Applying certain rules of thumb can help when determining whether a real estate investment is likely to be profitable. The 50% rule in real estate says that investors should expect a property’s operating expenses to be roughly 50% of its gross income. This is useful for estimating potential cash flow from a rental property, but it’s not always foolproof. A financial advisor may be able to help you figure out if a rental property makes sense. Try using SmartAsset’s free advisor matching tool to find advisors that serve your area.
What Is the 50% Rule in Real Estate?
The 50% rule or 50 rule in real estate says that half of the gross income generated by a rental property should be allocated to operating expenses when determining profitability. The rule is designed to help investors avoid the mistake of underestimating expenses and overestimating profits.
For example, a rental property that generates $40,000 annually in gross rents would spend $20,000 of that to cover expenses, according to the 50% rule. The remaining $20,000 would represent net operating income.
What Does the 50% Rule Include?
It’s important to note which expenses the 50% rule of real estate investing applies to. The rule doesn’t factor in mortgage payments, property management fees or HOA dues but it does include:
- Property taxes
- Property insurance
- Vacancy losses
- Maintenance and upkeep
If you’re attempting to estimate how much profit you could realize with a rental property investment, you’d need to calculate what you’ll pay for mortgage payments, HOA fees and property management costs separately. The exception would be if you’re paying cash for the property, it isn’t located in a housing development that’s governed by an HOA and you’re handling all property management duties yourself.
How to Calculate the 50% Rule in Real Estate
Calculating the 50% rule for real estate transactions is simple, there’s no complicated formula involved. You’d simply estimate the gross rent the property is likely to generate either monthly or annually, then divide by two.
So again, say you’re considering an investment in a property that is likely to generate $3,000 per month in gross rent. If you apply the 50% rule then $1,500 of that would be earmarked for expenses, excluding mortgage payments, HOA fees and property management costs.
Assuming the property has a monthly mortgage payment of $1,100 and HOA fees of $100 monthly, this would theoretically leave you with $300 of cash flow. This also assumes that you act as your own property manager, rather than outsourcing those duties to a property management company.
How Accurate Is the 50% Rule?
The 50% rule for real estate investments is meant to be a guideline rather than a carved-in-stone standard for evaluating profitability. The rule is simply designed to help investors estimate what they might be able to walk away with in cash flow if they were to invest in a specific rental property. Again, the 50% standard is intended to prevent investors from underestimating the costs of owning the property.
The 50% rule can also be problematic because it assumes you’re basing calculations on static figures. For example, say that you purchase a rental property and six months later, there’s a natural disaster in the area. The unit isn’t damaged but as a result of damages to other properties and an uptick in claims, insurers raise their rates to balance their books. That means you end up paying more for property insurance, something your initial 50% rule calculation didn’t take into account when you bought the property.
What Is the 1% Rule in Real Estate?
The 1% rule can be used with the 50% rule in real estate to get a better sense of whether a rental property is a good buy or not. The 1% rule in real estate says that a property’s monthly rent must be equal to or no less than 1% of its purchase price. So if you were considering a rental property that’s listed at $250,000, you should be able to rent it for at least $2,500 a month.
The 1% rule for real estate, along with the 50% rule, can be useful for gauging how much cash flow a property is likely to produce. You can also use the 1% rule when deciding how much rent to charge. But just like with the 50% rule, you have to consider the accuracy of your calculations.
How to Use the 50% Rule to Invest in Real Estate
The 50% rule in real estate can be a starting point when deciding whether an investment in a rental property makes sense. If you know the expected gross rent the property should generate, then you can quickly calculate 50% of that amount to estimate net operating income. From there, you can deduct other expenses, such as mortgage payments or HOA fees, to find your projected cash flow. You can then compare that number to your target or goal cash flow to help decide if the investment makes sense for you.
Of course, there are other things you’ll want to consider beyond the 50% rule for real estate. You also need to weigh the prospect of an increase in costs for taxes, insurance, repairs, maintenance and utilities over time and how that may correspond to an increase in rental prices. Higher inflation can benefit property owners because they can adjust rental prices upward but it also means they pay more to own the property.
Finally, it’s important to you do your research on the rental market in the area where the property is located. For example, it can be helpful to look at rental pricing trends, demand for rental housing and the overall desirability of the area. You can also research things like property values, insurance pricing and utility costs to get a better sense of how much you might pay to own a rental.
The 50% rule in real estate is a quick way to calculate a rental property’s expected profitability. The rule is not fixed, however, and it doesn’t always provide an accurate picture of how much cash flow a property can generate. Expanding on the 50% rule with additional research can help investors make the most informed decision possible when determining whether to buy a rental unit.
Financial Planning Tips
- A financial advisor may be able to help you with your financial well-being. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Real estate can be a useful addition to a portfolio if you’re interested in creating diversification and a potential hedge against inflation. It’s possible, however, to invest in properties without having to be a property owner. Real estate investment trusts (REITs), for example, allow investors to diversify with real estate without direct ownership.
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