One of the biggest mistakes new rental property owners make is under estimating the expenses on rental properties. The 50 percent rule is one way to estimate what the expenses will be on rental properties. The 50 percent rule states that the expenses on a rental property will be 50 percent of the rents. The 50 percent rule does not account for any mortgage expenses. This rule is widely used on many online forums and by many investors, but I do not think it is something that should be used by all landlords on every property. I personally do not like rules that assume all properties are the same and perform the same. I prefer to run the numbers on each property to make sure everything is accounted for and the potential returns are as accurate as possible.
What is the 50 percent rule when used for rental property expenses?
The 50 percent rule states the expenses (not including mortgages expense) on a rental will be 50 percent of the rent.
Many investors use this rule to judge the profitability on a rental and only this rule. However, I think using a blanket rule like this is not the best way to analyze a rental property. Here is an example of what the 50 percent rule would say the expenses are on one of my properties.
Rental property number 4
Rent: $1,600 a month
Mortgage payment: $740 (without taxes and insurance)
According to the 50 percent rule I make about $60 a month on this property. However, I make much more than that. If I were to use my cash flow calculator, it shows I am making over $350 a month on this property. What is the difference? On the cash flow calculator it figures all of the expenses, it does not use a blanket rule. Here are the expenses on this property using my calculator:
Property Management: $128
Total: $501 a month
The difference between my estimates and the 50 percent rule is $300 a month or $3,600 a year. Are my expenses really this low or am I just making stuff up? I did an analysis of my rentals last year and my expenses were almost exactly what I had estimated them to be. I have had rental properties since 2010 and my estimated expenses have been very close to what the actual expenses have been. This was not just a one year anomaly.
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Why would the 50 percent rule show the expenses are so much higher than what they may actually be?
There are a number of factors why I do not like the 50 percent rule and I think it can overestimate the expenses on rentals. The biggest reason I do not like the rule, is it assumes all rentals will have basically the same expenses in every state and on every type of property.
- Property Taxes: The property taxes in every state can vary by a huge amount. In Colorado my taxes are less than $1,000 a year on most of my properties. In other states those same properties would have taxes five times that amount. Difference in expenses on taxes: $80 a month versus $400 a month.
- HOA dues: If you own a condo or town home the chances are you have HOA dues. Many single family homes have them as well. I have one rental with an HOA and the rest have no HOA fees. Some HOAs can charge hundreds of dollars a month. The difference in HOA expenses: $0 versus $200 a month.
- Vacancies: Different types of properties have different vacancy rates and so do different towns. In Colorado we have had extremely low vacancy rates. In some cases and years the vacancies have been under 1 percent. In other parts of the country the vacancy rate is over 10 percent. Single family homes typically have lower vacancies than multifamily homes. College rentals will have much higher vacancies than other types of rentals as well. Some properties may have 5 percent vacancies expenses and others may have 15 percent or higher. The difference in vacancy expenses: $80 a month versus $240 a month.
- Maintenance: Properties will need work, even if they are brand new. The amount of work will vary on the condition of the property and the type of property as well. Multifamily usually has more wear and tear than single family and college rentals can have much more wear and tear. The older a property is, the more maintenance it will require. The worse shape a property is in, the more maintenance it will require. The maintenance expense can vary from 5 to 20 percent as well. The difference in maintenance expense: $80 versus $320 a month.
There are other expenses that will make a huge difference as well like insurance. If the property is in a flood or hurricane zone it will have much higher insurance. As you can see the expenses on similar priced rentals, that may cater to different tenants, in different areas of the country can vary from $400 (once you add insurance and property manager) a month to $1,160 a month! If we took the same $1,600 in rent that I am getting on rental property number 4. My expenses could be 25 percent of the rent or over 70 percent of the rent. These are extreme examples of what the expenses may be on rentals, but they show how different properties will have much different costs.
What else skews the expenses when using the 50 percent rule?
Another problem with the 50 percent rule is it uses the rent to determine the expenses. When I bought my fourth rental property in 2012, it rented for $1,300 a month. The rents have gone up over the last three years to $1,600 a month and it may rent for more than that if I were to get a new tenant. Look how much the expenses changed because my rent increased.
- With $1,300 a month in rent the 50 percent rule says my expenses are $650 a month
- With $1,600 a month in rent the 50 percent rule says my expenses are $800 a month.
Did my expenses really go up by $150 a month because the rent is higher? It could be argued that because the rent is higher my vacancy expenses would be higher, because when a month’s rent is missed I would lose more money. I agree with that but here is how much my vacancy costs would increase using different vacancy rates.
- 5 percent vacancy: Expense would increase from $65 to $80 a month
- 10 percent vacancy: Expense would increase from $130 to $160 a month
- 15 percent vacancy: Expense would increase from $185 to $240 a month
Even with 15 percent of the rents accounting for vacancies the increase would only be $75 a month, not $150 a month. With a 5 percent vacancy allowance the extra cost is only $15 a month. Maybe the other expenses would be higher with the higher rent? My property taxes have gone up slightly, but less than $10 a month, my insurance has not increased, my maintenance has not increased, but my property management has. If we look at property management the increase is about $22 a month. On certain properties it possible that the expenses would increase $150 a month when the rent changes if many other things change as well. It is also possible that the expenses would not change much at all, which is the problem with the 50 percent rule. It is a blanket rule that does not account for the different expenses that different properties will have.
The 50 percent rule might be dead on for some properties, but for other properties it could be hundreds of dollars a month off. This is why you cannot rely on a blanket rule to figure the expenses. You need to write everything out or you can use a cash flow calculator to help you know what all the expenses are. Knowing the exact expenses will make you a better investor and help you figure out what is and is not a good rental property.
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