens when he has an eviction? How about legal fees (I know what you'll say - maybe he has an uncle that works for free - LOL). What about damage done by tenants in excess of the security deposit? Utilities during vacancies? Placement fees after the initial placement. Etc, etc, etc!!!

The point is that in Nationwide's own listing, he's at 50% IF YOU INCLUDE ALL THE EXPENSES. We've had a lot of other people on this forum that claimed their expenses were well below the 45% - 50% range, yet in EVERY SINGLE INSTANCE, when they posted the numbers, their claims were not true.

Jason, if you live in an area where expenses are unusually low, post the numbers. I'd like to see one.

Mike claims he pays no taxes on his rental income (cash flow). I would challenge that

You can challenge that all you like, but those are the facts. Obviously, at some point in the future, certainly when the loans are paid off, I will have to pay taxes on the rental income. Unfortunately, I am not a tax expert and can't have an intelligent discussion with you about my tax situation. I pay a professional to do my taxes and the fact is that every year for the past 5 years, I have not owed taxes on my rentals.

Mike also invests in areas in which he carries a fire arm to the site, is faced with crack heads and low lifes (as he states in many posts on BP as well as his own blog).

That's true. In fact, with apartment buildings, I specifically target distressed properties (distressed owners) which are often occupied by crackers. That allows me to buy at a huge discount. I evict all the crackers, clean up the property and find good tenants, which turns around the property (and often the entire block).

Of course he has high operating expense ratios. Not to mention that these low income rentals produce low gross rents. So of course by percentages, his figures must be in the 50% or even higher range.

Quite the contrary, I have completely normal expenses, which by the way are identical to yours (as I proved above).

Keep in mind that Mike operates a self-employed business. Looking back to Robert Kiosaki's book, the Cash Flow Quadrant, he shows that the left side of the income quadrant is earned by employees and the self-employed. The right side is earned from business ownership and investments. The main difference between business owner on the right and self-employed on the left is this: If the self-employed owner was to take a 6 month vacation, he/she would come back to find their business was no more.

Now you're getting into more guru nonsense. I am in the rental business and yes I do work in the business. I change toilet rings; fix water leaks; paint; collect the rent; evict deadbeats, etc. What should I do - sit at home all day and watch soap operas? That's just silly. I like to get out there and do something each day. I'm not lazy!

Your comment about taking a 6 month vacation is more guru nonsense. First of all, I won't be taking a 6 month vacation. My wife and I certainly wouldn't leave our family for 6 months. What successful business person leaves their business for 6 months to go on vacation? Everyone in real estate talks about Donald Trump. I heard him say that he NEVER goes on vacation! I'm sure that he has fun, but he doesn't leave everything for 6 months to go sit on an island (I would be bored to death).

When I do go on vacation, usually to Hilton Head for a week or 10 days, my business will continue to operate just fine. During that 10 day period, I might get 3 or 4 calls from tenants who need something. If there is anything that can't wait til I return (very unlikely), then I can simply call a professional to handle it. For example, the mythical water line break at 2 am. That would take me about 2 minutes to call a plumber - problem fixed!

Mike does his own PM, repairs, etc. etc. which creates a situation in that if he is not there, there is no one to answer the phone call about the exploded water heater at 2am.

Since you have ZERO maintenance on your properties, I know that you've never had an exploded water heater! However, even though I do have maintenance (like every other landlord), I have never had the mythical 2am water line break. To directly address your concern, I use my cellphone as my business phone, so I can be anywhere and still get that " exploded water heater" call that you're worried about.

I think Mike is so passionate about painting a horror story in his " education" product he sells on his website, because he wants to rid his competition.

I don't paint a " horror story" about anything. I talk about the REALITY of being a landlord, which is what newbies deserve to hear. In addition, what competition am I trying to scare off? I have no desire to own every property in town. There are more than enough rentals and renters to go around. In fact, not only do I not consider myself in competition with the other investors in town, we actually work together. We pass leads (and deals) back and forth. We refer tenants to each other. Several of us even share an ad in the newspaper. We discuss our businesses openly and honestly trying to help each other. Competition? I don't think so. I'd consider the other investors to be an asset!

Even though this has been a lot of posting, I'm glad that we're covering this topic in such detail. This is a VERY IMPORTANT issue and deserves to be thoroughly explored.

Mike