50% Rule in Real Estate
Real estate investing is always a wise choice. While it is possible to sink money into a bad property, most deals will become profitable.
However, how do you know what your profit margin will be on an investment property? There are many variables and factors to consider, but one is the 50 percent rule. So, let's take a closer look at how the 50% rule works and whether it is a good benchmark.
What is the 50 Percent Rule in Real Estate?
This rule aims to provide investors with a "real-world" estimate of their profit margin. The 50 percent rule says that a real estate investor can expect to keep about half of their gross income. The rest will go toward operating expenses (but not the mortgage).
So, if you can rent a unit for $2,000, you will earn $1,000 in profit. This rule works best for single-family homes, not apartments or condo buildings.
That said, the 50 percent rule can be an inaccurate assessment, so do not take it literally. Instead, it is a decent guideline.
50 Percent Rule in Real Estate - The Math
So, what is included in "operating expenses?" Let's break them down:
- Property Taxes. You must check on your state's tax rate to know what to expect. For example, New Jersey has the highest property tax with a 1.89 percent rate. Delaware is the lowest with property taxes of 0.43 percent.
- Property Insurance. As an investor, you cannot buy a standard homeowners insurance policy. Since you rent out the property, you must purchase landlord insurance.
Usually, landlord insurance costs about 25 percent more than homeowners insurance. Again, your location will determine the rate. For example, Florida has some of the highest insurance costs because of hurricanes and flooding.
- Vacancy Losses. If you cannot find a tenant, you will not make rent for the month. Also, some tenants cannot pay their rent, meaning you need to terminate the lease or start an eviction.
- Repairs and Maintenance. There is another rule in real estate - the 1-percent rule. This guideline states that you will spend one percent of your property's value annually on maintenance costs. So, if the home is worth $500,000, expect to pay $5,000 annually, or $416 per month.
- Owner-Paid Utilities. Usually, landlords pay water, sewer, and garbage bills. Tenants pay for electricity, internet, gas, and other utilities.
Although the 50 percent rule can give you a guideline, you want to do the math for these monthly expenses. This way, you can figure out whether you will make a 50 percent profit or not.
As you will notice, some other fees are not included in this total. Examples include a monthly mortgage payment and HOA fees. So, if you are paying a hefty mortgage on top of everything else, your profit margin can shrink substantially.
Let's look at a hypothetical property and run the numbers. To make it easier, let's assume that you paid for the house in cash and that there is no HOA. The home is worth $400,000.
- Property Tax. Our hypothetical rental home is in Georgia, with a property tax rate of 0.83 percent. Annually, taxes are $3,320 or $276.66 per month.
- Property Insurance. The average cost of a Georgia home insurance policy is $1,376. So, 25 percent more than that is $1,720, or $143 per month.
- Vacancy Losses. This expense is hard to estimate, but let's say that you cannot fill the unit for one month. If you are charging $2,000, that will equate to $166.66 monthly.
- Repairs and Maintenance Expenses. Using the one percent rule, we know that you should expect to pay $4,000 per year. That translates to $333.33 monthly.
- Owner-Paid Utilities. Depending on where the property is, you can expect to pay around $56 for water and sewage. And Garbage costs about $15 to $20 per month, for a total of $75 (estimate).
Let's add up these expenses and see what we get for the net operating income.
$276.66 + $143 + $166.66 + $333.33 + $75 = $994.65
So, if you are charging monthly rent of $2,000, the 50 percent rule is pretty accurate.
Should Property Investors Use the 50 Percent Rule?
Yes, they should, but not as a strict guideline. Ideally, investors can use this deal analysis for homes they buy outright with cash. This way, they do not have to worry about mortgage payments eating into their bottom line.
This rule aims to help investors make snap decisions before putting money into a potential deal. Since most investors do not account for expenses accurately, this rule helps them get a ballpark figure. From there, it is up to the real estate investor to do their due diligence.
Pitfalls of Using the 50 Percent Rule in Real Estate
The biggest downside of the 50% rule is that investors may not calculate their expenses first. Also, since it does not include mortgages and HOA fees, it is not always accurate.
A better option is to multiply the total expenses by two. So, once you calculate the monthly bills, you then charge your tenants double. If you are paying a mortgage, be sure that you still have some profit left over.
The other downside of the 50 percent rule is that some variables are hard to calculate.
For example, what if you cannot find tenants for three months out of the year? That will eat into your net profit significantly. What if there is an expensive repair bill on your rental property that is not covered by insurance? What if the home is in a flood plain and you must buy flood insurance?
This rule also does not include property management expenses. So, if you are not a hands-on landlord, you have to subtract these fees from the rental income.
Also, just because you plan to charge a certain amount per month does not mean tenants will pay. Adding a loss of rental income endorsement to your landlord policy can help offset these setbacks, though.
Finally, if you are basing the rule off a $2,000 rent fee, what if you must lower it to $1,600 to meet market rental rates?
Use the 50% rule for ballpark estimates but understand it does not always reflect all rental property expenses.
Final Thoughts on the 50 Percent Rule in Real Estate
As a rule of thumb, the 50 percent rule is a good starting point, but do not rely on it too much. Instead, drill down your costs and expenses to figure out whether it is accurate or not. If it is not correct, you will have to weigh the pros and cons.
Hope that helps!
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