Some Serious Questions For Serious Long Term Real Estate Investors

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Whether it’s with callers, those emailing me, or even at a speaking engagement, it never ceases to amaze me what some seem to believe about long term real estate investing. But, somebody said it, they sound as if they’ve been there and done that, so they believe it. Don’t get me wrong, some of what this post will pillory are strongly held as Holy Writ by many. But it’s not my intention to offend anyone. It is my intention to hold some ‘em up to the light of day. To be honest, most of ‘em, in my opinion, have gone unchallenged for far too long.

Worshiping at the Altar of the 2% Formula.

This school of thought says if a property rents for $1,000 you shouldn’t pay more than $50,000 for it. For the record, I’ll take a dozen. :) ‘Course, before the stampede begins, let’s get some questions answered first, alright? Cool. Oh, and surely there are exceptions that will prove what I’m about to say as the rule. There’re always exceptions, but they’re so rare as to be evidence of the rule’s validity.

The Questions

  1. What is the quality of the neighborhood in which the 2% property was acquired?
  2. Would you put Mom or Grandma or your 19 year old daughter to live in that property by themselves? If you even pause in answering that question, the answer is no.
  3. If you defend the area’s quality, why are the prices so low? Are the rest of the investors who passed on it, um, under informed?
  4. Compared to unquestionably blue chip locations, do the tenants in these 2% properties compare in quality? Really?
  5. Would you hold this property ’til retirement if circumstances compelled you? Are you gettin’ all tingly with excitement just thinkin’ about that?

There are many more questions, but you no doubt see the trend here. Again, with rare exceptions even those who get outrageous prices on fixers, fix ‘em up, then rent ‘em, many times don’t get 2% rents to value. I talk to investors daily. As an experiment I’ve been askin’ about the number of properties in their long term portfolio that met the 2% rule. They think I’m messin’ with ‘em.

$200 (Or fill in the blank arbitrary number) per door cash flow

  1. Based on what?
  2. How much down payment?
  3. What’s the interest rate on your loan? Are you paying cash?
  4. Does your per door formula rely on a previously employed rent/price ratio?
  5. Did you think about how the property and/or its location will impact your retirement plan? How it might affect your retirement, period?

Again, a lot more questions can be asked. But here’s another formula without a cause.

Counting on your real estate investments to appreciate — even at a ‘reasonable’ rate.

This one may be THE most ill-advised strategy of them all — especially now.

  1. On what possible data do you predict several years — some go as far as the eye can see — of appreciation?
  2. Will there be even one year of interruption in your orgy of appreciation?
  3. If there is a year of rest from all that annual rise in value, will the following year’s rate of increase be far more than the average in order to make up for the lost year?
  4. In the ‘lost’ year, did the value of your properties retain their value at that point? Or, did they actually lose a bit?
  5. Consider that due to the 2% rule at purchase, your portfolio’s properties are in mediocre or worse quality neighborhoods. Why will they experience appreciation, year after year after year?

Do you think there’s any answer to any of these questions that won’t elicit snickers, if not outright laughter? Remember, you’re bettin’ on appreciation at the minimum expected rate for your investment to have been worthwhile. Really? Call me next Sunday. I’d like to make some NFL bets with ya. :)

We could do this with many more of the formulas sold as virtual guarantees of success. Again, speakin’ only for myself, if we took most of these so-called formulas, printed them, then shredded ‘em into confetti, we’d have the best fertilizer our lawns could ever experience, and the greenest lawns in our neighborhoods.

Formulas aren’t evil. Many of ‘em have demonstrable value. Not most of ‘em, many of them. What most formulas are in reality are weak substitutes for strategies based upon real live data. Data that has been analyzed within the context of ALL pertinent info — about the property — and about the investor.

The final question.

Are you really gonna bet your retirement on a buncha formulas? Really?

Bet you’re not.

Photo: Pablo

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About Author

Licensed since 1969, broker/owner since 1977. Extensively trained and experienced in tax deferred exchanges, and long term retirement planning.

25 Comments

  1. Jeff,

    You’re not going to tell me anyone uses the 2% rule for anything more then acquiring low income properties? Because 2% as a gauge to buying low income properties in certain markets is a little too high when considering the work that may be involved. Even then 2% in a landlord friendly State might be a gold mine, but I don’t think I would go there in California at least not in some Counties. We can even break that down more into parts of Cities, in Philly I would not consider buying in areas based on any percentage of rent collected.

    As far as putting family members in my rentals? I have set their standards a bit to high, but I would not have a problem living in my places, and I bought them at 2% or less.

    It would be much better to apply the 2% rule to properties owned by old time landlords who have not raised the rent in years or let the places go maintenance wise. I use the 2% more as a bargaining chip when buying.

    I would not however allow anyone to buy one of my renovated properties using the 2% rule. 50% of income to expenses rule is not going to work on a well renovated property in a low income area due to the fact that the expenses for daily repairs and maintenance will be very low in comparison to other similar properties.

    • Jeff Brown

      Hey Dennis — I get your point, for sure. I notice though, that you’d live in some of ‘em, but were silent on whether you’d put your 19 year old daughter to live there alone. :)

      I’ve been to many of the nation’s markets, and analyzed more than I’ve actually visited. My conclusion is that if I went to blue chip areas and even tried to mention 2% seriously in purchase negotiations, I’d be laughed outa da room. :)

      2% is a formula that works in neighborhoods most long term investors avoid. Short term profit ventures are a totally different kettle of fish. Who cares how crummy the location is as long as you get out alive with a solid profit?

  2. Well said Jeff! While there are a few 2% properties around. There’s not many, and with my investment model, rentals are suppose to be passive income. The 2% properties I find would be anything but passive. I’m a believer in quality rentals that attract quality tenants and minimize my headaches. Just make sure you have positive cashflow after you pay mortgage, insurance, taxes, maintenance, and factor in a vacancy rate. You, won’t get rich, but you’ll have slow and steady wealth building.

    • Jeff Brown

      Hey Keith and Kinsey — You sound as if you might’ve learned some of those things at the school of hard knocks. :)

      You said, “I’m a believer in quality rentals that attract quality tenants and minimize my headaches. Just make sure you have positive cashflow after you pay mortgage, insurance, taxes, maintenance, and factor in a vacancy rate. You, won’t get rich, but you’ll have slow and steady wealth building.”

      Not only WILL you get ‘rich’, but if inflation comes our way as most think likely, the rents and value of the high quality buildings in ‘Mom worthy’ locations will benefit most. What will happen in the thought process of investors is this. “Why on earth should I pay the new higher prices for the crappola old buildings in the relatively ‘unpleasant’ parts of town? If tenants in the less desirable neighborhoods had problems makin’ rent before inflation, it’s only gonna be worse now.”

      I know, cuz I’ve seen it happen time after time, cycle after cycle. Your point about passive income related to management is spot on. The 2% rule has taught more investors what not to do, than it’s made them ‘rich’.

  3. What I don’t understand about the 2% rule is how it seems to collide with the 1% rule. My father-in-law has worked as a landlord, property manager, and fix-it-upper for 20 years. He says that if we can get 1%, he usually does pretty well. I never hear him mention the 2% rule. But I defer to Bawld Guy’s bottom line that it’s not about quantity, but instead quality. Find top quality property with solid financials (50% rule) and the rest will follow suit.

    Murphy has already taken a pot shot by giving me 75% occupancy, and I’m positive with plenty of margin. I called up Jeff after a couple of months to ask what to do, and he said he’s already working on a solution. Jeff, you da’ man!

    • Jeff Brown

      Murphy doesn’t play favorites, Greg. :) For fun, try to imagine your rents being twice what they are. Ludicrous, isn’t it? 2% in great locations is the unicorn of real estate investment — a fairy tale.

  4. Brandon Turner

    Hey Jeff – You know I have to chime in on this conversation! ;)

    So – my first thought is: I think you are defining a good investment, and then using that definition that you defined to come to a conclusion about a strategy. For example, the question of would you put your mom or daughter in one of your properties? Heck no! I probably wouldn’t even live in my properties, but not because of the way they look/feel. I just am not a fan of the location (not that it’s a gang area – it’s just a blue collar, middle class neighborhood in a low income town). I invest there because the numbers make sense. But what does that have to do with anything? I mean, I wouldn’t live a lot of places because I have a job and make money enough money to live in a nice area. That’s like saying I wouldn’t eat an ice cream cone from Dairy Queen because I wouldn’t work there. Or I won’t own stock in Microsoft cause I own a Mac (okay… maybe that’s true!)

    I think (my own opinion) that low-income investing, the 2% rule, great cashflow, section 8, and the whole works is a fine investment if that is the type of investing someone wants to get into. I think if their goal is no headaches, no hassel, upstanding moral tenants, and not getting irritating phone calls – then you are 100% right. But that’s not the investing that these people (including, to some degree, myself) want to be in – because the profits aren’t there. I actively choose to invest in a little bit ‘lower” income area – knowing fully that I am going to have more headache. But making twice as much money as I would from a nice property? I’ll take a little headache.

    Finally, to use another analogy – my local high school just went to the State Championship for football. They were the severe underdog, with no great players and in a year that was supposed to be a “building year.” In the final championship game, against the #1 ranked team in the state (we weren’t even ranked) we were getting creamed in the first half, barely managing to hold on. Down by 6 right before the half (and only that close because of a couple really lucky TDs earlier) when they stopped the other team from scoring on 4th and Inches with 2 seconds left in the half (for non-football people: it means the other team was stopped just inches from scoring a touchdown.) The final play of the half was a, of course, a Hail Mary all the way down the field. The QB, from the endzone, threw a 60 yard+ pass to a receiver who was double covered, who then ran in for a touchdown. That play turned the game around, and the Bulldogs came out of the locker room a new team. They dominated the second half and won the state championship. A true “mighty ducks” moment.

    My point? The bulldogs were the “exception” not the rule – but they were only the “exception” because they practiced the “Hail Mary” in every practice. They had that play down perfectly. In the same way, aiming to be the “exception” is exactly what people need to do if they are going to succeed. The 2% rule, the 50% rule, and the rest are like the “Hail Mary” play. I don’t think there is anything wrong with using those formulas as a “rule of thumb” because if you never aim to be the exception – you never will be.

    Thank you for this article though. I appreciate your ideas, comments, and your heart on this issue! I may not agree 100%- but I know what you say is truth for the 99% of the investors out there. I’m just aiming to be the exception! ;)

    Thoughts?

    • Jeff Brown

      Hey Brandon — I love how you tee it up. :) I’ll preface and end my observations with the fact that this is my ‘school of thought’, and that, in the end, it’s still an opinion that won’t even buy us coffee ‘n cookies at Starbucks. :) Let’s start with this quote.

      “I think if their goal is no headaches, no hassel, upstanding moral tenants, and not getting irritating phone calls – then you are 100% right. But that’s not the investing that these people (including, to some degree, myself) want to be in – because the profits aren’t there. I actively choose to invest in a little bit ‘lower” income area – knowing fully that I am going to have more headache. But making twice as much money as I would from a nice property? I’ll take a little headache.”

      1. Thanks for puttin’ in the phrase that ushers in the concept of moral tenants. More than anything, that factor alone is what disrupts a huge portion of retirement plans. Please don’t infer that means I believe all tenants in bad locations are immoral. Far from it. It does mean that the percentage of ‘bad players’ in those locations are much higher, which causes all the problems and the bottomless money pit. It’s insidious cuz it works like bacteria. Slowly but surely the investor realizes they’re not where they planned to be, and they’ve lost years they’ll never get back.

      2. Over time, most experienced investors learn that buying properties long term in mediocre or worse locations end up being nowhere near what their spreadsheets predicted — even with the so-called 50% rule in place.

      3. Cap rates at purchase for these inferior buildings in inferior locations are a myth. Double digit cap rates quickly morph into what they really were all along, which was overpriced, with intense management that only partially mitigates the ‘headaches’. Furthermore, those who adhere to the ‘Mom rule’ of location, find out their management problems — and they will have them — are almost always on the management side of the ledger, not the tenant side. Much preferred.

      4. The exceptions to the rule of lousy location, old building, functional obsolescence and the rest, are a mirage, in my opinion and experience. This isn’t to say the investor can’t bulldog their way through. On the contrary. But all they’ll accomplish is to not quite overcome the root problem: Under earning, questionable credit, tenants who’re easily replaceable employees, who will be a problem whether they intend to be or not.

      5. Your management costs and general operating expenses will be higher than the better located, more modern properties. Over time, this will end up suckin’ the life from what could’ve been a magnificent retirement. Quality trumps cheap every time, at least when it comes to real estate investment for retirement.

      Here’s a ‘rule’ I’ve found that can’t be broken without consequences. The investor cannot bulldog or pull off a Hail Mary with a portfolio populated by poorly located properties which were built when Moses’s son walked the earth. :) It happens on paper, but not in the real world — at least in the long run, when retirement income is the measuring stick for results.

      But then that opinion, along with my heavily armed Starbucks card will get us both big cups of coffee with giant cookies. :)

  5. Hey Jeff:

    One thing you don’t mention here is “how” the property is purchased. When we take over a clean property subject-to or buy with 100% seller financing at 0% interest, we’ll throw those Percent Formulas out the window.

    Thanks for the article.

  6. Jeff
    Once again, you are right on. I dare anyone to find a house, in the United States, that you can buy for $200,000 and rent for $4,000 a month. Simple reason being anyone who would pay that much rent would most like buy the house! There was a successful investor on here, Mike O, who swore by the 2% rule, but he also posted what caliber handgun he carries to collect rent and make repairs. There is a small niche of investors who LOVE that kind of investing and do very well at it. The market place needs them just as much as any other type of investor. But for most of us, we like the slow and steady 5%-10% cap rate and owning a house that doesn’t keep us up at night.

    There are three simple rules to follow if you want to be a successful real estate investor, and millions more “rules” to follow be very successful.
    1. If 50% of the rent makes the PI mortgage payment, you should have a positive cash flow (no matter the interest rate of the mortgage or the percentage of price the rent is)
    2. You don’t have to own a rental near where you live. Here, in Orange County, I would have to spend $500,000 to get $2,000 rent, OUCH.
    3. Don’t try to be something you’re NOT. If you are not an electrician, don’t try to change out the breaker box! If you have never managed property, don’t try to be a property manager.

    • Jeff Brown

      Hey Jason — Short and long term are conceptual in nature, but I’ll give ya my take. Short term is for immediate profit, usually in 1-12 months. Long term is related to retirement income/net worth. Make sense?

  7. I could not agree with you more. Looking for future appreciation is speculation. There is no crystal ball that will tell anyone what the future value of a property will be…we sweat out re-fi appraisals sometimes and that is only 60-90 days after acquisition!

    I also agree that location is everything. You want a property in an area that attracts tenants that look good after a credit and nationwide criminal check.People with good track records and some assets and a good credit score to protect.

    Understand the numbers, what moves the numbers and establish thresholds for cash on cash return that you will not go below…each property is unique and understanding that will help investors find the properties that are right for them.

    Mike and the others commenting here are making good points as well…
    Thanks for the great article!

  8. Jeff:
    Thanks for shedding some practical light on the 2% rule. As a relative newby to this site, these “rules” can be pretty intimidating if your properties don’t meet those critera. I agree that focusing return on investment makes a lot more sense than the simple “rules” like 2% or 50%.
    Best,
    Neil Rainford

    • Jeff Brown

      Hey Neil — I used to tell investors the 2% rule was how often a property with that rent/price ratio wasn’t in an, um, less than desirable area. :) The 2% that were in better areas, they still wouldn’t put their 19 year old daughters to live in ‘em. They won’t admit it in public though.

  9. Overall I can agree with the points on the 2% stuff.
    Generally it aint going to easy to buy like that in above average areas.
    The places and areas don’t have to be totally craptastic but usually won’t be the best.
    Still I think it is a good goal to shoot for and if you fall short you can still do pretty good.

    100% agree with the appreciation problem you describe. Real estate doesn’t always go up. The last 5-8 years shows that pretty clearly. Overall you have the jagged line that tends to go up more than down but that is a gamble in the mid term.
    Mid term being say more than 1 year but less than 10.

    Not sure what is wrong with having a minimum cashflow goal though. If you aren’t banking on appreciation then you better be getting some cashflow! This can be a goal on any property you buy at any price point with any ratios you want to spit out.
    In my mind this is saying regardless of those other factors I don’t want to put up with the BS if I am not getting paid a certian amount for my trouble.

    • Jeff Brown

      Hey Shaun — You’ll not find me ever saying not to generate cash flow, including this post. :) Still, I take your point. It’s about context and chronology when it comes to cash flow. Remember, to the extent we go for cash flow, capital growth is retarded, and vice versa. You appear pretty young in your picture, so cash flow, if you’re gainfully employed, simply isn’t an issue. If you’re already living on your cash flow, what I’m about to say obviously wouldn’t apply.

      A 35 year old couple with a decent family income, who invests wisely, with capital growth as their #1 goal — initially — will completely slaughter those who begin and end with cash flow as their only focus. It won’t even be close. Why?

      It’s simple. Cash flow is just another name for yield. The investor retiring with a $3 million equity position gets the same X% yield as the guy with $1 million, all else being equal. The ONLY difference at that point — retirement — is in terms of dollars coming in. (Captain Obvious alert!) Triple the capital delivers triple the cash flow when the yield is identical.

      On the other hand, those who worshipped cash flow (Not sayin’ that’s you, Shaun.), sacrificed capital growth, at least to the extent of arriving at retirement with significantly less capital/equity than those who didn’t. The idea is to arrive at retirement, regardless of when that might be, with the largest, most reliable income possible.

      The rest is either wishful thinkin’ or HappyTalk. Going for cash flow from Day 1 has resulted in more disappointing retirements than any other real estate investment strategy.

      • Hey Jeff,

        Thanks for the taking the time to repond to my comment.

        I see where you are coming from with your comments but there are a couple things I have a couple questions about.

        1) In the article you say one of the misakes is counting on your investments appreciating but the argument is based totally on the capital growth likely being much less for the high cashflowing investment. How can yo get to that witut assuming the investment will appreciate at least at some “reasonable” rate?

        2) As you said obviously having 3 times the capital with the same yield will get you better returns. However why would I assume that many years down the road the yield will be equal if there was such a big gap now?

        Thanks,
        Shaun

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