A thorough deal analyzer is crucial to the success of any real estate investor, but a quick system that acts as the initial evaluation for potential properties is helpful too. With calculations like the 50% rule, investors can assess a deal with limited information and determine whether the property is worth more time and effort. Keep reading to learn how the real estate 50% rule works and add this calculation to your tool kit today.
What Is The 50% Rule?
The 50% rule is a guideline used by real estate investors to estimate the profitability of a given rental unit. As the name suggests, the rule involves subtracting 50 percent of a property’s monthly rental income when calculating its potential profits. According to the rule, 50 percent of the rental income should be designated to expenses and therefore not considered when comparing potential profits against the monthly mortgage or loan repayments.
The purpose of the 50% rule is to help investors make quick, informed decisions about rental properties.
One of the most common mistakes property owners make when searching for deals is underestimating the cost of expenses. This can lead to lower profit margins, or in some cases an unsuccessful deal altogether. Essentially, investors will incorporate the 50% rule into their initial review of a deal as a way to protect against unexpected costs and expenses.
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How The 50% Rule Works
The 50% rule works by taking the total monthly rental income, and dividing it in half. This is to account for potential expenses associated with owning the property. Expenses include repair costs, taxes, property management fees, utilities, and insurance costs. Investors do not need to know the exact expense amount to utilize this rule. In fact, this calculation is so popular because it allows investors to estimate potential deals quickly and on limited information.
One thing to point out is that the 50% rule does not classify mortgage or loan payments as “expenses”. Instead, loan payments should be compared to the remaining half of the rental income to determine whether or not to move forward with a property.
Why The 50% Rule Matters
The 50% rule matters when investors need to move quickly through potential properties. If you operate in a fast-moving, competitive market (which is increasingly common these days) the 50% rule can help you know when to move forward or pass on a deal. If a property’s numbers fit the rule it signals a more thorough analysis. If, however, the property’s numbers don’t fit you can move on without losing too much time or energy.
The 50% rule can also be applied to multiple property types in residential real estate: single-family, multifamily, condos, duplexes, etc. The versatility makes it especially easy to apply when you find a potential deal and need to act fast.
Using The 50% Rule To Calculate Cash Flow
Despite its simplicity, the 50% rule can be used as part of a more comprehensive deal analysis as well. Namely, the 50% rule can help investors calculate cash flow. After you work through the 50% rule to determine the net operating income (NOI), subtract your estimated mortgage repayment. The resulting number will provide a good estimate of the monthly cash flow you can expect from the property. The following example will help better illustrate the rule and formula.
An Example of the 50% Rule
Let’s say you are looking at a single-family home in your market with an estimated monthly rental income of $3,000. Following the 50% rule would mean about $1,500 of that will be used for property expenses. That would leave you with another $1,500 to evaluate in comparison with your loan payment. If you have a monthly mortgage payment on the property of $1,200, this investment would, in theory, cash flow at $300 a month. You could then use this number to decide whether or not to complete a more thorough analysis of the home.
Is the 50% Rule Accurate?
The 50% rule provides a good guideline for the first evaluation of a property, though it should not be treated as an entirely accurate representation when calculating expenses. The purpose of the rule is to help investors somewhat accurately evaluate expenses without underestimating costs, even with limited information on the property. In the first stage of a deal analysis, investors likely do not have all the numbers on a property needed to nail down total expenses. Therefore, the 50% rule should be treated as a general guideline and not a hard and fast rule.
Many investors find that the 50% rule overestimates the expenses associated with a property. The reason being that not all homes have the same property taxes, HOA fees, or maintenance requirements. In reality, these costs may not total up to half of the overall rent, which should come as a pleasant surprise as you dig deeper into the numbers. A further limitation of the 50% 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.
How to Make Money Using the 50% Rule in Real Estate
The best way to utilize the 50% rule is to consider it an appetizer with a more thorough, full-course analysis to follow. If a property passes the test, calculate other metrics before moving forward. The 50% rule should never be used as a final say when deciding to invest; however, it can be used when determining when not to invest. For example, if you run the numbers on a property and your mortgage far exceeds half of the rental income, the deal (or your loan) may not be the best option.
As you already know, it is crucial to mind your due diligence before taking on an investment opportunity. If you want to use the 50% rule to make money, then understand it should go hand in hand with a strong rental property calculator. Be sure to ask the previous landlord questions, research the market area, and evaluate all aspects of a property when it comes time to actually invest. In the meantime, use the 50% deal to quickly analyze potential options and whether or not they are worth a second look.
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What Is The 1% Rule?
The 1% rule is another formula used to provide a quick overview of a potential investment property. In essence, the rule states that the monthly rent must be equal to or greater than 1% of the overall purchase price. The purpose of this guideline is to help ensure regular cash flow.
If you are interested in buying a $200,000 single-family home, per the 1% rule the monthly rent would need to be no less than $2,000. If the average rent in that market for a similar property is significantly less than $2,000, the property would not fit the rule. Some investors also use this rule to decide how much rent to charge, in combination with a market analysis. Overall, the 1% rule is a general guideline when reviewing potential investment properties.
As a busy investor, it can be time consuming to conduct a thorough analysis of every potential deal that comes your way. That’s where calculations like the 50% 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 encounter a potential deal and see for yourself how the 50% rule can work for you.
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