BiggerPockets

I thought I had heard another investor say that the two rules were basically the same thing. Maybe I misunderstood, but if not could someone explain how they are the same thing??? And also, the 2% rule seems to work best when searching for properties under 100k. It seems that rents are a larger portion of the purchase price the lower the purchase price. Hope these make sense.

THANKS!!

They're related, but are actually two separate rules of thumb. The 50% rule is that operating expenses and vacancy are about 50% of the rent.

The 2% rule says if you can find a property priced such that the rent is 2% of the purchase price, it will cash flow. Note that you cannot use this to figure out what the rent should be. The market dictates the rent. Rather, you have to use it to determine how much you can pay.

The 50% rule is an emperical rule from observations of many properties. I've seen it other places than posters here. For any particular property, esp. a SFR, it may be less in some years. But, all it takes it one big expense to go way over and bring the average up.

The two rules do work together. If you collect 2% of the rent each month, you're collecting 24%/year. If expenses eat 50%, your NOI is 12%/year. Interest will probably run you about 8%. That leaves you 4% of the purchase price each year as profit. If you only collect 1% each monty, and pay 50% in expenses, that leaves you an NOI of 6%. Interest is going to take all that and 2% more. If you have an amortized loan, you'll have a bit less cash each month, but you'll get that back when you sell.

Sometimes people say, well, I'll put a big down payment on the property to try to make a higher price work. Say 50%, and assume 1% rent. You still have the same 6% NOI. But, now your interest cost is only half, or 4%. So, it looks like the property cash flows 2%. If you look at it that way, you've invested that 50% into an investment that returns nothing. Or, if you look at it as a cash on cash return, you're 4% on your money. Less than bank CD's.

Reflex, you say its impossible to find a property in your area that will cash flow using these numbers. I assume you really mean its very hard to find a property that meets the 2% guideline. True in many places, including right here. But, if you pay more, you won't make any money.

Jon

Jon, I did say " nearly impossible" because I will not give up.

I have been looking a multi-family properties (1-4), and none of the more desirable units will cash flow using these numbers.

Is there any numbers/calculations that one can use which eliminate taxes from the equation? As some properties would have higher taxes, they may not work even at 50%, while some with lower taxes may work with a lower percentage.

So the 2% rule is a screening tool, but is the 50% rule a screening tool too??

When using these screening tools, should one apply a down payment if they know they will need one??

Thanks for the replies everyone!

Chaz,

The 50% Rule is nothing more than the historical average of operating expenses throughout the United States. If it were possible to use the actual expenses for a property, I would do that. Unfortunately, that is nearly impossible. Most residential rental properties in the United States are owned by mom and pop type owners. The have one, two, or a few rentals. Most of these owners don't have the slightest idea what their operating expenses are, and they certainly don't have detailed records going back many years. It is also true that the vast majority of newbies don't make it in the rental business and therefore there is a continuous turnover of rentals.

Since there is no way to determine the actual expenses for a property you're looking at, then the best way that I've found is to use the 50% rule, which simply means that you're assuming the operating expenses over time will be 50% of the gross rents. I have found that this is an accurate number but you should understand that expenses will vary for any particular unit in any particular year.

For example, I have one house that has had the same tenant for the past 4 years. In the first year, I replaced the water heater, but in the next 3 years I have had absolutely no maintenance. Should I conclude from looking at this house that vacancies are zero and maintenance is almost non-existent? My operating expenses for this house over the past 4 years have been lower than 40%.

On the other hand, I have another house that has had two horrible tenants in the past two years. The first tenant was an RN who allowed a friend to sell crack from the house. When it was raided by the drug task force, a LOT of damage was done. The front door was broken down; the NEW carpet was burned by the concussion grenade; all the light fixtures were torn down; the outlets were ripped from the walls; and all of this was in addition to the damage done by the tenant. Next, I had a Section 8 Tenant in there that lived like a PIG - a very lazy pig whose very last ambition in life was to clean. She and her teenage swine children destroyed the place again. All the new carpet is ruined. The front door is broken. The walls will need to be repainted. It is just simply a disaster. Should I conclude from this incident that operating expenses on SFHs in my area are 65% per year?

Of course, the answer in both cases is no. The operating expenses average 45% to 50%. That is the 50% " Rule" . It just says that your operating expenses will run about 50% of the gross rents.

One more thing while I'm on this topic. The 50% Rule assumes that you are doing everything right as a landlord. The data behind these numbers comes from the large apartment associations, where you have a high percentage of professionals. If someone is making a bunch of landlording mistakes (like letting the tenants go months without paying or not screening the tenants), then obviously the operating expenses will be MUCH higher!

Hope this makes it a little clearer.

Mike

Jason,

I get a judgement if I think I have a chance to collect (because they have a good job) or if they are on Section 8. If I get a judgement against a Section 8 tenant, they won't be able to get any future Section 8 benefits unless they first pay the judgement. Either way is fine with me. Of course, I'd like to get the money but that almost never happens. So, I'm just as happy to know that the deadbeat won't be getting any more Section 8 (my taxpayer) money.

I am not happy when someone steals from me. I will do whatever I can to make their life miserable and to prevent them from getting another rental. I will let other landlords know about the deadbeat and will do everything possible to have their Section 8 cancelled (which I've done many times).

If someone holds you up at gunpoint, they go to jail. I consider a deadbeat tenant to be no different!

Mike

Also, is the 2% on annual rents or just one months rent? Finally, with the 2% rule, what percent down payment is assumed. Thanks.

Thank you. One additional question - are leasing commissions included in the operating expenses factored into the 50% rule

I am trying to figure out the industry practice for leasing agents. Are onsite leasing agents salaried or do they recieve a commission each time they get a unit leased or re-leased. that's one question and then is that cost (salaries to leasing agent or commssions to leasing agent) factored into the 50%. thanks!

Thanks.