2% rule won't work in my market - now what?
Grand Junction, CO · Member since 2012 · 4 posts · 0 votes
2% rule won't work in my market - now what?
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Rental Property Investor · Mercer Island, WA · Member since 2008 · 22k+ posts · 14k+ votes
14yOriginally posted by Bill Gulley:
Geeez, how many rules do you need? 1% when revenues exceed 500 bucks, 2% when it's different, 5% when it's something else.....did anyone pass highschool math class?
How many rules do you need? Why don't you learn how to look at any property by the facts at hand, that rule can never be out dated!
Why in the heck can't you people figure actual costs and provide reasonable estimates, is it that simple percentages makes your life easier for the lazy and stupid or is it that you need rules because you can't think?
Sorry, just can't get over all the "rules" you so called "investors" want to use......if you can't do simple math, dig ditches and get out of real estate! Thanks! Get out of the way of real investors.......
Really, you just need one - the 50% rule. The others , 2% for low rents, 1.5% for higher rents, are derived from that. Even the 50% rule has caveats. If you're willing to put in your own labor, 35-40% might be more reasonable. If you or your PM does a bad job, 50% might be too low.
The reason this is helpful is that new investors, and especially the people pitching properties to new investors, often claim you only expenses are taxes and insurance and that you'll never have a vacancy. The 50% rule may or may not be accurate for any particular property in any particular year, but its a heck of a lot closer than "cash flow = rent - PITI".
The "facts at hand" are often unknowable. How much will maintenance costs you? How long will the property be vacant between tenants? How much will you need for capital over the next 20 years? What should you allocated for a messy eviction? Any number you put for any of these is just a guess. By lumping it all into one big number - 50% - you avoid the temptation to skim a little off here, a little off there and make a bad deal look OK. Reality will be whatever it will be. You can't control that and you cannot predict it very accurately. The 50% (or less if you self manage) is just a way to account for that lack of predicitibity.
I personally dislike the 2%, 1% or any of those rules. And I agree, Bill Gulley you better be able to do math if you're going to be in this, or any, business. Excel or a financial calculator is essential and actually running the numbers on a prospective property is better than a rule of thumb.
-- Lazarus Long (aka Robert Heinlein)
35 Replies
- Rental Property Investor · Mercer Island, WA · Member since 2008 · 22k+ posts · 14k+ votes14y
The 2% rule only works for rents around $500. Higher rents work with lower percentages.
What's you goal for buying rentals?
Are there any other ways you might make a profit on rentals on your area?
- Grand Junction, CO · Member since 2012 · 4 posts · 0 votes14y
Hi Jon, my plan is to buy and hold as rentals and keep increasing my cash flowing properties, eventually living off of the cash flow. I want to invest close to home as I know the area, but it seems others areas may be smarter investments...
- 14yDon KonipolBusiness MemberInvestor · The Woodlands TX / Avon, CT · Member since 2009 · 6k+ posts · 10k+ votes
When I invested in Class C commercial and residential, I was able to better the 2% rule. Now that I am investing for less risk, less aggravation, and increased capital gain potential, I use the 1% rule for Class A residential and the 1.5% rule for Class B. It will be interesting to see over time how the results work out.
In some markets, you have to improve the property and raise rents to approach the 2% rule, even in C/D properties. Overall, I think we have to discuss property classification when talking about cap rates or any measurement of price to income.
- Investor · Columbus, OH · Member since 2011 · 24 posts · 8 votes14y
I agree with Don and Jon (for some reason Don Johnson's name just popped into my head...).
I prefer to look for Class A and B properties in my area and 1% would be considered "good" for a MFH. I could get 2% in a number of other areas, but I'm just not interested in those areas right now. That may not be the most cost effective and cash flow efficient mindset, but that's where I'm comfortable with starting for now. Another big factor is that I'm looking for a long term hold (10-15+). Now that doesn't mean that I won't consider Class C, but time will tell.
Another thing; look at slowly adding upgraded amenities to your properties as your capital permits, particularly when changing tenants. This may allow you to increase your rent more than inflation and capture higher returns above 1%.
- Rental Property Investor · Mercer Island, WA · Member since 2008 · 22k+ posts · 14k+ votes14y
Personally I wouldn't bet on rents increasing, let alone more than inflation. I guess it could happen, but if I was investing for cash flow, I'd want cash flow from the start.
Lots disagree with the "50% rule". But the datasets that have been posted that support that rule of thumb all come from apartments, not SFRs. SFRs are more of a crap shoot, IMHO, because a good tenant will produce higher returns while a major expense will really hurt. With apartments you're getting closer and closer to the average.
If you buy at a price equal to 100 months rent your rental income is 12% of the price you paid. That's the 1% rule of thumb. If expenses, capital and vacancy are 50% of that, you're left with an NOI of 6% of gross scheduled (market) rents. That's a 6% cap rate. I'd consider that very low. I'd never pay that here in Denver, and I see apartments trade hands below that. A C class 12-16 unit building with rents around $600 in a less-than-the-best area will sell for $40K or more around here. That's 1.5%. That's a 9% cap, and even that seems overpriced. And almost all those building here have common boilers for heat.
A lot is going to come down to financing, though. If you can get a 6%, 25% down loan and you buy at a 9% cap rate, your cash on cash will be 18%. Getting a commercial loan may be challenging, though. At a 6% cap, you're only getting 6% cash on cash.
I don't know what the market is like in Grand Junction. I think you may bet getting some higher values because of the oil related activity. Unfortunately, you sort of stuck for anywhere else to invest that's in easy distance. I continue to look a bit at Kansas City. That's a quick flight from Denver. I don't think its a good idea to start investing far away because you're stuck paying someone $100 for a two minute, zero real cost repair. But if you can't even hit 1% properties, it may be your only option.
- Monroe, NY · Member since 2012 · 21 posts · 3 votes14y
What do you guys consider a Class A property, B, C, etc?
- Investor · Central Valley, CA · Member since 2012 · 6k+ posts · 3k+ votes14y
Originally posted by Don Konipol:
When I invested in Class C commercial and residential, I was able to better the 2% rule. Now that I am investing for less risk, less aggravation, and increased capital gain potential, I use the 1% rule for Class A residential and the 1.5% rule for Class B. It will be interesting to see over time how the results work out.In some markets, you have to improve the property and raise rents to approach the 2% rule, even in C/D properties. Overall, I think we have to discuss property classification when talking about cap rates or any measurement of price to income.
I'll admit that I had never heard of the A, B, C classification for props before I was became a BP member. I had my own ideas about it, but didn't know the definitions/classifications already existed.
Don Konipol I'll bite. Can you provide an example of Class C residential where you were doing better than 2%? I like to think I already know the potential and pitfalls of Class C props. But maybe you have a really good example?
- Investor · Baltimore, MD · Member since 2008 · 17k+ posts · 13k+ votes14y
Sandy Hammer, you have to use the right search terms when searching in the MLS. Enter the following search terms: "owner financing, no money down, positive cash flow" . . . Just kidding, you won't often find those deals on listed properties or anywhere else. Generally good deals are not found, they are negotiated.
There are good deals in your market. You have to look and negotiate harder. They may not be listed properties. I have bought perhaps 50+ properties and I doubt 5 have been listed properties. As Jon Holdman and Don Konipol said you may not need to get to the 2% rule. Also it may mean buying fixer uppers to get in at a low enough price.
Regarding A, B & C class properties, this is common terminology in the commercial market but not that commonly used in the SFH rental market. Perhaps Don can correct me but I don't thing there is a strict definition as to what determines A, B or C.
For my own SFH investing and grading properties for tax sale bidding I use;
A = very nice areas probably to nice to be profitable as rentals.
B= the kind of neighbor hood I want to own rentals, nice blue collar homeowner areas.
C= Viable rental areas where there are landlords buying but I wouldn't want to own there. Some boarded up properties, mostly rentals with some homeowners that have lived there forever. People sitting of the front stoop during the day because they don't have jobs. Few cars because people can't afford them.
D= War Zone, I wouldn't even be confident of finding a buyer for a wholesale deal here.
(Keep in Mind this is for inner city Baltimore MD. My scale could be totally inappropriate for your area.) - Investor, Entrepreneur, Educator · Springfield, MO · Member since 2009 · 21k+ posts · 12k+ votes14y
Geeez, how many rules do you need? 1% when revenues exceed 500 bucks, 2% when it's different, 5% when it's something else.....did anyone pass highschool math class?
How many rules do you need? Why don't you learn how to look at any property by the facts at hand, that rule can never be out dated!
Why in the heck can't you people figure actual costs and provide reasonable estimates, is it that simple percentages makes your life easier for the lazy and stupid or is it that you need rules because you can't think?
Sorry, just can't get over all the "rules" you so called "investors" want to use......if you can't do simple math, dig ditches and get out of real estate! Thanks! Get out of the way of real investors.......
- Investor · Atkinson, NH · Member since 2010 · 36 posts · 27 votes14y
Bill, these rules are useful benchmarks to help evaluate a deal. They provide insight in what other investors are willing to pay for properties. This information is invaluable.
I do agree with you the final decision to purchase needs to be based on actual costs and reasonable estimates.
These are rules a great way to value a property when doing a driveby, scrolling through the mls, but thats about it... If you are getting serious about making a purchase, actual expenses should be the only things used.
For example, I have multifamily that is close to 3% and my cap rate fro 2011 was less than a single family that I have that is closer to 1.5%. Although both properties are solid perfomers, actual numbers tell the full story. The single family less effort to manage also.
Tenant paid utilities are one of the biggest factors when assessing properties.
- Rental Property Investor · Mercer Island, WA · Member since 2008 · 22k+ posts · 14k+ votes14y
Originally posted by Bill Gulley:
Geeez, how many rules do you need? 1% when revenues exceed 500 bucks, 2% when it's different, 5% when it's something else.....did anyone pass highschool math class?How many rules do you need? Why don't you learn how to look at any property by the facts at hand, that rule can never be out dated!
Why in the heck can't you people figure actual costs and provide reasonable estimates, is it that simple percentages makes your life easier for the lazy and stupid or is it that you need rules because you can't think?
Sorry, just can't get over all the "rules" you so called "investors" want to use......if you can't do simple math, dig ditches and get out of real estate! Thanks! Get out of the way of real investors.......
Really, you just need one - the 50% rule. The others , 2% for low rents, 1.5% for higher rents, are derived from that. Even the 50% rule has caveats. If you're willing to put in your own labor, 35-40% might be more reasonable. If you or your PM does a bad job, 50% might be too low.
The reason this is helpful is that new investors, and especially the people pitching properties to new investors, often claim you only expenses are taxes and insurance and that you'll never have a vacancy. The 50% rule may or may not be accurate for any particular property in any particular year, but its a heck of a lot closer than "cash flow = rent - PITI".
The "facts at hand" are often unknowable. How much will maintenance costs you? How long will the property be vacant between tenants? How much will you need for capital over the next 20 years? What should you allocated for a messy eviction? Any number you put for any of these is just a guess. By lumping it all into one big number - 50% - you avoid the temptation to skim a little off here, a little off there and make a bad deal look OK. Reality will be whatever it will be. You can't control that and you cannot predict it very accurately. The 50% (or less if you self manage) is just a way to account for that lack of predicitibity.
I personally dislike the 2%, 1% or any of those rules. And I agree, Bill Gulley you better be able to do math if you're going to be in this, or any, business. Excel or a financial calculator is essential and actually running the numbers on a prospective property is better than a rule of thumb.
-- Lazarus Long (aka Robert Heinlein)
- 14yDon KonipolBusiness MemberInvestor · The Woodlands TX / Avon, CT · Member since 2009 · 6k+ posts · 10k+ votes
Taylor Hall, here is a reprint of Karen Hanover's take on apartment building classifications:
Lender Ratings of Residential Investment Properties
Lenders have developed general classifications of apartment buildings so that they can communicate amongst themselves and other members of the industry with some level of uniformity. The classifications are Class A, Class B, Class C, and Class D.
Grade 1. Class A.....Newer, Institutional
Grade 2. Class B.....Older, Institutional
Grade 3. Class C..... Older, Declining Area
Grade 4. Class D......Older, Declining Area, Poor ConditionClass A Apartments - Institutional buyers like new, larger apartments in prime locations because of low deferred maintenance. These properties are typically occupied by white collar workers and have amenities such as garages, in-unit washer/dryers, pools, spas, exercise gyms, the latest technology, etc. They are typically between 1-10 years old. Typically they are in the path of progress and as of this writing (July 2008) can be bought at cap rates of 7%. They will likely have less cash flow than properties with higher cap rates but will have greater appreciation potential.
Class B Apartments - Class B buildings are in good areas with many of the same amenities as Class A properties, but Class B buildings are 10-20 years old and occupied by both white and blue collar workers. Class B properties are often owned by investment groups, such as limited partnerships and limited liability companies. As of this writing (July 2008) they can typically be bought at cap rates of 8% - 9%. These properties will have decent cash flow and decent appreciation potential.
Class C Apartments - These apartments are older properties built within the last 21-30 years in working class areas typically occupied by blue collar workers and even some Section 8 tenants(please see my article on Section 8). The properties may be in declining areas but not necessarily dangerous areas. The units in Class C buildings are smaller than those in Class A and B buildings and the projects have fewer amenities. The occupancy rates are typically higher than Class A 0r B because they are more affordable. Individuals usually own Class C properties, which as of this writing (July 2008) can be bought at cap rates of 10%. These properties will have decent cash flow but little opportunity for appreciation.
Class D Apartments - These buildings are older, in declining and even dangerous areas and as a result may have high vacancy rates, deferred maintenance, functional obsolescence and demand a high level of hands-on management from their individual owners. As of this writing, they can typically be purchased for cap rates of 12% but may generate less income than other properties despite their higher cap rates because of higher maintenance and management demands.
Rules of Thumb:
1. Class A & Class B properties are purchased for appreciation potential.
2. Class B & Class C properties are purchased for cash flow
3. Unless you are an experienced investor, don't buy Class D properties.Article Source: http://EzineArticles.com/1373544
- Rental Property Investor · Mercer Island, WA · Member since 2008 · 22k+ posts · 14k+ votes14y
I'll add, too, that interest rates are incredibly low right now. If you're paying 7% for money (like I paid for my first rental in 2008), then your P&I is much higher than current rates around 4% for investor loans. At 4%, even a 1% deal is pretty attractive. Unfortunately, getting a 20 or 30 year fixed, fully amortized commercial loan seems to be a pipe dream. That makes SFRs even more attractive.
There's also a hypothesis that there are a lot of older commercial loans that have balloons coming due and that the owners are going to have a very tough time refinancing. Unfortunately I have some personal experience that bears this our. This may mean a lot of commercial properties, including multi family buildings, will come onto the market in the coming years.
- 14yDon KonipolBusiness MemberInvestor · The Woodlands TX / Avon, CT · Member since 2009 · 6k+ posts · 10k+ votes
K. Marie Poe, in 2008 we purchased 12 unit Arlington, Texas complex about half was govt subsidized. Paid $180,000, spend $60,000 for deferred maintenance. Gross rent roll was $7550/month. So monthly rents were 3.1% of purchase price + repairs. The project was so much aggravation that we sold it a year later for very little profit.
- Grand Junction, CO · Member since 2012 · 4 posts · 0 votes14y
Thanks so much for all the insights, I am learning a lot! @Ned Carey, I am very interested to know how you work the deals that are not advertised? That sounds like the ticket for me :)
- Investor · Hampton Bays, NY · Member since 2009 · 907 posts · 258 votes14y
I agree with Ned when he says that you need to negotiate a good deal. I do not invest in my home market for income. I found better opportunities in Dayton Ohio which is over 700 miles away.
The choice I faced was to try to invest near home and force the issue because even the most distressed properties would not meet my income needs or look elsewhere.
If you chose to invest close to home you need to work hard at finding distressed situations Divorce, inherited property that the family cant manage, property where real estate taxes are years overdue etc.) or properties that are in need of repair.
Even in my farm area in Dayton where the 2% rule is more easily attained, If I work harder and purchase properties in need of repair I can achieve better than the 2% because my after repair cost is lower than buying a move in ready property.
- Investor, Entrepreneur, Educator · Springfield, MO · Member since 2009 · 21k+ posts · 12k+ votes14y
Originally posted by Jon Holdman:
-- Lazarus Long (aka Robert Heinlein)
I choked on my coffee Jon Holdman, LOL! That's cold man! But true LMAO!
I agree Jon, you can quickly look at a deal with 50% or your % in seconds. If I park at the street or in a driveway and know the asking price, I know what rents would have to be before I get to the front door,or pretty close to it.
But there is no substitute for looking at real costs. In a 15 minute walk through and a trip around the property, I'm pretty close to rehab or costs for lipstick. By the time I get in my car I'm within a hundred bucks of closing costs (not counting per diem accounts cause you don't know when it will close) and pretty much what an offer will be.
If you run numbers a thousand times you get to a point where don't need a calculator, you know what closing costs are for a purchase in 5k increments, like 60k, 65k, 70k, etc. later you can pencil it, 3.50 per thousand for title insurance, 300 closing agent's fee, etc. I"m never really surprised at anything on the HUD when I get to closing.....I just do the numbers.
Didn't mean to ruffel feathers of the ratio types, but think in terms of real numbers, it won't take long....
- Real Estate Broker · Canton, GA · Member since 2010 · 15k+ posts · 11k+ votes14y
I didn't read all of this but yes I have had investors call me from these oil towns and they are talking about 4.5% caps etc. trying to buy stuff there and it just isn't working.
They like the yield they can get in Georgia.
If you do not want a low cap then you will have to go outside of that market if that is what every buyer is paying.A seller is not going to sell to you at a 10 cap when everything is trading at a 4 to 5 and people are beating down their doors to purchase.
- Investor, Entrepreneur, Educator · Springfield, MO · Member since 2009 · 21k+ posts · 12k+ votes14y
One way to increase the cap is to improve the property, including the image of the property, in a stagnet market, that's usually the only alternative, change the use, the market, population served and better define the area you are in.
As Don mentioned, most should stay away from the D properties, but they can also have the greatest opportunity, if ya know what you're doing.
There is a real push here to redevelop older buildings to upscale condos and apts. Think about revitalization opportunities to move that cap rate up....
- Real Estate Investor · the villages, FL · Member since 2008 · 5k+ posts · 3k+ votes14y
From what I have seen, normally the class A, B, C, etc. is based on age of the commercial property. I own a class C property in Garland Texas with over 150 units. I received a weekly report of occupancy, vacancy, and units ready for rent. For the last several months the majority of my weekly reports have shown 100% occupancy. It is normally much easier to accumulate cash flow with a class C property as opposed to class A or B.
in answer to your question in your thread I've never been one that has followed strictly the 2% or 1% thought process. As Jon H mentioned, normally these percentages will only work in lower-priced rentals which unfortunately also means lower quality rentals, sometimes even ghetto type properties. For those of you who don't know how I evaluate ghettos, I only have two rules:
I want to feel comfortable that my wife can drive to the area during the day.
I want to feel comfortable that I can go and collect rent after dark and I don't need a 357 Magnum.
Rich
- Developer · Santa Clarita, CA · Member since 2008 · 15k+ posts · 10k+ votes14y
FYI: Nobody should take advice from, do business with, or be associated with a scam artist and person arrested for impersonating an FBI agent. With that said, Karen H was mentioned above on her definition of A-D class buildings. I am willing to bet that the information was likely plagerized or stolen from someone else who actually got it right. While I would agree with the assessment and definitions, I would not sugggest anyone take any advice from this person.
Read for yourself all about her via Google, one of those articles being this one:
http://articles.dailypilot.com/2011-02-10/news/tn-dpt-0211-hanover-20110210_1_fbi-agent-federal-agent-fbi-offices - Investor · Westminster, CO · Member since 2009 · 1k+ posts · 1k+ votes14y
Like Rich said, if you invest in D, you need a C&C.
So Ms. Hanover is a scam artist, I hope she is blocked from BP from now on.
I keep seeing people complain about 6% return. Why? One year T-Bills are paying a whopping 0.185%, 10 year is paying 1.75% and a 30 year is paying 3%. And with a Tbill, your capital stays the same, it does not appreciate.
If I can get 6% return just on the rental income with my capital having a chance to appreciate, I will take that all day long. There has been no 30 year period in the history of the United States where the average price of a home was lower after 30 years. Even with the huge, recent downturn, home prices in 2011 are higher than they were in 1981.
If a 6% return means an 80% change of long term appreciation, I will take that over a 12% return that gives me a 25% chance of long term appreciation. Remember, there is a socio/economic reason you are getting a 2% rental amount and those reasons are the same reasons appreciation will be mostly absent.
- Developer · Santa Clarita, CA · Member since 2008 · 15k+ posts · 10k+ votes14y
Some great points Mike.
And Yes, Josh already informed me she will be blocked for our site! - Investor · Baltimore, MD · Member since 2008 · 17k+ posts · 13k+ votes14y
Sandy Hammer, there are lots of ways to find properties that are not listed. Look around the site and you will find many threads on the subject.
Here are a few examples, track down the owners below and work a deal.
Marketing ideas
For sale by owner
Craig's List ads
For rent ads - if a landlord has a vacant property, maybe they are ready to sell.
Pre-foreclosure
code violations
owners behind in water or tax bills
rent court
vacant and or boarded up houses
estates
Direct mail to any of the above, to absentee, or out of state owners
non arms length transactions
nominal transfers
Bandit signs
"we buy houses" ads
Networking
Real estate clubs
AuctionsDriving for dollars is a good one. Look for any signs of the above. Talk to neighbors about the vacant house next door. Walk into properties being renovated and get cards from the contractor or owner.
That's what I come up with off the top of my head but I know there are more ways to find deals.
Good Luck - Ned
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