Union City, CA · Member since 2011 · 14 posts · 0 votes
Hello everyone,
This forum has been invaluable to me. Thank you for sharing your knowledge.
I live in CA, and I'm looking at a duplex out of state. No way could I afford anything around here.
Anyway, the duplex is $15K. One half is currently rented $475. The other is vacant and needs repairs.
So according to the 2% rule, I should be getting at least $300 in rent? I read on here that it is based on purchase price + repairs to make it rent ready. So if I put $10K into repairs for a total of $25K including purchase price, I should be getting at least $500?
I'm having trouble with the 50% part. What expenses does the 50% cover? The other 50% would be cash flow?
Sorry. I'm a newbie and tend to look at homes emotionally - since I want to restore them in the future. I hope someone can help me with the logic/numbers part.
Rental Property Investor · Mercer Island, WA · Member since 2008 · 22k+ posts · 14k+ votes
14y
I don't use the 2% rule. It works if rents are about $500. Otherwise, its too conservative. There are some $500 rent units here, but I never see anything priced low enough to meet that criteria.
I do believe the 50% rule is a good rule of thumb. I'm repeating myself (even in this thread), but any particular property in any particular year can vary widely, especially on the high side. You're bounded on the low side by your actual rent, taxes and insurance. It just doesn't get any better than that. And Mark makes a great point that it's really market rent.
If you're self managing and handling minor maintenance yourself, a ratio as high as 65% may be achievable. Again, for 1000 units over ten years, not for 10 units for five years. But it doesn't scale. I count on a vacancy every year. That's typically half a month's rent, or about 4% of rents. Plus 10% of collected rents. And a lot of maintenance is really minor stuff that I can spend $10 and two hours and fix or I can pay a handyman $100. But if I had 50 units, that would mean four or so vacancies every month. I figure it takes ten showings to get a tenant, and probably 50 phone calls. Now I always schedule showings all at once, once a week, unless I'm planning to be there anyway. But that pretty much translates to showing several properties every week. And handling four make ready's a month, rough one every week. That sounds like a JOB to me. I already have a JOB and it pays me better than 50 rentals, especially here in Denver.
To me, this is a way to build some long term wealth. Eventually, those rentals will be paid off. If I do buy such that they're at least break even assuming 50% rule, then I can turn them over to a PM and still be OK (i.e., not coming out of pocket when something goes wrong.) But if I hold for the long term, a furnace that was new in 2008 is going to be replaced in 2028. If you have 50 properties, you're replacing something like two or three furnaces EVERY WINTER. You're replacing a roof or two every year. ETC.
I get beat up, at least by implication, for being too focused on cash flow. That's absolutely not true. I do want people, especially new investors, to be aware of the reality of cash flow. True cash flow, not "rent - PITI" phony cash flow. I truly think that 20 years from now both rent and expenses are going to be higher, but my mortgage payment will be the same, or even zero if I pay off a property. But when someone says "this cash flows" and what they mean is the rent is higher than PITI, they are doing a disservice to their potential customers. I see that all too often in real estate listings and in e-mails from wholesalers. I pity the buyer who believes that only to get caught off guard when a big, unpredictable-but-inevitable expense crops up.
Investor · Hampton Bays, NY · Member since 2009 · 907 posts · 258 votes
14y
Cheryl, the 50% would include taxes, insurance, maintenance, property management, vacancy and in some cases the water bill if the tenant is not responsible for that. The 50% rule is a guide but a duplex that costs $15,000 with only $10k in rehab could eat up profits very fast. A new roof could set you back most of your first years rent if you missed this cost in your rehab estimate. Hope this helps. I learned this by making the mistake of underestimating rehab cost. I too have to invest out of state to meet my investment criteria. Best of luck to you.
Flipper/Rehabber · Los Angeles, CA · Member since 2009 · 1k+ posts · 732 votes
14y
You seem to have a good grasp of the 2% rule.
50% rule generally includes all of your expenses EXCEPT for mortgage payment/debt service.
Not all successful investors follow these rules exactly, but they are good guidelines to follow.
Also a couple of important things . Many people are going to mention to you that it is quite difficult to manage/own out of state property (more difficult than owning local property). Also you mention that a unit needs repairs , so you're going to have to find an honest,reliable person to do those repairs..that is hard enough when you live in the same town...but MUCH harder to do from far away.
You also mention that you look at homes emotionally..that is not a way to look at real estate investment. You are going to want to look at the figures/numbers and take emotion out of it. You especially shouldn't be restoring or turning rentals into trophy properties.
If you are focusing on rehabbing,and flipping property then it makes sense to restore homes to an owner occupant...if it makes sense and the numbers work.
Also, there are years of posts on this forum on both the 2% rule and 50% rule. I recommend doing a search for more details.
I definitely understand your frustration regarding the prices in California, as I live here too.
Rental Property Investor · Mercer Island, WA · Member since 2008 · 22k+ posts · 14k+ votes
14y
The 50% covers expenses (things the IRS lets you deduct in the year you spend the money), capital (things the IRS makes you deduct over several years), and vacancy. It does not cover debt service. The forumlas look like this:
NOI (net operating income) = 50% * gross scheduled rent
cash flow = NOI - your P&I payment
You're running the 2% rule backwards. The factor which you have the least control over is rent. The market sets that. If you have an especially nice unit you might get a little more than market rent in your area. If its crummy, you may have to rent it for less. But if rents in your are are $500 for units like yours is essentially impossible to make it nice enough to get $750.
So, you have to start with the rent and work backwards. For $500 in rent, you can't afford to pay more than about $25K if you actually want to turn a profit based on cash flow. The are other reasons you might want to own a more expensive unit, but cash flow wise, that's about all you can afford to pay.
If the rent is higher, the 2% rule is too conservative and you can pay more and still get about the same profit.
If the rent is lower, the 2% rule is too optimistic. You have to pay even less than the price implied by the 2% rule.
Commercial Real Estate Broker · Nashville, TN · Member since 2008 · 151 posts · 46 votes
14y
Cheryl,
I think it might be worth learning to do a full multi-unit analysis.
People who use those shortcuts already know how to analyze a property from top to bottom, and use those shortcuts as a quick tool to decide whether they should continue to analyze or just move onto another deal.
It's not that hard to mathematize (i made that word up) a few units, or any small multi-unit building, and there are even spreadsheets with cells built in to help you add your required profit, to pad or trend expenses, and to stress numbers up or down in future years.
Again, in my own opinion, if you're going to spend money on a few units you might as well know how to analyze those units and make an informed decision. Otherwise trying to figure out a shortcut is going to take just as much mind power as figuring out how to do the real analysis.
The easiest explanation of a multi-unit analysis for beginners is found in a book called What Every Real Estate Investor Needs to Know About Cash Flow... And 36 Other Key Financial Measures, written by Ralph Gallinelli. I don't know him and have never spoken to him, but I find his book really breaks down the steps in unit analysis very well.
http://www.amazon.com/exec/obidos/ASIN/0071603271/realdata-20/ref=nosim
Real Estate Investor · Chattanooga, TN · Member since 2009 · 191 posts · 47 votes
14y
Great answers to your question. I have a couple of questions for you.
1. Where is the duplex?
2. What made you choose that town?
3. What made you choose that duplex?
4. Are you positive about the rehab costs?
I only ask because I've made mistakes in the past regarding the town, the property and the rehab costs.
Union City, CA · Member since 2011 · 14 posts · 0 votes
14y
Michael - Thank you. I'm sure I'm underestimating the rehab costs. I was wondering how the rules worked. I would definitely have an inspection to see what I'd be getting myself into. And if I want to get into it.
Joseph - Thank you. I know that out of state investing is way harder. I would buy some older homes here in the Bay Area if I could afford it.
You're right about the emotion part. It's hard because of my goals. These are properties I want to eventually restore and become part of my "collection." I might have a gut feeling about a place, and want to get it. That's when I have to make sure that it's at least making a little money but definitely NOT losing.
Regarding CA - I swear when I look at other parts of the country, the cost of my modest house could get me loads more elsewhere.
Jon - Thank you for pointing out that I'm doing it backwards. Now, I don't know how to do it the right way. Do you have a formula to be able to figure out how much home I can buy based on the rents?
Craig - Thanks for the book recommendation. I will definitely look into that because I need it explained at a very basic level. I will definitely need help "mathematizing."
McKellar - Thanks for responding. Let's see...
1. St. Louis MO
2. I like the red brick and the architectural styles there.
3. The price and the fact that it is a multi-unit that is physically symmetrical. I know that sounds weird, but it's something I consider in properties I want to restore.
4. Absolutely not. I was throwing out a number to help me understand these "rules." An inspection and some contractor quotes will help me figure out if I can afford it.
Real Estate Investor · Chattanooga, TN · Member since 2009 · 191 posts · 47 votes
14y
I don't know much about the St. Louis market but I've seen some neighborhoods there with really low prices and lots of foreclosures. Make sure you buy some equity.
When I look at a property, I usually look up and down first. My architectural style is a newer roof, a dry ceiling and dry floors.
When you do get the quotes, add some extra "just in case" costs. Good luck. mck
Union City, CA · Member since 2011 · 14 posts · 0 votes
14y
Thanks McKellar. Obviously, the condition is a huge factor. That's a given. Because restoration is the end goal, architectural style is important to me.
Rental Property Investor · Mercer Island, WA · Member since 2008 · 22k+ posts · 14k+ votes
14y
Doing a more detailed analysis is not a bad idea. But take care not to slice the onion too thin. If you break up expenses into a bunch of slices its easy to tweak each one down just a little and end up at a really high NOI estimate. If you're paying for a PM (15% of gross rents or so) and you come up with an NOI estimate above 50%, you're being too optimistic. If you manage yourself and do it "for free" (i.e., contribute your labor to the property), then don't go about 65% of gross scheduled rents.
Here's how to do the math from rent to a price you can pay:
Rent $500
ratio 50%
NOI $250
desired cash flow $100
max payment $150
rate 5%
term 30
max loan $27,942.24
down 25%
down $6,985.56
loan $20,956.68
actual payment $112.50
actual cash flow $137.50
CoC 24%
Based on this calculation, you could pay about %28K for a $500 rent unit and make 24% cash on cash return.
The first part of the calculation assumes you want $100 in true cash flow from the unit. So, it calculations a max price based on 100% financing. Then, I add back in the actual financing terms. The increases cash flow, but that's really from the cash you've invested. You're earning the same 5% on your cash as you're paying on the loan.
Now, its often not that simple. For one thing, getting a loan this small can be a big challenge. For another, you'll often have rehab expenses. If you put 25% down plus rehab, then your cash invested is higher and your CoC may be lower.
Rental Property Investor · Mercer Island, WA · Member since 2008 · 22k+ posts · 14k+ votes
14y
Meant to add that I also highly recommend Ralph Gallinelli's book. Math is essential to real estate investing. Understanding how to put this together is really helpful.
Commercial Real Estate Broker · Nashville, TN · Member since 2008 · 151 posts · 46 votes
14y
you got it keith. check around the internet and on his site realdata - you may be able to find it cheaper. It might even be at your local library.
I think he bundles his books with software too, like templates for analyzing property. But even if you can't find those, just reading that book you'll be able to develop a pretty good template for yourself to us.
I made my first MF template using suggestions in his books, ran quick numbers based off of how much money I knew I had to invest (which wasn't much), and sent my sheets to my agent who made offers on properties that fit my parameters. It was a great way to be proactive and get into properties where the sellers required an offer to take a peek and then get the real docs.
Union City, CA · Member since 2011 · 14 posts · 0 votes
14y
Jon - OK all those numbers are making my eyes glaze over. This would be a cash deal. So to get $100 cash flow, from $500/mo rent, I can spend max $28K (price + rehab)?
Keith & Craig - I got it at alibris cheap. coupon code: salinger
http://www.alibris.com/booksearch?qisbn=9780071603270&qwork=7835112#search-anchor
Not as high as if you were getting a loan, but respectable and less risk. That 11% is called the "cap rate", short for "capitalization rate", which is simply your annual rate of return assuming you pay all cash. Very commonly used as a metric on commercial properties, though duplexes generally aren't considered commercial.
To work backwards, start with the rent and your desired cash on cash return. Say you want to get 15% on your money and the rent is $500.
Rent: $500
NOI: $250 (what's left after taking out 50% for capital, expenses and vacancy)
Annual NOI: $3000
desired return: 15%
Max investment: $20,000 ($3,000 / 15%)
Real Estate Investor · Audubon, PA · Member since 2009 · 13k+ posts · 8k+ votes
14y
Originally posted by Cheryl S:
Thanks McKellar. Obviously, the condition is a huge factor. That's a given. Because restoration is the end goal, architectural style is important to me.
You are getting hung up on "restoration", when a "rehab" will suffice for rental purposes. There is a VERY big difference in costs between the two IMO. For rentals, you should be concerned more with cash flow, and that sometimes means that you don't get too fancy; restoration typically requires that the fancy stuff gets put back as it once was.
If you want to be in business (that's what rentals are), you will have to be profitable; lowering costs is one method for attaining profitability.
Now, there's nothing wrong in inexpensively purchasing a property with architectural details that remain intact (little to no restoration required). But it sounds like you are setting this restoration as a goal, when a business really sets profits as the ultimate goal.
Union City, CA · Member since 2011 · 14 posts · 0 votes
14y
Steve Thank you for your reply. Restoration is the ultimate goal. For now, I want to rent them out. The fancy stuff won't go in now. That will be like 15 years from now when I move in and restore. I need renters to cover taxes and inevitable repairs. I don't want the property to sit vacant, exposed to the elements. I hope that makes sense.
Bismarck, ND · Member since 2011 · 142 posts · 16 votes
14y
Not to hijack this thread but I find it really interesting to hear about the different real estate markets and what constitutes a good deal.
Im from Bismarck, North Dakota where there are rarely foreclosures and if a property happens to foreclose, it sells for market value so there are never really any truly great deals. All the properties that I have bought have been solid, cashflowing properties but they don't come close to the 2%/50% rule.
Rental Property Investor · Mercer Island, WA · Member since 2008 · 22k+ posts · 14k+ votes
14y
There have been a couple of large datasets provided over the years. Both bear out the 50% rule. You really must have a large dataset - dozens or hundreds of units for a number of years. A handful of units for a few years can vary widely from the 50%. Its tough to do much better than just taxes and insurance, but its entirely possible those really are your only expenses. But its also possible to have a big expense and just kill the numbers. I know one of my houses is going to need a sewer line one of these days, and that will eat almost 50% of annual rents in one big check. Eventually you do have those big expense like sewer lines, roofs, and furnaces, and those are in the 50% number. If you've avoided any or those, or any ugly evictions or major tenant damage, you actuals will be better than the 50%. Self-managing also saves a big chunk of the 50%. Post your numbers and lets have a look.
Flipper/Rehabber · Los Angeles, CA · Member since 2009 · 1k+ posts · 732 votes
14y
Cheryl..I am still a little bit confused. You live in California, but you say you want to purchase a duplex out of state to rent out. But then you mention that you want to "restore" the property in the future and move in.
Is this correct?
There isn't really a point to restore a low priced / low income property if you are going to end up over improving it. But it all depends on what the neighborhood supports. If the most expensive house in that area is like under $50,000 for example, there is no point really to restore it because you won't even get your money back.
If you own rentals you need to treat it purely as a business. All improvements done to the property should reflect the neighborhood. Example, No point in putting in granite counter tops ,etc if none of the other rentals have that.
It's great that you have an interest in restoration , but that should be something that you reserve for your own personal residence rather than a low income rental property.
Union City, CA · Member since 2011 · 14 posts · 0 votes
14y
Joseph - Thank you for your reply. Yes, that is the plan.
The duplex is in a Neighborhood Preservation Area. This is how it's described:
“Neighborhood Preservation” areas that already exist and will be improved and augmented in a manner that preserves the existing character."
The city is investing in the area so by the time I'm ready to move in, hopefully, it will be one of those neat historic districts. Or at least improved dramatically.
The fancy stuff is for later. For a rental, I know it's not going to have custom cabinets and soapstone counterstops. Clean and liveable.
Investor · Westminster, CO · Member since 2009 · 1k+ posts · 1k+ votes
14y
Jon is correct Zachary, you need a pretty large dataset to do the research and come up with accurate numbers. If I recall, one of the datasets Jon alludes too was about 1,000,000 apartment units nationwide. Obviously, if you stick to one market and a small number of rentals (less than 10), the 50% number can vary greatly in the short run.
There are several errors that people make when calculating the 50%. The first mistake they do is use 50% of the "COLLECTED RENT" when you are suppose to use 50% of the "MARKET RENT." For example, if a house rents at market for $1,000 a month, you have to use $12,000 as the annual rent. Just because you discount the rent to $900 doesn't mean the expenses will be discounted. Or if you got lucky and rent it for $1,100 a month, your expenses will not go up.
Next, investors forget to count vacancy as an expense. If your rental rents for $1,000 and you have a one month vacancy, you have $11,000 of rental income, but you use $12,000 as the starting number and the $1,000 of lost rent is an "expense" (not for tax purposes, but for the 50% rule)
A third mistake investors make is to not count their own time as an expense. Your time has a 'market value' and you need to take that into account. At the extreme, you would not see Bill Gates or Warren Buffet knock on a door and collect $295 month's rent. Their time is more valuable elsewhere.
The 50% rule pertains to long term rental holds for cash flow. Flipping, wholesaling and other RE investments use different sets of guidelines.
I don't mind investing out of your area, but I would be cautious about low income housing. The headaches aren't worth the hundred bucks a month. If you have to make an emergency flight out to the area, you can lose a whole years worth of profit. The potential negatives are numerous.
Commercial Real Estate Broker · Nashville, TN · Member since 2008 · 151 posts · 46 votes
14y
I think what jon and Mike mention regarding your time and expected profit is very smart. You MUST build that into your analysis.
If you just run the stock numbers bare bones to see what the ratios and returns are I think you sell yourself short.
If you expect a certain return on your time and money work that into the analysis upfront. If you determine your offer price needs to be (and i'm just making up this number) $50,000, but that's more than what the property is worth, then you have a choice to make - do you lower your expectation of profit or move on to another deal.
That's only a question you can answer. Play with a few deals in your area, make a few offers, and go to see a few properties. It's pretty standard to include a walk clause in these MF deals, so if you see something you don't like you can cancel the offer without any trouble.
Real Estate Investor · Audubon, PA · Member since 2009 · 13k+ posts · 8k+ votes
14y
Originally posted by Cheryl S:
... hopefully, it will be one of those neat historic districts. ...
Beware of what you wish (or hope for)! In one of those historic districts, it can be worse than any HOA, where somebody has to give approval for any little thing you want (or need) to change - like say you are looking to replace windows. They will say it must be some certain set of specifications, and when you see the cost, you might regret your wish (or hopes in this case).