When an investor decides to buy a rental property, there are usually scores of choices. But how do you know if you are choosing the most profitable property? The last thing that you want to do is to buy a new investment property only to find out that it does not cash flow and it is constantly sucking the profits from your other investments. The 50% rule can help.
There are several methods to gauge the money making potential of a rental property. This article will show you how to initially analyze the listing. Rather than completing an in-depth financial analysis of all available properties, the 50% rule will help you to weed out the duds so you can focus on the promising opportunities.
What is the 50% Rule?
This is a formula that is used by most experienced investors. It has been found to be very effective in determining if a property will cash flow. Investors have found that residential rental properties require 50% of the gross income to cover a rental’s expenses. This formula works for any type of residential rental including single family houses, townhouses and even large apartment buildings. It is a tried and true formula.
What is Included in the 50% Rule?
The 50% rule factors in expenses that are common to all rental properties. They include the following items:
- Vacancy Loss
- Property Taxes
- Home Owners Insurance
- Repairs and Maintenance
- Owner Paid Utilities
- Capital Repairs
How Does the 50% Rule Work?
The 50% rule is based off the total rents that a property generates. Here is an example of how it works and the typical allocation of the expenses:
Property Address: 1343 Country Boulevard
Purchase Price: $250,000
Rental Units: 4
Rent Per Unit: $ 850
Total Monthly Gross Rent: $ 3,400
Vacancy Loss 10%
Property Taxes 10%
Property Insurance 10%
Owner Paid Utilities 5%
Capital Expenses 5%
Total Expenses 50%
Total Estimated Monthly Expenses: $ 1,700
Estimated Net Operating Income: $1,700
What is Not Included in the 50% Rule?
There are some expenses, however, that are not included in this formula which have a dramatic impact on whether a property can cash flow or not. They include:
- Property Manager Expenses
- Home Owner Association Fees
- Mortgage Payments
These items not required to own an investment property. If an investor prefers to self-manage his rentals, he should not have to automatically factor in that expense. In addition, not all properties are part of an association, so these expenses should be added in on a per-property basis. Though many, if not most, investment properties carry a mortgage, the terms and payments vary and are factored into the equation after the 50% rule has been applied.
Using the above example, we will now factor in the average cost of a property manager (10% of gross income) and typical loan costs. Notice how it will affect the analysis:
Estimated Net Operating Income: $ 1,700
Less Property Management (10%) $ 340
Home Owner Association Fees None
Purchase Price: $250,000
Down Payment: 20%
Amount Financed: $200,000
Term: 30 Years
Interest Rate: 5.5%
Payment: $ 1,136
Monthly NOI (Pre-Tax) $ 224
What initially looked like a good investment, has shifted dramatically after factoring in the cost of the mortgage. Experienced investors expect their rental properties to earn them a minimum of $100 each month per unit. Since our sample property has four units, it should be able to provide the owner a monthly pre-tax income of at least $400. If this property was self-managed, then it would be an investment candidate with a monthly net operating income of $ 564.00 or $141 per unit.
How Not to Use the 50% Rule?
This is a tried and tested approach to rental property analysis. One of the biggest mistakes a new investor can make is to think that they can beat the odds. If you purchase a property that cannot cash flow using the 50% rule, you will be taking on a large financial risk. Rather, look for properties that can create a positive monthly income after applying the 50% formula. If you can shave off some of the expenses down the road, then all the better.