The 50% Rule of Thumb

Many successful investors use the following quick formula to quickly gauge the strength of a deal.

Estimate or verify the current monthly market rent for a house, duplex, triplex, quad or other investment property. Then take 50% of that number. Then deduct your desired cash flow and the number you are left with is the maximum monthly payment for principal and interest you have to work with. From that you can work backwards to your maximum loan amount and consequently your maximum purchase amount. The maximum loan amount can be calculated using the remaining 50% of the available rents as the monthly payment on any financing proposed for the purchase. The maximum purchase price would be that amount plus any anticipated down payment on the purchase.

The 50% ratio is a quick way to identify the net operating income you can expect from the property given the market rents available. In essence, you are saying the properties operating expenses are 50% of the rent.

Often times, someone will say, but my expenses aren't 50%. When I look at all of my real expenses I am only at 35% or 25% or some other percentage.

Maybe. But, more often than not, they are confusing accounting with analysis and I can almost guarantee they are leaving out some items they should include. They usually look at the tax return and eliminate the items where they didn't really expend any cash, like depreciation. What they are left with are the actual dollar costs of that year or two years they are looking at.

These are the general items I include in the operating expenses verses projected rents for analysis:

  • Vacancies
  • Maintenance/Repairs
  • Landscaping/Ground Maintenance
  • Utilities
  • Management Fees
  • Advertising
  • Office Expenses
  • Travel to and from the units
  • Telephone/Internet used for business
  • Entertainment
  • Bank Fees
  • Permits and Business License Fees
  • Payroll including taxes
  • Professional fees (Accountant, Attorney, Etc.)
  • Property Taxes
  • Property Insurance
  • Miscellaneous
  • Capital Expenses*

*Some investors leave out Capital Expenses because they increase the cost basis of the property and get depreciated over time. Or they present some creative ways to account for them in the list after they have been incurred. The way I account for the Capital Expenses and the way I recommend it for analysis is as a reserve amount for future capital expenditures.

When you lump all of those together which is basically every expense EXCEPT depreciation, principal repayment and interest on that principal, you will usually find yourself near the 50% mark of the projected rents.

Don't confuse this exercise with figuring out what is allowed as a deduction by the IRS. We are not trying to figure out the taxable income with this ratio.

This is not a guarantee of profitability. This is only intended to help keep you from buying a negative cash flow property.