The 50% rule is one of the most common formulas that investors use to quickly analyze a potential deal. 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 cash flow
- A personal example showing that while useful, the 50% rule is not foolproof
The Basics
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
- Maintenance/Repairs
- Utilities
- 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 and the rental property will continue to be profitable. You don’t want to buy yourself another job.
- Reserve Funds/Capital Expenditures
Why Is The 50% Rule Important?
When analyzing deals, it’s important to do so quickly; otherwise someone else may pick up the deal 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 each and every deal and will determine whether or not you should proceed with the deal.
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 very quick 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 type of 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.
How to Use The 50% Real to Estimate Cash Flow
First, you start with your gross income. For most single-family rentals (SFRs), this will be the rent collected. Then, you subtract 50% of the gross income to estimate all operating expenses; this leaves you with the net operating income (NOI) of the property. Next, determine what the mortgage payment will be. Whatever is left over becomes monthly cash flow.
It’s helpful to have a ballpark idea of how to estimate your monthly mortgage payment, so here’s an easy way to look at it:
A $100,000 fixed rate loan, amortized over 30 years at 5% interest, will have a monthly principal and interest payment of $536.82. Thus, for approximately every $100k borrowed, your payment will be +/- $500 per month. Keep in mind that as your terms and loan amount changes, so will the monthly mortgage payment.
This is a very quick and simple method for determining monthly cash flow.
Now let’s look at an example:
A property is listed for sale at $250k and you’re able to obtain an 80% loan-to-value mortgage (i.e. only 20% down payment) amortized over 30 years at a 5% fixed interest rate. You offer full asking price because the property is already listed under market value. The current monthly rent is $2,500.
Question:
- How much is your ballpark monthly cash flow?
Solution:
- Loan value of $200k, thus approximate loan payment is $1,000/mo.
- Annual gross income potential = ($2,500/mo x 12 months) = $30,000.
- Approximate expenses using the 50% rule = $15,000 annually which corresponds to $1,250 per month in expenses.
- Monthly cash flow = $2,500 (rent) - $1,250 (expenses) - $1,000 (mortgage payment) = $250/mo (i.e. $3,000 annually).
- Since you put down $50,000 as a 20% down payment, this would correspond to a 6% cash on cash return.
Since this deal cash flows, it is probably worth investigating further to determine what the actual financial picture would look like. However, your investing strategy -- i.e. investing in an appreciation ace, cash cow, or balanced buff -- will help drive you to your conclusions.
If the deal didn’t cash flow, you could still decide to analyze it further, but the 50% rule gives you a ballpark idea of what to expect. Remember, if cash flow isn’t necessary to your investment strategy, the 50% rule is still helpful to determine what the NOI of the property is, even if it is negative.
Once you use the 50% rule to determine that there is the possibility to cash flow, you should make an offer on the property and get it under contract. Once it’s under contract, that’s when the due diligence period comes into effect and you can really start to analyze what the true annual expenses are.
All the expenses should be summarized in what’s called a T12, or the last 12 months of income and expenses. It could also simply be on the seller’s previous year tax return or a year to date P&L (profit & loss statement).
However, if the property currently is not under professional management, you may simply have to pore over utility bills and property tax receipts. Be prepared to dig through the weeds to find out what the expenses are.
Why The 50% Rule Isn’t Foolproof
Remember, the 50% Rule is not a hard and fast rule.
To demonstrate what I mean, let’s take an example from my own portfolio.
Note: the below is an example for a triplex, but for any and all of you SFR investors, the same principles and tactics apply.
I own a triplex in Alaska; when I purchased it, it violated the 1% Rule and I wasn’t even aware of the 50% Rule. That means I didn’t do a good job estimating what the expenses were going to be. However, since ignorance is bliss, I proceeded to get the property under contract and what I found out amazed me.
The previous owner had put in around $60K of upgrades to make the building essentially maintenance free. This included a brand new metal roof, new wood deck, and new vapor barrier and insulation underneath the property.
I learned all that during the due diligence period and because the property has had such low maintenance costs/expenses, I knew that I could use a very low expense ratio. So I found out exactly what all the operating expenses were and what they would be after the sale. (Thankfully, Alaska doesn’t do a reassessment of a property based on a sale, so the property taxes remained unchanged).
Additionally, what I discovered during my due diligence phase was that the current rents had remained unchanged for a long time, and thus they were severely under market. These conclusions allowed for two things to happen:
- The projected operating expenses went way down because I didn’t need to hold cash for a new roof (metal roofs can have usable lives to around 50+ years!) Additionally, the new deck and insulation meant that the property would look good and operate efficiently for heating (which I, as the new owner, was responsible for).
- Since the rents were under market, I knew that as soon as I took over I would be able to increase rents slightly, which would allow rents to exceed the 1% rule.
When it was all said and done, the operating expenses were as expected, however the heating of the building was eating away significantly at my cash flow -- to the tune of around $600/mo on average. This was because the building heat was supplied by an old diesel fire boiler, which I was well aware of. I wanted to look at ways to reduce my monthly expenses even further.
I decided to spend $20,000 and upgrade the heating system to a tankless electric heater, attach one to each unit, and hook it up to each unit’s main electrical meter. Thus, as the owner I was no longer paying for tenant heat: the tenants were. The project has a 2.7 year payback, which in the buy and hold world is a short amount of time.
Since the boiler upgrade, this triplex has been one of the best performing properties in my portfolio. I purchased this property as a still semi-new investor and I got really, really lucky.
That being said, I also looked for creative ways to solve problems and I didn’t just take things at face value. I investigated deeper into the property to discover what the previous owner had done. Had I not done that, I may not have ended up purchasing the property.
If and when you use the 50% Rule and the numbers are close, it may be worth some more investigation. The rule can be used to disqualify egregious properties fairly quickly.
Final Thoughts
Use the 50% Rule as a starting block, but keep in mind that it is by no means the “be-all, end-all” rule.
Don’t be afraid to uncover things that others do not see.
As you gain experience and understanding, that feeling you get when you’re looking at a deal and ask yourself, “Why is this deal still on the market? What have others seen that made them walk away? What am I missing?” will start to vanish.
And if you still need help building out your investing strategy, check out this webinar recording on "Identifying The Right Property For You":
