When a real estate investor decides to purchase a property, there are usually scores of options. Some investors even compare the search for a good real estate deal like a treasure hunt – you need to turn a lot of stones before unearthing a true gem.
So, how do you know if you are choosing the most beneficial property? The last thing you want is to buy an investment property that does not have cash flow, but is also continuously draining your profits.
While a thorough analysis is needed for any successful investment, a quick system that acts as the initial screening for a potential property is helpful too.
The 50 per cent rule is one of the most common guidelines that investors use to quickly analyse a potential deal. Simply put, this rule of thumb states that you should estimate your total operating expenses to be 50 per cent of your gross income.
Keep reading to learn how the real estate 50 percent rule works, and add this calculation to your tool kit today.
What is the 50 per cent rule?
The 50 per cent rule is a guideline used by real estate investors to estimate the profitability of a property. The purpose of this rule is to help investors make quick, informed decisions about rental properties.
One of the most common mistakes property investors make when searching for deals is underestimating the cost of expenses. This can lead to lower profit margins, or in the worst case scenario, a bad buy altogether. Essentially, investors will incorporate the 50 per cent rule into their initial assessment of a deal as a way to lessen the risk against unexpected costs and expenses.
According to the rule, 50 percent of the monthly rent should be designated to expenses and therefore not considered when comparing potential profits against the monthly mortgage payment.
Rental property expenses included in the 50 per cent rule are:
- Property insurance
- Property taxes
- Maintenance expenses
- Repairs
- Utilities
- Property management
- Reserve funds/Capital Expenditures
Meanwhile, expenses excluded from the 50 per cent rule calculation are:
- Mortgage payments
- Tax on rental income
- Property Depreciation
Do you need the exact amount of each cost to use the rule? No. This is why this rule is so popular with investors because it allows them to estimate potential deals quickly and with just a few details on hand. The rule is also mainly used to determine the property’s cash flow.
How do you calculate a 50 per cent rule?
The basic equation for the 50 per cent rule goes as follows:
Total operating expenses of rental property = Gross monthly income x 50%
Next, subtract your monthly mortgage payment. Whatever is left over becomes monthly cash flow.
If you run the numbers on an investment property and your mortgage is significantly higher than half of the rental income, the deal may not be the best option.
How to apply the 50 per cent rule
For example, you are looking to buy a single-family home with an estimated monthly rental income of $3, 000.
If you want to follow the 50 per cent rule, that would mean that around $1,500 of your income would be utilised for expenses that we have mentioned above.
The remaining $1,500 will be evaluated in comparison with your loan payment. For example, you have a monthly mortgage payment of $1,200, in theory, the property will give you a cash flow of $300 per month.
After you run the numbers, you can then decide if the estimated cash flow of the property makes it a good deal and if you should go through with an in depth evaluation of the investment property.
Pros and cons of the 50 per cent rule
Like all the other percentage rules when investing in real estate, such as the 1 per cent and 2 per cent, the 50 per cent rule has its advantages and disadvantages.
Pros of the 50 per cent rule
- Speed: It should take you less than a minute to use the rule.
- Simplicity of formula: If you know the estimated rental income of the property, you should be able to work out the expenses in your head, by simply dividing the rental income in half.
- Good for screening properties: Using the 50 percent rule can help you weed out properties that are unlikely to be cash flow positive, given that it is one of your main criterias for choosing a property.
Cons of the 50 per cent rule
- Accuracy. Is the 50 per cent rule accurate? No. The biggest weakness of the 50 per cent rule is its inability to give exact figures, only a quick ballpark estimate for rental property expenses. However, each property on your list should be evaluated further.
- Expenses can be lower than estimated. Many investors find that the 50 per cent rule overestimates the expenses associated with a property. The reason being that not all homes have the same property taxes or maintenance requirements. If you do a little more research on properties, you will learn that there are a lot of properties with operating monthly expenses that are significantly lower than the 50 per cent rule would indicate.
- Fails to factor in vacancy periods. Another limitation of the 50 percent rule is that it fails to account for vacancies, as there is no guarantee you will be able to rent out a property year round or right away.
Should you use the 50 per cent rule in real estate investing?
Like any other percentage rule we have written on, we advise that the 50 per cent rule should only be used as a screening tool.
As any investor would tell you, due diligence is needed before taking on an investment opportunity. If you are determined to use the 50 per cent rule to make money, it’s important to use it with other strategies that are more fleshed out.
Make sure to ask the previous owner of the property the right question, research the market area, and assess all the aspects of a property when it’s time to seal the deal.
The best way to use the 50 per cent rule is to see it as an appetizer with a more indepth full-course analysis to follow. It should not be used as the deciding test when deciding if you should or shouldn’t buy a property.
We understand that it can be overwhelming to conduct a thorough analysis of every potential property that comes your way. That’s when percentage rules like the 50 per cent rule can come in handy.
By comparing rental income and estimated expenses you can quickly discern whether or not a property is worth a second look.
Run these numbers next time you spot a potential deal and see for yourself how this rule can work for you.
Feel free to contact our investment team to find out how we can help you reach your financial goals. Give us a call at 08 8231 4709 or send us an email at info@centrawealth.com.au
Article courtesy of Nestegg
