BiggerPockets

How are you determining the amount per dollar of rental income?

If you are looking at the max price to pay for a long term buy and hold - take the rental income and divide it by 2%

Example - $600/.02 = $30,000

Your example based on your assumptions doesn't fit in the 50% rule - monthly rent = 600/2 = $300 - debt service of $264 = $36 of monthly cash flow.

Not to say you have to follow these rules, but I don't know what you are trying to accomplish. I'm sure someone else will chime in.

What's your investment strategy?

The formula is pretty simple, but it doesn't work out to a specific amount you can spend per dollar of rent. That's because you want a certain amount of cash flow, regardless of the rent. A tenant is a tenant, and has about the same amount of effort whether they're in a $500 rental or a $1000 rental.

If you just want to hit break even, you can come up with a number. The answer is $75. Here's how I got that:
Rent: $1
Expense: $0.50
NOI: $0.50
Desired cash flow: $0
Max payment: $0.50
May loan: $75 (7%, 30 years)

If you pay that, you'll be break even.

However, if you want $100 per unit, then for $1000 in rent you can pay only $60K
Rent: $1000
Expense: $500
NOI: $500
Cash flow: $100
Max payment: $400
Max loan: $60,123

At $500 in rent, though, you can only afford to pay $22,546 because you max payment is only $150. $100 out of $250 NOI is a much bigger hit than $100 out of $500 NOI.

That's why I don't much like the 2% rule. It works OK at rents of about $500, but puts the price too low at higher prices.

How much down payment are you guys talking about in your examples ?
In my calculation a 1% property is good and will cash flow with 20 to 25% down.
Or are you guys talking about 100% financing ?

Michael,

The 2% Rule is very easy and has nothing to do with the financing. As I said, it's a screening tool, but it is very effective at giving you an idea if a rental is a potential deal or not.

Very simple, the 2% Rule says that the monthly gross rents need to be at least 2% of the acquisition cost (purchase price + initial rehab).

So, to determine the maximum acquisition price (purchase price if no rehab is needed), you divide the monthly rent by .02 or multiply the monthly rent by 50 (which is exactly the same thing). For example, if the monthly rent is $600, you multiply that by 50 to get a maximum acquisition cost of $30,000. Subtract any initial rehab from the $30,000 and you'll have the maximum purchase price.

As I've said, the 2% Rule is a screening tool. If you use the 2% Rule to come up with a $30,000 purchase price and you can get the property for $32,000 - then it's worth doing a cash flow analysis. If you use the 2% Rule to come up with a $30,000 purchase price and you will have to pay $50,000 for the property, I wouldn't even give it a second glance!

As for the downpayment, even the worst property will "cash flow" if you put down a big enough downpayment. Putting down money to buy cash flow doesn't change the character of the deal or turn a bad deal into a good deal. There is an opportunity cost to your money and you definitely should consider that!

Mike

Michael-

You are not thinking of true cash flow. I'm sure MikeOH or Jon will pipe in. Do a search on the 50% rule and you'll see the definition of true cash flow.

By the way, I am new to this forum, but I love this place and love being around pple who share my interest.

Now I still maintain that a ratio of 1% can be pretty good if you put 20% down, you will have in most cases true positive cash flow.
Am I missing something ?

What you're missing is that putting money down doesn't alter the quality of the deal. All the downpayment does is BUY the cash flow. Using that theory, you should always pay cash for the property and then you would have a LOT of 'cash flow'. The issue is that there is an opportunity cost to that money you're putting down. That money has value. When you use it to buy cash flow, you're not considering the value of that money.

Another issue is how many properties you can buy if you put down 20% on each one and then they don't generate cash or lose cash each month.

Let's look at a real example:

Purchase price: $80,000
Down payment (20%): $16,000
Mortgage amount: $64,000

Gross rent (1% of purchase price): $800
Operating expenses: $400
NOI: $400

Mortgage ($64K, 30 yr, 7% NOO): $425

Cash flow: $25 LOSS (ouch!)

So, for the privilege of putting down $16,000, you're still losing $25 per month. Yes, it's true that you will be getting the principal paydown, depreciation for tax purposes, and appreciation over time; and those things may make you rich decades from now, if you can afford to plunk down a lot of $16,000 downpayments, while losing money each month. In the mean time, you've put down a bunch of your own money so that you can lose money each month. In addition, even though you're losing money, you'll still get the privilege of dealing with tenants and all their problems (or at least management companies and all their problems).

The point is that there is no reason to pay retail for a deal and lose money on it every month. You can buy property at a discount and actually make money while you're building wealth.

Good Luck,

Mike

Another way to look at the 1% rule is to go to an annualized basis. 1% monthly rent means the annual rent is 12% of the purchase price. If 50% of that is expenses, etc., then your NOI is only 6% of the purchase price. One way or another, you have to come up with the entire purchase price, and there is a "cost of capital" for that money. If you finace 100% of the purchase at 6%, then your cost of capital is 6%. So, you'll spend the entire 6% NOI on the capital, leaving you nothing for cash flow. In reality, cash flow is even less because you'll have the interest payments.

If you consider your own money is worthless, and you put 20% down, then your cost of capital become 80% of 6% or 4.8%. That gives you a return on the deal of 1.2%.

Personally, I don't think my money's worthless. For sure I can get 2-3% in bank CDs. With hard money loans, I can get up in the double digits. Further, my cash is hard to come by and I don't want to invest it in just anything. So, with a 20% down payment I'd consider my cost of capital to be over 6%.

Not to mention I think getting a 6% loan right now for investment property would be stupendous. Heck, I'm beginning to think getting any loan is a miracle.

Jon, you mentioned hard money loans, and they are in the double digits. Do you use them successfully and if so, how would you structure a deal to make money on a property that cost for example 50k before rehab, needs 10k or rehab and would rent for $1200 a month after rehab. I am interested to know how to make money on such a deal without using conventional financing or seller's financing ?
a break down please.

Brian,
Yeah I don't buy in my area, too expensive, I have 2 rentals in Austin cos' I thought Austin was both good for cash flown and a strong univesity white collar city.
Now as I m not satisfied enough with the cash flow in Austin, so I am about to start investing in Dallas Fort Worth area where cash flow in superior to Austin. I am happy to learn as I go.