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50% rule

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Jim McMillen

Real Estate Investor from Columbus, OH

Feb 08 '08, 06:03 AM
1 vote


noob here.....Can someone explain the 50% rule, 2.5% rule.....I can't seem to find a definition for it.

Thanks.

Jim


Edited Jun 26 2010, 04:40


Tim W. Donor

Inspector from Tampa, FL

Feb 08 '08, 06:26 AM
5 votes


50% of what you hear about real estate investing is crap.
Of that 50%, only 2.5% works in a down market.

Seriously, here's what it means. If you buy right - at least 50% of your rental income will be spent on expenses. The general guideline is that you want to get rental income that is at least 2% of the purchase price. I used to believe in 1% but 2% is certainly better....and 2.5% is even better than that. With REOs the way they are, I've been applying the 4-5% rule. :mrgreen:


Edited Jun 26 2010, 04:40


Ken Mitchell

Real Estate Broker from charlotte, NC

Feb 08 '08, 06:38 AM
2 votes


tim, i kinda liked your first scenario....


Edited Jun 26 2010, 04:40


Jeff Wilcox

Real Estate Investor from Rowley, Massachusetts

Feb 08 '08, 08:31 AM


Tim,

What do you consider expenses? I.e. does it includes your debt service, taxes, insurance, + the all the other stuff (maint, advertising, vacancies, etc.), or does the 50% rule mean that in addition to your PITI you'll have other expenses that total approximately 50% of your planned rent?

Sorry to ask a basic one, but I'm still in the early stages of learning the property analysis bit.

Thanks
Jeff


Edited Jun 26 2010, 04:40


Tim W. Donor

Inspector from Tampa, FL

Feb 08 '08, 08:44 AM


No sweat Jeff.

For me, expenses are everything that goes out of pocket (including mortgage) before income taxes are figured. Yes, PITI is part of that when I have it on a property.

That's the hard thing with some areas. Properties just cost too friggin' much to cash flow properly. I scanned Virginia Beach and saw that your cheapest houses there start at 150k. Unless rents are $3,000/month that's hard to cashflow. On the other hand, I've seen property that sells as low as $6,000 per unit after repairs. Not hard to cashflow that. Don't expect it to be a hot appreciation market though....lol.

Tim


Edited Jun 26 2010, 04:40


Michael Rossi

Real Estate Investor from Ohio

Feb 08 '08, 05:21 PM


Jeff,

The 50% rule is nothing more than the fact that throughout the United States, operating expenses run 45% to 50% of the gross rents for rental properties. Operating expenses include all the expenses that are associated with operating your rental business, but DO NOT include the mortgage payment (Principal and Interest). Operating expenses include (but are not limited to): taxes, insurance, management, maintenance, entity maintenance, advertising, utilities (at least during vacancies), legal fees, damage done by tenants (over the security deposit), vacancies, setouts, lawsuits, and capital expenses (not technically an operating expense).

There is no 2.5% rule. The 2% rule is simply a screening tool that says that you need the monthly gross rents to be about 2% of the acquisition cost of a rental (purchase price + rehab). Very simple math will tell you that if the monthly gross rents are not about 2% of the acquisition cost, the property will not cash flow properly.

Good Luck,

Mike


Edited Jun 26 2010, 04:40


Jeff Wilcox

Real Estate Investor from Rowley, Massachusetts

Feb 08 '08, 07:57 PM
2 votes


Tim, Mike,

Thanks for taking the time to answer my question. Tim, I've come to the same conclusion about Va Beach as well. The cheap properties aren't so cheap here.

Just to summarize my understanding. When I analyze a property, I should consider the following.

1. Can I set the rent at 2% of acquisition costs and have it be realistic/competitive in my area?
2. My cash flow analysis needs to consider....

Cash Flow = Rent - Debt Service (Princ and Int) - All other expenses (est at 50% of Rent)

So if you do a little math and want to figure a rough break even point on either the rent or the debt service, you can set cash flow = 0 and solve for one of the other variables.

e.g. 0 = Rent - Debt Svc - 0.5 Rent

0 = 0.5 Rent - Debt Svc

Concluding that .....

Debt Svc = 0.5 Rent OR Rent = 2 Debt Svc

Solving for rent will tell you what you need to charge given the acquisition cost of the home in order to break even. Or, solving for debt service will give you an idea (albeit subject to the details of your financing arrangements) of how much you can spend to acquire the property given the average/acceptable rents in a particular area.

I like bar room napkin math and this looks like a quick and dirty way to determine whether I should spend more time considering a particular property or not.

Please let me know if my conclusions are flawed.
Thanks again,


Edited Jun 26 2010, 04:40


Michael Rossi

Real Estate Investor from Ohio

Feb 08 '08, 08:16 PM


1. Can I set the rent at 2% of acquisition costs and have it be realistic/competitive in my area?

That would be great, but unfortunately you do not get to set the rent. The rent is set by the market. So, the real question is whether the market rents are at least 2% of the acquisition cost.

So if you do a little math and want to figure a rough break even point on either the rent or the debt service, you can set cash flow = 0 and solve for one of the other variables.

Why would you want a break even property? The point of being in business is to MAKE MONEY, not break even.

Or, solving for debt service will give you an idea (albeit subject to the details of your financing arrangements) of how much you can spend to acquire the property given the average/acceptable rents in a particular area.

THAT'S IT!

Good Luck,

Mike


Edited Jun 26 2010, 04:40


Jeff Wilcox

Real Estate Investor from Rowley, Massachusetts

Feb 08 '08, 09:53 PM
1 vote


Mike,

I couldn't agree with you more. I see no reason to get into this game to break even. It's a statement I've made to my wife many times before. My point was just merely stating the obvious that you can quickly draw the line in the sand with the simple math rule of thumb to determine where the (+) cash flow is and where the (-) cash flow is.

Despite the other sources of building wealth via REI (appreciation etc), I think the cash flow aspect will probably be my number one requirement. No (+) cash flow, no deal. While I think there are probably many reasons why one would buy an REI at a break even cash flow, I believe that I need to start slow and get a few wins under my belt before going there.

Thanks again for the education,


Edited Jun 26 2010, 04:40


Michael Rossi

Real Estate Investor from Ohio

Feb 08 '08, 10:17 PM


Jeff,

I would draw the line in the sand a little higher - at about +$100 per unit per month.

Good Luck,

Mike


Edited Jun 26 2010, 04:40


N.A N.A

Property Manager from Honolulu, HI

Feb 08 '08, 10:23 PM


MikeOH-

Do you include an exit value in the " income" side of your calcs? Why?


Edited Jun 26 2010, 04:40


Steve Shanes

Real Estate Consultant from

Feb 08 '08, 10:50 PM
1 vote


Jeff,

Personally, I'd rather distinguish (with rentals) like so, to create a method:

a. My policy: some parameters have to reach certain points before I buy.

b. My thumb rules: 2% is a bit higher but I've got mine, which I developed after a while and is still improving. The main thing about it is, let you determine if the property goes to step II - analaysing

c. Analysing - a complete analysis for the property that shows some scenarios, mainly the worse and exit strategies. Many times this varies a lot from what you have with the tumb rules. Analysis shows you what is your expected income, cashflow etc., but also shows you on a timeline at which point you are about to need a huge sudden amount of cash, and whether you've got it. It also shows you what's next.

d. Note: Important: your equations are correct but, most of the part of it are given! Of course, you can set cashflow = 0, but what does it mean, when the other parts are set by the market? So, you put everything in place and eventually get a couple of ratios. Then, you find the ones most important for you and check them. This is the right method.

e(and back to a - policy). What are these parameters? Depends on the scenario. Rental property usually what you are looking for is positive cashflow, of higher than X (personally, I'd rather include x in an early calculation and see if I got a positive value. This way I know I took everything into account, otherwise what's the meaning of this x?). You should also consider the following parameters as analysing basics: the return on invested capital ratio (it should be quite good, otherwise you could have invested elsewhere!), and the available financial resources left after considering the future plans.

Steve


Edited Jun 26 2010, 04:40


Michael Rossi

Real Estate Investor from Ohio

Feb 08 '08, 11:02 PM
8 votes


Do you include an exit value in the " income" side of your calcs? Why?

No, because I don't intend to ever sell them. I'm in the rental business, not the slow-motion flip business. In addition, I can't eat future profits or go snowboarding with principal paydown, so they really aren't relevant to today's situation. If you doubt this, try taking a personal financial statement to Park City and see if they'll give you a lift ticket. I don't think so!

I am interested in only two things: CASH FLOW and EQUITY AT CLOSING. If you've got both of these, it's hard to go wrong.

Mike


Edited Jun 26 2010, 04:40


Tim W. Donor

Inspector from Tampa, FL

Feb 09 '08, 08:38 AM
2 votes


Originally posted by "MikeOH":
No, because I don't intend to ever sell them. I'm in the rental business, not the slow-motion flip business. In addition, I can't eat future profits go snowboarding with principal paydown, so they really aren't relevant to today's situation. If you doubt this, try taking a personal financial statement to Park City and see if they'll give you a lift ticket. I don't think so!

I am interested in only two things: CASH FLOW and EQUITY AT CLOSING. If you've got both of these, it's hard to go wrong.

Alright - EVERYONE MUST listen to this post. This post right here is the key to long term Real Estate investing success. Anyone who has made a successful career of real estate investing anywhere beyond 3-5 years and has been successful in both up and down markets employs these principles. Dynasties are built on these simple principles.

Ironically this is nothing new. Our system of real estate is built on the principles of feudalism that were founded by Charles Martel in the 8th century. These principles have been working for 12 centuries. (Where do you think we get the term " landLORD" ?.) It doesn't take a brain surgeon to see that they will continue to work another century or two.

Great post Mike - hopefully one or two will listen.

Tim


Edited Jun 26 2010, 04:40


Mike Seluk

Fort Myers, Florida

Feb 09 '08, 09:38 PM


Originally posted by "TimWieneke":

That's the hard thing with some areas. Properties just cost too friggin' much to cash flow properly.

So when you run into that, do you just move on to the next area, or try to put down enough to make it cash flow? Or is it a waste to tie up that kind of cash?

Where I am, things are still too expensive to make it work in my favor - and the market IS down. I'd have to be able to acquire something for ~40% below market value to get the numbers in the ballpark.


Edited Jun 26 2010, 04:41


This post has been removed.

Michael Rossi

Real Estate Investor from Ohio

Feb 10 '08, 12:09 AM
2 votes


**********,

Here's an example of a property purchased for $50,000 with gross rents of $1,000 per month

Gross rents: $1,000
Operating Expenses: $500
NOI: $500

Mortgage Payment ($50K, 30 yr, 7%): $332

Cash flow: $168 per month

Hope this helps,

Mike


Edited Jun 26 2010, 04:41


This post has been removed.

Michael Rossi

Real Estate Investor from Ohio

Feb 10 '08, 03:40 AM


Cash down doesn't affect the quality of the deal at all.

Mike


Edited Jun 26 2010, 04:41


Tim W. Donor

Inspector from Tampa, FL

Feb 10 '08, 06:43 AM


Originally posted by "FtMyersMike":
Originally posted by "TimWieneke":

That's the hard thing with some areas. Properties just cost too friggin' much to cash flow properly.

So when you run into that, do you just move on to the next area, or try to put down enough to make it cash flow? Or is it a waste to tie up that kind of cash?

Yes. I go somewhere else. I don't fish for trout in a bass pond. Do a radius check of about an hour and a half to two hours drive out from your location. Chances are you'll find a town that cashflows. If not, stretch a little further. I seem to recall some decent cashflow potential in Gainesville.

Tim


Edited Jun 26 2010, 04:41


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