When a real estate investor plans to invest he does a thorough analysis, but a quick calculation is also crucial. With this 50% rule in real estate, the investors can assess the initial potentiality of the property. Instead of performing an in-depth analysis of each and every property, you can use this rule. This rule is a rule of thumb to do a quick evaluation for a single-family investment property. It generally states that the expenses associated with the operation of investment are 50% of its gross rents.
This article is for those who want to accumulate knowledge about the 50% rule, how it works, and how foolproof the rule is to the investors.
What is the 50% rule in real estate investing?
The 50% rule in real estate is an analysis tool used to evaluate a property. Through this, you can assess whether they generate adequate cash flow or not. The purpose of this rule is to allow the investor to make quick and informed decisions about the property. In real estate, it denotes approximately half the net operating income for deriving the gross income.
The 50% rule formula is calculated as below:
Operating expenses = (Net Operating income) / 2
Through this, we can calculate the operating expenses and also the net operating income. Moreover, cash flow calculations using this rule are quite popular among investors during the initial stage of evaluation. They check the rate of positive cash flow and whether the property is worth it or not. The 50 percent rule in real estate includes property taxes, insurances, vacancies, renovations, maintenance expenses, and other utility expenses.
This rule in real estate does not cover the monthly mortgage payments, expenses regarding property management, and the fees of the owner.
How does this rule work?
The 50% rule in real estate is used to estimate the potential cash flow. Furthermore, it derives the operating expenses and the net operating income.
However, for utilizing this rule investors do not require the actual expenses. The popularity of this rule has increased because by using this rule the investor can estimate potential deals. And for this, limited knowledge is required.
An example will help you to understand this better:
Let’s say that you are looking for a single-family home with a monthly rental income of $4,000. According to the 50% rule, $2,000 is used for property expenses.
And you are having another $2,000 to evaluate in comparison with your loan payment. Moreover, the monthly mortgage loan for the property is $1,500. Hence, you receive $500 as cash flow per month by subtracting both values.
After the estimation of the potentiality of the cash flow, you can take your decisions. It helps you to decide whether to go ahead with the property or not.
Is the rule in real estate investing accurate?
50% rule is just a guideline to evaluate the property at the beginning level. But, while calculating the gross income accurately you can’t completely rely on it. In the beginning, the investors do not have all the expenses on that property.
Therefore, this rule is treated as a general guideline to evaluate expenses without underestimating costs. So, it’s not a hard and fast rule.
In many cases, the 50% rule in real estate overestimates the gross expenses. Since, the property taxes, HOA fees, or requirements for renovation differs. It’s not the same for all the properties. Thus, the expenses also vary.
In reality, the operating expenses are not exactly half of the total monthly rent. The 50% rule also has another major drawback. That is, if the property remains vacant the owner has to bear all the expenses.
Thus it fails to account for vacancies. Also, this rule can’t guarantee you to have tenants all throughout the year
How to make money using the 50% rule in real estate?
To get the best deal you have to use the 50% rule as a beginner followed by thorough research and analysis. If the investment property clears the rule, then evaluate other metrics too before moving forward.
The 50% rule can go simultaneously with other strong rental property calculations. We can use the 50% rule to quickly analyze the property. But before investing you have to research the market area and evaluate all the aspects of that property.
Sometimes the investors underestimate the costs of expense while making a deal. Thus, this leads to a low-profit margin and makes the deal an unsuccessful one.
This 50% rule is used by investors to filter the properties with excessive-high expenses compared to the potential rents. So, by using this rule you can also avoid investment properties with high property taxes, maintenance costs, or capital expenditures.
Being a busy investor it’s not always possible to analyze every investment property thoroughly. In that case, the 50% rule comes handy to evaluate the property at the initial stages. By comparing the operating expenses and the net operating income you can choose whether the property is worth it.
This 50% rule doesn’t evaluate the exact situation but it provides a good estimate. So, before purchasing an investment property mind your due diligence along with the 50% rule.