Which "Rules" Do You Use?

Question

I'm a newbie just beginning to learn.  I've got about $350K to invest and live in the SF Bay Area.  I read the beginner's guide on this site and was wondering which "rules" help you the most (the 2% rule, 70% rule, etc.)?  I only ask because when I look at real estate around me, none of those seem to work.  I was originally thinking of a buying a SFH in Sacramento suburbs, or dicier parts of Oakland/Hayward, but the math is not working out.  I'm interested in modest cash flow and long-term appreciation (10+ years).  I'm thinking I may need to look elsewhere but the thought of long-distance purchasing for my first investment is a big scary.

Randall Alan · Answer

So I’ll give you my own “rule”... it’s not about percentage return, but rather finding out what property works best for you in your area!

Maybe  I need to come up with a flashy name for it!  I’m going to call it Randy’s Triple Compare method!

So in short, the gist of the exercise is to see which property gives you the most return for your money so that you can focus your efforts on the right segment of the market

Pick a  “cheap”, then “mid-range”, then “higher end reasonably priced”  home in your area and run the real numbers for Principle, interest, taxes, and insurance (PITI), plus a repair reserve to get a close approximation of your all in monthly cost for each property.  In my area those numbers might be $75k, 125k, and $250k.  You can look up the taxes for each on your property appraiser’s website.  For Insurance you could bother your insurance agent, but approximating them will be fine.., maybe you could use numbers from your own portfolio for similar homes, or you could use mine, which would be like $800 for the cheap one, $1,500 on the mid price, and $2,200 for the biggest ones.  But use what makes sense for your area.

Then look at the average rent for each of those properties by looking at similar properties in the same areas that are for rent. Try using Zillow, or apartments.com, or whatever website you think will give you an accurate rental price for similar houses in your area. For repair reserve just keep it simple... maybe increase it by $25 per size. In my area I use $75, $100, and $125/month. Also, you can break down the rent on your comps to $/sf so that you can accurately multiply the size of your target property by the $/sf that you found for your comp to get what your target property should rent for.

Next subtract your PITI and repair reserve from the rental rate you found for each level of rental and look closely at your resulting Net operating Income! Which property netted you the most income? What you may find is that the numbers are way closer than you ever thought that they would be!

So if that is what you find, ask yourself, “Why would you pay 3 times the price for a house if it earns the same amount of return as the cheap house?”

If you are looking to maximize your resources and income in your real estate portfolio, I think it makes a lot of sense to target only those properties that give you the most bang for your buck!  This knowledge will help you focus your efforts on the right segment of the market, and not over-spend on properties that, while may be nicer, don’t earn you any more income.

I hope you enjoy “Randy’s Triple  Compare Method”!!

What I found is that I earn the same amount of money from the $75,000 house as the $200,000 house. So I can make 3 times the rental
income by buying 3 of the smaller units as compared to one of the larger units!

Now... plot that point of your best deal of the 3 on a Graph that has house price on the X Axis and Total gross monthly Rental income (on the Y Axis. This is your sweet spot for purchases and should be your reference point when analyzing every other deal you look at. For me it looks like this: my best deal is any house I can buy for $75,000 or less and rents for $1,000 or more.

But what about the $90,000 house, or a $125,000 house. They aren't off the table, but they need to "justify themselves" by earning a higher rent that covers their increased cost to acquire. So if you find a $125,000 house but it only command $1,000 in rent, why would you buy it instead of a $75,000 house that would do the same thing. The $125,000 house would need to demand at least $300 more a month to equal the income of the $75,000 house (just the mortgage difference is roughly $225/month), plus additional expenses for all the other PITI expenses.

But by knowing just your one sweet spot you can quickly analyze price /rent combinations to almost instantly know whether you are looking at a “great deal”, or one that is “less than great”, before you even look at a picture of the property. I can literally scan square footages of properties against their price and eliminate 9 out of 10 properties almost immediately because they don’t fit the profile that I identified works best for my rentals.

Hopefully you can use this exercise to make you more efficient at targeting properties that will work best for you!

All the best!

Randy

Jon Schwartz · Answer

Jerry, the "rules" that are all over this website are for appreciation-poor, cashflow-rich markets in the Midwest. CA is a different ballpark. For that reason, Midwesterners on this site like to poopoo investing in CA.

$350K is more than enough for a down payment on a good investment in the Bay Area. My suggestion to you is to start with a househack. You'll get a better mortgage on an owner-occupied property, you'll build equity more quickly, and you'll find yourself in a few years with a lot of net worth and options.

Good luck!

Jon

Darius Ogloza · Answer

What a lot of these rules - and investors - miss is the element of time.  Cash flowing on day 1 of an investment is not meaningful if your intent is to hold 10, 15 or 20 years.  You need to consider total return in that context which is usually comprised of cash flow, mortgage reduction and appreciation.  Over the lifetime of an investment, each and every one of these factors can be challenged.  There are times a capital repair will swallow cash flow and mortgage reduction but will enhance the value of the asset.  In this respect, buy and hold real estate investing is much like stock investing - you look to the total return and not merely to the dividend that is being paid in order to evaluate performance.

Fix and flip real estate investing has a different logic - that of a value-add service business.  Taking a home made for the American family of the 1960's and making changes so that it is suitable for the American family of the 2020's will usually generate a premium for the service you are providing.

Aaron K. · Answer

@Jerry Nelson all of the rules are garbage because they lack nuance.  The 2% rule is unattainable in quality properties in almost the entire country, the 1% rule is achievable in some places but in CA it isn't as relevant partly because we have lower expenses here (lower property taxes over time, lower insurance, HVACs and roofs last longer, management is a lower percentage etc.)  Also CA has historically had appreciation so the market has priced that in.

Account Closed · Answer

@Jerry Nelson Jerry - the 2%, 1% rules are so location dependent. 2% as has been mentioned appears to not exist, 1% is definitely attainable but I'm not sure in your area (I'm in PA where the 1% rule isn't hard to find).

If you are interested in buy and hold, I would just focus on cash flow. Learn how to analyze a deal on that and I think you'll be fine.

Dave Peterson · Answer

I agree with Darius regarding buy and hold.  For many years I never bought anything as I couldn't make the numbers work.  I also had enough income from my day job to cover any negative cash flow.  I would be much better off today had I not waited.

John Teachout · Answer

The 1%/2% rule is the only rule I use and it's just a screening aid when sifting through properties. We just do buy/hold so the other rules don't really apply.

Brian Garlington · Answer

I'm here in the East Bay and you will not get 2% rule in California. 1% rule you may get on a fourplex or triplex in a "working class, blue collar, up and coming neighborhood in East Oakland". Not saying anything ois wrong about that by the way. I own some in that exact type of area in East Oakland for cashflow.

Which "Rules" Do You Use?

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