When to apply the 50% Rule

Question

While reading the Ultimate Beginners Guide I was introduced to the 50% Rule and the 70% Rule, and the 1% Rule I have heard was bumped up to 2%. I like the 70% Rule as a good guide to make sure you are getting a good deal, but when I crunched the numbers on the property I currently live in, using the 50% Rule I found I would actually have negative cash flow.

Ideally I would rent the property for $1,400/month, my mortgage comes to roughly $830/month which includes the taxes and insurance in escrow, bringing my operating costs to $1,530/month.

I undertand the 50% Rule is there to cover vacancies and repairs, but just about everything in the property is new from the roof to the central air, and I don't foresee any major repairs for the foreseeable future. And as I stated, the taxes and insurance are escrowed in the mortgage. Would I be correct in assuming I could knock the 50% down to say, 20%, to net a positive cash flow of $600/month?

Skylar Simpson · Answer

Hey Steven,

So be really careful about taking these "rules" you read about too seriously. It's very rare I see big investor using the 70% rule or the 1% rule. In fact most the big guys I know are using customized rules for their specific buying criteria. For instance they just calculate 10% for maintenance and 10% for management etc...

There are a TON of deals I've done where if I used the 70% rule I would have never considered the deal yet they made me 30k or more.

One of the most trusted investors I know who is making 100k a month in passive income has a rule of $200 per door and 10% maintenance/management, insurance cost etc...

Write out the numbers and see what it comes out to. If you don't plan to use management ever then don't calculate 10% for that. Customize it for what YOU want out of a property.

Sam Shueh · Answer

Those rules were applicable decades ago. During the Great Recession many home flippers used their own savings to purchase at then market rate. Using low interest to refinance many were enjoying 5-8% cap rate here in Silicon Valley, CA. Many had 30%+ downpayment or trying to break it even. Most recent investors are running a negative cash flow hoping the potential appreciation will make up the difference somehow later.

If your investment has appreciated a lot and time the lease will expire and it is in a D, F neighborhood it is time to consider cashing out and do something else.

Sean Lambert · Answer

instead of using the blanket 50% for expenses, list out the actual expenses and get a closer to exact number for cash flow.  You just have to list out the income vs expenses.  Good luck.

Brent Coombs · Answer

@Steven Lebischak, on the plus side, the "50% Rule" does include Property Taxes and Insurance, so, don't account for those numbers twice.

It's as Sean wrote: "You just have to list out the income vs expenses".

I'm glad you got the message about property managing not being "passive income", so should be included as one of your expenses, whether it's managed by you, or someone else.

As a general "rule of thumb", if your $200k primary will only gross $1,400/m (ie. a lot less than 1%/m), it won't be a good candidate to allow you maximum levage and positive cash flow!

ie. As an investor, you want your 75% LTV investments to not cash flow negatively!

ie. If gross rent per month is less than 1% of a property's value, yep, time to consider selling.

But what if you're expecting lots more appreciation, and/or it has value-adding possibilities?

[If those two things don't come to pass as expected - you've been warned!]

Steven Lebischak · Answer

Brent Coombs I appreciate the reply and the good points!

I understand the vacancy issue, and I may have  jumbled my train of thought, I don't foresee any repairs being needed because of all the work I put into it, but vacancy is a real concern. I have read both 3% and 10% are good numbers when calculating that expense. And you are right, I did not account for a management fee since I am planning on managing the property myself. My thinking was a management fee for a self managed property would be the income generated from the positive cash flow. I can see how that is a flawed way of thinking.

To answer your question, I am planning on building my next primary residence, with an apartment over the garage. As for the second part of your question, I purchased the property I am currently living in with the intention of turning it into a rental in the future. I had just gotten a new job, and this proerty was a 10 minute commute from the job and well below what I was willing to spend. So I was always looking at this as an investment property, butI didn't know the first thing about REI at the time.

Let me ask you a question: The property value has increased by about $40k with comps selling for close to $200k. I am expecting my total rehab cost to come in at $14k. Would you suggest selling the property and looking for a better deal?

Brent Coombs · Answer

@Steven Lebischak, it would be nice to think that your $1400/m tenants would just be happy to pay you more than they'd be paying if they bought a place themselves, forever, but, you should allow around 1 months vacancy each year (rather than the 3% vacancy allowance I see on many of the pro forma "Calc Review Reports"). Also, many people don't want to put a price on "Property Management" expenses, because they're doing it themselves.

I trust that you're not one of those people who place no value on your own time?

So, that's 6-10% expenses not to be forgotten.

And from what I've heard, the nicer your home is and the higher the rent is, the pickier your tenants will be in demanding everything be set out according to their taste/specification!

ie. I doubt if a realistic expenses projection will come in as low as 20% rent.

Question: Will your next primary be a good investment from day one, if you rented it out instead? That's another way of asking: Would you buy your own home as an investment - now?...

When to apply the 50% Rule

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