Continuing with our Rule of Thumb series, today we will cover the 50% Rule for real estate expenses. This rule helps provide guidance when budgeting for expense costs with a real estate investment. You can read my intro to the Rule of Thumb Series on the 1% Post.
50% Rule for Real Estate Expenses
50% Rule says the estimated expenses will be 50% of the gross rents.
i.e. a place that is rented for $1400 / month will have $700 in expenses / month.
These expenses include property tax, insurance, HOA dues, maintenance and management fees. It also provides a cushion for unexpected expenses such as vacancies, repairs, special assessments etc. That last part is important because when you are you assessing a deal you invariably forget one expense or another.
Why do we need this rule?
A typical investment begins with number crunching to determine if an investment is worth it. For this calculation, you need three numbers:
The first two are easy to estimate but expenses can be difficult to budget because they vary drastically between properties. A brand new building might have a minimal excess cost of ownership for the first 5-10 years but then be hit with a $20,000 special assessment, while an older building might require repairs quarterly.
That said, regardless of what you buy, it will eventually require care and maintenance. The 50% rule helps allocate for these inevitable expenses and gives you a realistic idea of the cost of long-term ownership.
When Does the Rule Not Work?
The biggest argument against the 50% rule is that it is too conservative and overestimates expenses. Woodstock and I had a long debate over this rule when we were evaluating one of his rentals. These are his thoughts:
For low maintenance high-rise condo’s that are new construction where heating, cooling, and water are covered by the building, the 50% rule allocates far too much for unexpected expenses. These expenses covered by the building come at a premium in purchase price. That premium artificially increases the expense allocation from the 50% rule while in reality it likely decreases the actual expense and should move the need for misc funds downward. In these type of cases, it’s safe to reduce ones expense allocation to 35-40% of rent.
It’s hard to disagree with him when looking at real examples. My rental properties have needed significantly less than the 50% of gross rents for expenses, but without significant vacancy issues or need for large repairs it’s hard to say that it will ALWAYS be less than 50%. The rule is meant to be conservative and create a worst case scenario for your return on investment. If you find a property with a decent return using the 50% rule, then you’re building in long term protections against the unknown.
How To Apply the Rule in Practice?
I like to use this rule in combination with the 1% rule to quickly decide if I like an investment property. The 1% rule weeds out a significant number of investments while the 50% rule helps verify that it will still be worth the investment in a worst-case scenario. Let’s look at a quick example:
|Rent||$2,000||Based on 1% Rule|
|Expenses||$1000||Based on 50% Rule|
|Mortgage||$800||20% down, 4.25%|
|ROE||6%||$2,400 / $40,000|
The combination of the two rules gives us a quick and dirty back of the napkin estimate for the cap rate in a high expense situation. If you are able to rent the place without any vacancy issues, avoid large repairs, and screen your tenants well then your return will be higher than the 6% estimated.
Do you use the 50% Rule or do you prefer exact historical numbers?
— Dr. Linus