The 50% rule in real estate investing is a guideline that suggests that operating expenses can be estimated as half of the gross rent collected. This rule is useful to investors when evaluating potential properties, as it provides a framework for reasonable expenses. In this blog post, we will discuss what the 50 percent rule is and how to use it to estimate your operating expenses.
The 50% rule in real estate investing is a general guideline that can be used to estimate total operating expenses for a rental property. Operating expenses include items such as property tax, insurance, utilities, and repairs. The 50% rule suggests that these expenses will be approximately half of the gross rent collected from the property.
Operating expenses can vary greatly from property to property, and even within the same market. It’s important to do your research and due diligence to determine what the actual operating expenses will be for a particular property.
The 50% rule is a helpful guideline when you’re evaluating potential rental properties. By estimating operating expenses as half of the gross rents, you can get a general idea of what your expenses will be. However, it’s important to do your research and due diligence to determine the actual operating expenses for a particular property.
While the 50 percent rule is useful as a first step in screening potential investments, real estate investors need to perform a detailed cash flow analysis of any property before making an investment decision.
What Is The 50% Rule In Real Estate Investing?
The 50 percent rule is a tool that can help real estate investors quickly determine if a property has the potential to meet cash flow goals. It’s intended to be an easily calculated metric that is used in the screening process. If a property passes the 50% rule, a real estate investor should move on to a more detailed cash flow analysis (assuming the property meets all of their other criteria).
The 50% rule is intended to estimate all of the operating expenses for the property. This includes property management, property tax, insurance, and many other expenses. It, however, does not include the cost of financing including loan repayments and closing costs. To get a clear picture of the cash flow produced by the rental property, you’ll need to also subtract your loan payment.
It’s important to note that the 50% rule has some flexibility. Depending on the local rental market, property tax rates, and other factors, the 50 percent rule can be adjusted. For instance, if your area has high property tax, you might want to use a more conservative estimate, like 55%. Alternatively, if you plan to manage the property yourself, you might use 45%.
To use the 50 percent rule, start by estimating the gross monthly rents that a property can generate. Then, estimate the operating expenses as half of the monthly rents. For example, if a property could generate $2000 in monthly rent, you would estimate the operating expenses to be $1000 per month.
Why The 50% Rule Is A Useful Guideline
The 50% rule is a useful guideline because it can help you quickly screen properties to determine if they have the potential to meet your cash flow goals. By estimating the operating expenses as half of the monthly rent, you can get a general idea of what your expenses will be.
In particular, the 50 percent rule provides the following benefits.
- Quickly determines estimated cash flow — The 50 percent rule is a fast rule which provides a reasonable analysis of the financials of the real estate deal. A real estate investor can do some quick math to gauge the potential profitability of an investment.
- Creates comparisons between potential investments — You can calculate the 50% rule for multiple different properties and compare them to help choose which property warrants a more detailed analysis. This assumes the initial investment in each of the rental properties is the same.
- Saves time — By using the 50% rule, you can quickly screen properties to identify those that have the potential to meet your cash flow goals. This allows you to focus your time and energy on a smaller group of properties.
Expenses Included In The 50% Rule
The 50 percent rule is intended to estimate all of the operating expenses for the property. This includes property management, property tax, insurance, and many other expenses. It does not, however, include the cost of financing. To get a clear picture of the cash flow produced by the rental property, you’ll need to also subtract your loan payment.
Depending on your situation, you may have more or less of these expenses. It’s a good idea to adjust the 50% rule if you believe your expenses will be higher or lower than average.
Keep in mind that these are just estimates. The 50% rule is not an exact science. There will always be some variation in your actual expenses. The goal is to use the 50 percent rule as a guideline to help you quickly screen properties and identify those with the potential to meet your cash flow goals.
Some of the specific rental property expenses that are included in the 50% rule are:
1. Property Management
You may choose to hire a property manager for your rental to handle filling vacancies, collecting rents, and interacting with tenants. Or you may choose to be the landlord. Property management fees can consume more than 10% of your net income so you might want to be more conservative with the 50% rule if you plan to hire property management.
2. Insurance
You’ll want to carry insurance on your rental property regardless of your situation. Insurance rates don’t vary too wildly so there isn’t much need to adjust the 50 percent rule.
3. Property Taxes
Property taxes can vary significantly from one area to another. They may also vary depending on the type of property. For example, a duplex in one area might have higher property taxes than a single-family home in another area. If you think your property taxes will be higher than average, you may want to adjust the 50% rule.
4. Maintenance and Repairs
You’ll also need to budget for routine maintenance and repairs. This bucket covers everything from roof replacement to appliances, plumbing, and electrical work. It tends to be hard to predict these expenses, but you can get a feel for whether the property will need any work in the near term through an inspection. If there is any major work that needs to be addressed, it’s a good idea to plan for that expense in your initial investment. This will help to keep the ongoing maintenance and repair costs lower.
5. HOA Fees
If the property you’re considering is part of a homeowners association (HOA), there will be monthly or annual fees to pay. These fees can range from a few hundred dollars to several thousand dollars per year. Make sure you factor these into your 50% rule calculation.
6. Vacancy Loss And Turnover
You’ll also need to account for vacancy loss and turnover. This is the amount of rent you lose when a tenant moves out and the unit is vacant until a new tenant moves in. The 50% rule assumes that you’ll lose one month’s rent for every vacancy. So, if your gross rents are $2000 per month, you can expect to lose $2000 per year to vacancy and turnover. This expense is often overlooked but it’s important to factor it into your calculations.
How Accurate Is The 50% Rule?
After examining the expenses that are included in the 50% rule, you may be how accurate it is. The 50% rule is just a guideline and it’s not an exact science. There will always be some variation in your actual expenses. The goal is to use the 50% rule to help you quickly screen properties and identify those with the potential to meet your cash flow goals.
You can also adjust the 50% rule if you believe your expenses will be higher or lower than average. For example, if you’re considering a property in an area with high property tax rates, you may want to adjust the 50% rule to account for that expense.
Keep in mind that the 50 percent rule simply uses average estimates and you’ll need to do further analysis of any potential deal you’re considering to determine if it’s a good fit for your investment goals.
50% Rule Formula
The 50 percent rule is a simple formula that provides a quick estimate of the net operating income produced by a potential investment property. The 50% rule states that 50% of the gross rent collected from a property will be consumed by operating expenses. The remaining 50% can be used to cover mortgage payments and other non-operating expenses. This leaves the investor with a cash flow after all expenses are paid.
Here’s the formula for the 50% Rule:
NOI = Net Operating Income
GI = Expected gross rental income
ER = Expense ratio (50% or adjusted)
How To Estimate Net Operating Income With The 50% Rule
Estimating NOI with the 50 percent rule is as simple as plugging a few numbers into the formula. But before we can do that, we have to figure out the expected gross income from rents.
To estimate the gross income, we’ll need an idea of what the monthly rent is. If the property is already a rental, you can likely get an income statement from the current owner. If not, then you will need to research comparable units to get an idea of what a reasonable rent should be. Also, if you have a property manager, they can do this for you as they have more knowledge of the local rental market. If the property you’re considering has more than one rental unit, you should include each unit in your calculation.
Next, we need to consider any adjustments to the expense ratio. There is no exact science here. You’ll need to use your best judgment to decide if 50% is a reasonable estimate of your expenses. If you’re unsure, you can always err on the side of caution and adjust the expense ratio upwards.
Now that we have all the information we need, we can plug it into the formula.
Let’s say, for example, we are considering a real estate investment that has a monthly rent of $2000. Multiplying $2000 by 12 months gives us a yearly gross income of $24,000. If we use the 50 percent rule without adjustments, then the expenses would be $24,000 * 0.5 = $12,000. Subtracting the expenses from the income leaves us with an NOI of $12,000.
Using The 50% Rule To Estimate Rental Property Cash Flow
After using the 50 percent rule to estimate NOI, you can go a step further and estimate cash flow from the real estate investment. Evaluating cash flow is important for any rental property investor because it shows how much money you have leftover after all expenses are paid. This cash can be used to pay down debt, reinvest in the property, or you can withdraw it for personal use.
To estimate cash flow, we need to subtract any non-operating expenses from the NOI. Typically this is just a monthly mortgage payment. There is a wide array of mortgage payment calculators on the internet that can help you determine your loan repayments.
Once you know the monthly mortgage payment amount, you can multiply by 12 to figure out the yearly loan repayment. Simply subtract this from the estimated NOI to determine your annual cash flow.
You can then divide the annual cash flow by 12 to get the monthly cash flow; this is extra profit that you can use to pay your bills or invest in other properties.
Real estate investors should strive to reach a positive cash flow in any investment property because it means the monthly rental income will cover all the expenses of the rental property.
Examples Of The 50% Rule In Real Estate Investing
Now that we’ve gone over how to calculate the 50% rule, let’s look at a few examples. You can use these examples as a starting point for your own 50 percent rule calculations.
Single-family Property Without Adjustments
In the first example, let’s assume the monthly expenses are reasonable and average in the market you’re investing in. In this case, we can use 50% as the expense ratio. We’re looking at single-family homes so this example is for a single unit.
Let’s also assume you borrow $150,000 at a 5% interest rate. This loan has monthly mortgage payments of $800.
Gross Rental Income: $2000/month
Total Operating Expenses (50%): $1000/month ($2000 x 0.5)
Cash Flow: $200/month ($1000 – $800) or $2400/year ($200 x 12)
Single-family Property With Adjustments
Now, let’s make a few changes from the previous example. We’ll assume the same rental income, but this time, we will do the management and maintenance ourselves. Because our costs are lower in this case, we will assume that estimated expenses are only 45% of the rental income.
Gross Rental Income: $2000/month
Total Operating Expenses (45%): $900/month ($2000 x 0.45)
Cash Flow: $300/month ($1100 – $800) or $3600/year ($300 x 12)
Multi-family Property
The 50 percent rule applies to multi-family real estate as well. The biggest difference is that this type of real estate deal has more than one rentable unit.
But the same principles apply. Because the property is larger and handles more tenants, the operating costs scale upwards with the number of units. We still want to ensure the rental income can cover expenses with this analysis.
Let’s look at a 20-unit multi-family deal that charges an average of $1200 per month in rent. The loan is for $1,500,000 at a 5% interest rate with a monthly payment of $8000.
Gross Rental Income: $24,000/month ($1200 x 20)
Total Operating Expenses (50%): $12,000/month ($24,000 x 0.5)
Cash Flow: $4000/month ($12,000 – $4000) or $48,000/year ($4000 x 12)
Summary
The 50 percent rule is a great starting point for analyzing any potential property investment, but it’s important to keep in mind that many factors go into any real estate decision. By tailoring the expectations of the rule to match the individual property and its surrounding market, investors can use this quick screening tool to weed out bad deals and focus on the best opportunities.
After screening properties with this rule, investors should move on to a detailed cash flow analysis of any property they are considering.
Have you tried using the 50 percent rule when evaluating a potential real estate investment? Let us know how it worked for you!