Is the 50% really an average? I thought it was more like a conservative estimate. My thinking...
If it is an average, it means that approximately half of the time the expenses are higher and half they are lower than 50%. If you have multiple properties, than it is probably ok because you may hit the 50% on average. But if you have only one property, you would have 50% chance of having more than 50% in expenses...
The 50% rule (of thumb) is only an estimating tool which you might use to screen potential candidate properties that you would consider adding to your rental portfolio. It is an average based on the actual performance of a large number of rental properties across the nation over time.
The problem with a forecasting rule derived from a very large data sample is that it breaks down when you try use the rule to predict the actual operating expense for a specific property. Only the actual numbers for that property will determine that property's operating expense.
I do find that the 50% rule holds up fairly well both for a large number of properties averaged for a single year and for a small number of properties averaged over several years.
Some properties in a single year will have an operating expense less than 50% while others may be somewhat greater. The more properties you have in your rental portfolio and the more geographically diversified your portfolio becomes, the closer you will get to hitting the 50% number every year.
For a single, or even a small number of properties, you will have some years when your operating expenses are greater than others. Some years your rental market will be strong with a low vacancy rate, while other years will have a softer rental market that may require you to endure longer vacancies and even lower rents. Some years nothing will break so your repair cost will be minimal, other years the cost will be much higher. I have found that over several years, my total operating cost for a single property has still averaged about 50% of rental income.
So, to answer your question, I would say, "YES", 50% is really an average expectation that you should use when doing your cash flow analysis for a property you may consider buying for your rental portfolio.
How do the formulas change when you get to more expensive properties? If the price tag is $500k or even $1mil, and the mortgages are larger, do the formulas compensate for that?
I am working on a deal that is $550k, but that .02 theory comes back with around $340k as the price.
The 50% rule and the 2% rule are really complementary. You shouldn't really use one and ignore the other.
If you accept that half of the market rent for a property will be used to pay your operating expenses (the 50% rule), then you must conclude that only half of your rental income is available to pay your debt service and give you cash flow.
For example, consider a property that you want to purchase for your rental portfolio. The purchase price and rehab cost will total $50K. The property will rent for $750 per month. If half of your income is allocated to operating expenses, then you only have $375 each month available to pay your debt service and give you your desired cash flow. Let's assume that you use a commercial loan to finance all $50K at 7% amortized over 15 years. Your debt service will be $449.41 each month, giving you a negative cash flow.
Obviously, if the rent were $1000 per month, then there would be $500 left over after operating expenses to pay the debt service and have a little left over for a positive cash flow. It is not a surprise that $1000 monthly rental income is about 2% of the (after repaired) cost of the property in this example.
Of course you can manipulate the cash flow by simply financing less of your purchase price. If you routinely use 80% financing with 30 year amortizations and pay your rehab cost out of pocket, then you might have a positive cash flow with rents at 1.5% of your purchase price.
Mike (propertymanager) has not given me a copy of his book, so I don't know the complete analysis that he used to derive his 2% rule of thumb. However, I believe Mike's acquisition strategy is based on 100% financing (including rehab cost) using commercial financing to purchase low-cost properties. If your eventual goal is 100% financing (no money down) and a large rental property portfolio, then you will probably need to gravitate to commercial financing at higher rates and shorter amortization periods. For these financing parameters, the 2% rule seems to be valid if you need a positive cash flow.
I don't purchase anything more expensive than about $100K for my rental portfolio, so I don't know how the 2% rule holds up with the more expensive properties. I can only say that in my experience with properties costing less than $100K, I need about 2% of the purchase price in monthly rental income to generate a positive cash flow if I use 100% commercial financing (including rehab cost).
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