If I'm cash-flowing why does Bigger Pockets make me feel like I failed?
Investor · Decatur, GA · Member since 2014 · 56 posts · 16 votes
If I'm cash-flowing why does Bigger Pockets make me feel like I failed?
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Investor · Atlanta, GA · Member since 2013 · 922 posts · 336 votes
12yHey David
It's funny reading this post. I am actually sitting in Atlanta in the West End.
I am going to tell you this. If it makes financial sense and the properties support themselves then I don't actually see the issue. It may not fit their criteria, but if a property is putting a cushion in your pocket every month then keep doing what you are doing. Your niche makes sense to you. It definately makes sense to me.
Keep going!
Best of Luck to you!
Gerald
104 Replies
- Investor · Decatur, GA · Member since 2014 · 56 posts · 16 votes12y
What I don't understand is if CapEx is 50% of rent, than how does that scale. I would think if you're renting a 4 bd SFR for $2000 a month in one area of town and a 4 bd SFR for $1000 a month in another area, the repairs would be similar and not more just because of the 50% rule. How is this wrong?
- Investor · San Jose, CA · Member since 2012 · 2k+ posts · 3k+ votes12y
David,
My investment partner is renting his 4-bedroom house for $9,800/month. Do do you scale that? Keep on doing what works for you.
- Memphis, TN · Member since 2013 · 969 posts · 524 votes12y
We all give are examples of what works and doesn't work for us in our investing strategies. I look at what you are doing this way "if it isn't broke don't fix it" LOL!! BP will beat you down if you let it, everyone seems to have the perfect investing strategy or best idea to invest for appreciation or Buy and Holding. Last but not least who made up the 2% rule or guidelines to investing it's all based off opinions from other investors they may work for you and not work for others. You have done what a lot of others have only talk about doing you own 6 cash flowing properties. You are doing GREAT in my eyes!!
Keep you head up. Rules are made to be broken LOL!!!
"A successful man is one who can lay a firm foundation with the bricks that others throw at him."
-Sidney Greenburg
- Real Estate Investor · Nashville, TN · Member since 2014 · 78 posts · 44 votes12y
@David Cohen If you aren't doing so already I would suggest running your future purchases through a good SFR spreadsheet like the one J Scott has available in the resources section of BP. That is going to give you a far more realistic idea of what your numbers are going to look like over time than following x% rule.
- Bedford, NH · Member since 2012 · 2k+ posts · 1k+ votes12y
It is all about managing risk. There is not one way to do it, not just the 2% rule or the 50% rule, there are many.
For example, I am barely getting 1%. Some might say I am therefore not adequately protected against risk. On the other hand, I am not at all highly-leveraged (LTV across my *very small* portfolio is way under 50%). That is a way to mitigate risk.
I have also, so far, not pulled a penny out. We live on my salary; cashflow is rolled back in, in the form of saving for the next down payment, rennovations/additions to the houses, or principal pay-down.
These "rules" are rules of thumb. Maybe if I am eyeing a piece of 2x4 it looks like I need 8 thumbs worth, and I only have 7 and therefore don't have enough. I'm still going to actually measure in inches, and if it fits, it fits.
- 12yJay HinrichsBusiness MemberReal Estate Consultant · Summerlin, NV · Member since 2014 · 45k+ posts · 66k+ votes
I get your point.... however to be fair you live it and work it and manage it all. your not investing 5 states away and trusting others to secure your outcome.
I totally agree that if you live in these markets and want to build up a large portfolio over time of cash flow rentals and its your business it can work very well for the owner operator or small group of local investors..
the danger zone is buying 1 or 2 or 3 of these homes far from were you live and thinking that this is a long term wealth strategy...
If I lived in your market I would do exactly what your doing and build a business around it.
I think the issue comes from out of state investors that get lulled into thinking that this type of investing is all done for them.. Everything is going to run as the promotional material states etc etc.. when the reality is far different than the dream in many cases not all but in a heck of a lot... I have first hand experience at this lending to 400 plus LA based investors over the years... I have heard the horror stories and to do the work outs... Saw people crushed emotionally and financially thinking they could buy low end homes.. The first 5 years of my HML in this space I really did not have a clue as I got paid off every 90 to 120 days and never really had contact with the client after that they now had a country wide loan . But when it crashed in 08 and I got stuck with 200 non performing loans in the Mid west I got a PHD in how dangerous this can be for out of state investors... And all from the front lines... literally banging on doors.
This is when I personally came to the conclusion that this investing in 500 to 800 dollar rentals in the mid west was a locals game... and really not appropriate for out of state folks especially inner city and rough demographics... The reality is were do all these SFRs come from today.. they come from investors who gave up... Why do investors sell houses they paid 80k for for 20k today... happens everyday every turn key company in the USA is buying their inventory from these failed landlords...
Obviously many will do fine and think I don't know what I am talking about.. But many TK companies are here today and gone tomorrow and leave their clients high and dry.
I can think of only a handful of TK companies that are more than 7 to 10 years old. So there is no history to go on to say whats going to happen with these properties.
You are right. I have found the majority of the posts are flippers or folks wholesaling and the more more more group where 10k properties is just a good year.....lol. Very few posts of the buy and hold that btw I am in myself. Here is how I see it. All those great properties I bought in the downturn from overextended homeowners and investors I still own. They have all doubled and tripled in some cases in value yet I am still cashing the monthly dividend check on them. On the other hand I see the flipers as the next fix. They have long ago cashed in these great properties and now have to pay much more for them. I can only guess they need to sell them cause they need the funds to live on and do the next deal. In the end be glad your are in a position to hold them and who cares about any formula most likely made up by a flipper who thinks 100 days is a long time. No offense flippers...money is money
Originally posted by @David Cohen:
What I don't understand is if CapEx is 50% of rent, than how does that scale. I would think if you're renting a 4 bd SFR for $2000 a month in one area of town and a 4 bd SFR for $1000 a month in another area, the repairs would be similar and not more just because of the 50% rule. How is this wrong?
First, a little clarification of terms...
CapEx is "Capital Expenses" and this includes big ticket items that are depreciated -- things like a new roof, new HVAC, new water heater, etc. Expenses encompass most other things: taxes, insurance, maintenance, property management, lawn care, etc.
When we talk about the 50% rule, we're talking about the following three things that typically encompass about 50% of the gross rent:
1. Expenses (as defined above)
2. Capital Expenses (as defined above)
3. Rent Loss (vacancy, concessions made to tenants, non-payers, etc)
In general, on average, and across many units, those three things tend to account for about 50% (anywhere from 45-55%) of gross rents. If you're doing Property Management yourself, you might save 10%, btw.
Now, to your question about why/how the 50% rule scales to different houses in different areas...
First, remember that the 50% rule typically is based on "market rent." If you're renting a property for $500 where other similar properties are getting $1000, then the 50% rule is based off the $1000 gross rent assumption.
Second, for houses that command higher rent, the following things are likely true:
- They are generally valued higher, so taxes are likely higher
- They are generally valued higher, so insurance is likely higher
- With higher rent comes higher Property Management costs (in absolute dollars)
- Higher rent may mean bigger house, which means higher maintenance costs
- Higher rent may mean bigger house, which means higher capital costs
- Higher rent may mean larger lot, which means higher lawn care/snow removal costs
- Higher rent may mean larger house, which means higher utility costs
Do things things necessarily scale linearly? Nope. But, again, we're talking about averages. And the best numbers I've seen across large numbers of units and across large geographic areas, the 45-55% average for expenses as a percentage of gross rents has held true.
Does that make sense?
Going back to your original post...
If the properties are cash flowing, and you're happy with your yield/return, that's all that matters. You don't need to adhere to any rules in terms of what yield you're receiving -- that's completely personal to your financial situation and decisions.
That said, I will bring up two things to consider:
1. You say the properties are cash flowing. Are you sure? Just because you've made money every month since you bought the property, that doesn't mean it's cash flowing. To consider an extreme example:
What if you made money every month, but knew that next month you'd have to pay $10M in taxes? Then, after that, you'd continue to be profitable again every month.
Would you still say that you're cash flowing (since you've been profitable every month except for next month)? Or would you say, "****! It doesn't matter that I'm profitable every month except next month, as the cost I'm paying next month will make this thing a money loser for the next 200 years! So, because of just one really, really, really bad month, this thing really doesn't cash flow."
Hopefully, in that situation, you'd agree with the second assessment -- the property doesn't really cashflow because the money you spent in one month negates all the cash flow you'll ever receive, plus much more.
Now, you'll never have a month where you'll have to pay $10M. But, over the long haul, you will have months where you'll have to pay $100 or $3000 or $5000 or maybe $10,000 to cover things like new new roof, new HVAC, new water heater, siding repairs, plumbing/electrical updates, etc. If every 20 years, you're spending $20K on those things, that averages out to $1000/year, or about $80/month.
There will also be months where you lose $1000 by not having a tenant in there (vacancy). Let's say you lose a month every two years between tenants. That averages to about $500/year -- or about $40/month.
Hopefully it won't happen for a long, but at some point, you're going to get a bad tenant who you have to evict. He may not pay rent for a few months, and then you spend another few thousand dollars to go to court and get him evicted. If this happens every 10 years, that could average to about $500/year for those costs. That's another $40/month.
Just looking at those three things above, you can see how you could be spending over $150/month without even realizing it -- not realizing it because these will be lump sums spent at some point in the future that you're not even thinking about today!
So, when you say you're cash flowing, have you considered all these future expenses into the equation? If so, great...ignore everything I just said. But, many new landlords read what I wrote above, and a lightbulb turns on for them. For others, the lightbulb turns on when they get the bill for the new roof and realize they just spent a half-year worth of rental income on it.
2. The nice thing about investing is that we can apply math to most situations. We talk about the 1% rule and the 2% rule a lot, but we don't often think about why those "rules" are there and why they may (or may not) make sense.
Let me give you some math to support the theory behind these rules:
If a property adheres to the 2% rule, that means that it generates 2% of the purchase price in gross rents each month. If we can accept the 50% rule that I discussed in the previous post, we can agree that of the 2% of the purchase price we receive each month, we're actually keeping (cashflowing) about 1% of the purchase price (50% went away to expenses, vacancy and capex).
That means that over the course of a year, we're generating 12% of the purchase price in cash flow (1% per month time 12 months). Good so far?
Now, if you're familiar with Cap Rate, you'll quickly realize that this means our property has a 12% cap rate. In other words, if a particular property follows the 2% rule and you accept the 50% rule, you should expect that the property should generate about a 12% cap rate.
Without going through the math, it should be obvious that a property meeting the 1% rule and using the 50% rule, that property will have a 6% cap rate.
Given that your property doesn't meet the 1% rule, and again assuming you accept the 50% rule, that means your property is less than a 6 cap (lower than 6% cap rate).
With leverage, you can likely get higher returns than that -- THESE DAYS. But, the questions become:
- How much higher can you get?
- For how much longer will 6% cap rate properties be able to attain positive leverage?
Personally, I wouldn't buy a 6% cap rate investment these days, even using leverage. I have better opportunities. But, that doesn't mean others aren't happy with those levels of returns.
The point is, using some basic math, we can quantify the returns you're likely receiving. It's now up to you to decide if those returns meet your goals. Are you happy with a 6% cap rate, with or without leverage?
If so, again, ignore everything I wrote above. But, at least you have the framework to consider whether it meets your goals or not.
Originally posted by @David Greene:
1) The 50% rule says about half of your income will go to expenses. I, like you, have bought nicer homes in nicer areas. And my expenses don't come to even CLOSE of my rental income. They are much less. I think this has become a rule of thumb because in order to obtain the coveted 1% or 2% rules, most investors are forced to invest in lower income, older homes.
Have you had to replace any roofs yet? Any HVAC systems? Any water heaters? If not, you will at some point, and for nicer homes in nicer areas, you'll spend more on this stuff.
Not saying that your numbers aren't fine/great/awesome, but don't think that having a newer home means fewer LONG TERM expenses. Over the long run, it costs just as much to replace a capital items on a newer home as it does an older home...you just have a longer grace period before the first time you have to do it... :)
See my two posts above for more details...
- Broker · Logan, UT · Member since 2013 · 1k+ posts · 1k+ votes12y
Lots of good posts.
I have a client who has made a mint in land speculation. He operates on the 0% rule.
I have another client who lease/options A properties and sets the options due 2/3 of the way through building's useful lifecycle. He has yet to replace a furnace or roof.
The 2% rule and 50% rule are very useful if you plan on holding the properties forever, but there are lots of ways to make money in real estate.
Keep doing what you're doing, but plan for the big ticket items long in advance.
Cheers.
Originally posted by @William Hochstedler:
I have another client who lease/options A properties and sets the options due 2/3 of the way through building's useful lifecycle. He has yet to replace a furnace or roof.
This is the standard argument when it comes to capex costs -- if you sell it before you do the work, it's a loophole...
My typical response to that is two-fold:
1. If you're not planning to hold a property long-term, all the rental rules of thumb go out the window;
2. Notwithstanding #1 above, there are no loopholes. If you're selling a property when capital items are 2/3 to end-of-life, that information will be reflected in the offers you get. Buyers will have inspections, and they'll account for the fact that a roof is only 6 years from end-of-life or a compressor only has a couple years left. In other words, if you purchased the property when these things were new, you likely paid a premium, and when you sell (and they're no longer new), your buyer WON'T pay you the same premium.
That said, these are just rules of thumb, and I'm sure there are exceptions out there. Those who have been in this business for a long time are experienced enough to know when they're looking at an exception; the rest of us should heed the rules of thumb unless/until we know better.
- Investor · Decatur, GA · Member since 2014 · 56 posts · 16 votes12y
I didn't think the 50% rule included interest, taxes, insurance. I thought it was just maintenance and management. With those included, it's more than 50% of my costs.
- Landlord and Rehabber · Newton, MA · Member since 2010 · 2k+ posts · 877 votes12y
Originally posted by @David Cohen:
I didn't think the 50% rule included interest, taxes, insurance. I thought it was just maintenance and management. With those included, it's more than 50% of my costs.
The 50% does not include interest (or the principle portion of a mortgage payment, which will affect cashflow) but does include the taxes and insurance. So that stuff along with the maintenance and management like you said as well as vacancy and reserves for these CapEx expenses, and anything else that comes along.
The "Other" 50% is what you have for your mortgage payment (Principle and interest, so payment less any escrow for taxes and insurance) and profit.
- Investor · Bethel, CT · Member since 2014 · 55 posts · 12 votes12y
Great discussion and really good points. As a newbie still learning and not yet invested I am really trying to better evaluate the more expensive lower cash flow properties vs. the higher cash flow less expensive and lower rental income properties in my area. I have analyzed dozens of properties currently on the market and I definitely see better cash flow in the lower rental income properties that are typically multi-family. My concern with these properties is the potential for those expenses that I may not be estimating properly to come in much higher like those expenses associated with higher turnover and potentially higher repair costs due to the fact that most of these properties are older homes. I understand that using general percentages when estimating expenses as a rule of thumb is necessary to evaluate the opportunity but in the end I'd like to be as educated as I can be and use as much market specific data to fine tune those estimates that I can before I jump in.
- Investor · Honolulu, HI · Member since 2013 · 3k+ posts · 1k+ votes12y
Originally posted by @J Scott:
, if a particular property follows the 2% rule and you accept the 50% rule, you should expect that the property should generate about a 12% cap rate
Dang @J Scott I thought you finally understood cap rates. First, the 50% rule can be used to get a rough cash flow amount. You cannot compute a cap rate using the 50% rule. That is a CRAP rate. A cap rate is ALL about the components of the NOI. If your 50% expenses consists of 20% vacancy and another property has a 5% vacancy the NOI will be DRAMATICALLY different. The CAP RATE is all about the NOI.
Second, a property DOES NOT generate a cap rate. It generates NOI. Then buyers will look at the NOI and bid for what they will pay for that NOI. Lets say you have $20,000 NOI in Indiana and the same in San Francisco. The San Francisco property could very well get a bid (sales price) of $333.333. Then the market would say that property sold at a 6% cap. Now in Indiana the same amount of NOI may only be worth to the market $166,666 at a 12% cap. The market is telling you that the Indiana property/NOI is worth LESS than the San Francisco property. But you want to think you're "making" more money on the Indiana property since 12 is bigger than 6. Do you see the flaw in your reasoning?
- Real Estate Investor · Grass Valley, CA · Member since 2014 · 124 posts · 85 votes12y
I just joined Bigger Pockets and gotta say that I'm really enjoying the discussions. They're like a book I can't put down. As for my property, I would've been lucky to hit the .5% rule when I purchased it 8 years ago...haha. But it fit my goals, and still does for now. I needed a place to park the cash I had made on a flip, and so I put it into a neighborhood that I know (near my own), in a property that I felt reasonably confident would hold its value at the least, would be easy to manage and give me good rents. While I was looking to at least break even, cash flow wasn't a huge concern because I have a good job. I was thinking more nest egg. If I stick with it until the mortgage is paid off in 11 years, it will cash flow like crazy. I probably could've invested my money from the flip elsewhere and created a good source of cash flow, but being a bit of a multi-family neophyte, I wanted to stay in my comfort zone. Luckily, the property has appreciated significantly and now as I get older, I'm considering my options.
- Landlord and Rehabber · Newton, MA · Member since 2010 · 2k+ posts · 877 votes12y
Originally posted by @Account Closed:
Originally posted by @J Scott:
, if a particular property follows the 2% rule and you accept the 50% rule, you should expect that the property should generate about a 12% cap rate
Dang @J Scott I thought you finally understood cap rates. First, the 50% rule can be used to get a rough cash flow amount. You cannot compute a cap rate using the 50% rule. That is a CRAP rate. A cap rate is ALL about the components of the NOI. If your 50% expenses consists of 20% vacancy and another property has a 5% vacancy the NOI will be DRAMATICALLY different. The CAP RATE is all about the NOI.
Second, a property DOES NOT generate a cap rate. It generates NOI. Then buyers will look at the NOI and bid for what they will pay for that NOI. Lets say you have $20,000 NOI in Indiana and the same in San Francisco. The San Francisco property could very well get a bid (sales price) of $333.333. Then the market would say that property sold at a 6% cap. Now in Indiana the same amount of NOI may only be worth to the market $166,666 at a 12% cap. The market is telling you that the Indiana property/NOI is worth LESS than the San Francisco property. But you want to think you're "making" more money on the Indiana property since 12 is bigger than 6. Do you see the flaw in your reasoning?
Other than the misuse of the term "generates" not sure what you are complaining about?
First that huge gap in vacancy rate would be totally irrelevant to the NOI IF the total of vacancy, credit loses and expenses all shake out to be 50% of the gross rent. You can argue that is a bad assumption, but using that assumption it is 6 of one half a dozen of the other.
Mathematically finding a 2% property is the same as using the 50% rule to estimate annual NOI and dividing by a 12% Cap rate.
Example (on the level of property that will often meet the 2% rule)
$500 monthly rent says you buy it at $25,000 to meet the 2% rule.
Take the same place and assume the 50% rule which gives you $250 a month or $3,000 a year. Divide that by 12% and you get $25,000.
For your other comment you are 100% correct that 12% in one market can't be compared to the 6% in a totally different market to say one is a better deal. If in the IN property if they bought at a 12 Cap and things are typically trading at a 10 Cap then they bought below market, good job! If they bought the SF place at 6% and things are trading at 8% (Yes I know that 6% is probably a good deal in SF, not the point) then this guy overpaid. If you switch the market caps to 14 and 4 you will also flip who the "savvy" investor was as well.
- Investor · Honolulu, HI · Member since 2013 · 3k+ posts · 1k+ votes12y
Originally posted by @Shaun Reilly:
Originally posted by @Account Closed:
First that huge gap in vacancy rate would be totally irrelevant to the NOI IF the total of vacancy, credit loses and expenses all shake out to be 50% of the gross rent.
Would you please show the calculation for both? You'll be VERY surprised by the result.
Originally posted by @Account Closed:
Nope...
As Sean noted above, a 2% property that generates a cash flow equal to 50% gross rents (NOI of 1% of purchase price per month) is a 12% cap rate.
And actually, there is a flaw there -- technically, capex is factored below the line for NOI, not above. But for the intents and purposes of this discussion, a landlord would generate a 12% return on a cash investment on such a property.
Do you disagree with this? If so, I'll need to see some math.
Now, if you're whole point was that I used the word "generate" when I shouldn't have, then your nit is correct.
- Landlord and Rehabber · Newton, MA · Member since 2010 · 2k+ posts · 877 votes12y
Originally posted by @Account Closed:
Originally posted by @Shaun Reilly:
Originally posted by @Account Closed:
First that huge gap in vacancy rate would be totally irrelevant to the NOI IF the total of vacancy, credit loses and expenses all shake out to be 50% of the gross rent.
Would you please show the calculation for both? You'll be VERY surprised by the result.
Can you show a calculation why it is different?
All I'd do is say for a $1000 rent I would say one place has $200 in vacancy and the other has $50 in vacancy then I'd artificially say that all the other expense for the first place adds up to $300 and for the 2nd $450 since my assumption is that NOI is 50% of gross rent.
If you are figuring your other percentages after accounting for vacancy that is fine, but that isn't using the 50% rule.
Originally posted by @Account Closed:
Originally posted by @Shaun Reilly:
Originally posted by @Account Closed:
First that huge gap in vacancy rate would be totally irrelevant to the NOI IF the total of vacancy, credit loses and expenses all shake out to be 50% of the gross rent.
Would you please show the calculation for both? You'll be VERY surprised by the result.
Sure, let's take a look at two properties:
1. Property A
Value: $100,000
Gross Annual Rent: $24,000 (2% Rule)
Vacancy: 5%
OpEx + CapEx + Rent Loss = 50% (50% Rule)
NOI = $6000 (If you include CapEx above the line)
Cap Rate = 12%
2. Property B
Value: $100,000
Gross Annual Rent: $24,000 (2% Rule)
Vacancy: 10%
OpEx + CapEx + Rent Loss = 50% (50% Rule)
NOI = $6000 (If you include CapEx above the line)
Cap Rate = 12%
In both examples, the property hits the defined metrics:
- 2% Rule
- 50% Rule
In the examples, the vacancies are different.
In the examples, the cap rates are equivalent.
Therefore, if a property hits the 2% Rule and the 50% Rule, the cap rate will be 12% regardless of the vacancy rate.
Q.E.D. (not really, but for emphasis :)
- Investor · Honolulu, HI · Member since 2013 · 3k+ posts · 1k+ votes12y
Originally posted by @Shaun Reilly:
First that huge gap in vacancy rate would be totally irrelevant to the NOI IF the total of vacancy, credit loses and expenses all shake out to be 50% of the gross rent.
For your other comment you are 100% correct that 12% in one market can't be compared to the 6% in a totally different market to say one is a better deal. If in the IN property if they bought at a 12 Cap and things are typically trading at a 10 Cap then they bought below market, good job! If they bought the SF place at 6% and things are trading at 8% (Yes I know that 6% is probably a good deal in SF, not the point) then this guy overpaid. If you switch the market caps to 14 and 4 you will also flip who the "savvy" investor was as well.
Yes, I walked right into that one. It's just that all this cap rate computations on the subject property is completely backwards to how it is done in real life that I am trying to explain from that point instead of from the correct way.
So yes 50% off gross rents to get NOI is mathematically the same. But, a property will not have 10% less expenses JUST because it has 10% more vacancy. The fixed cost will remain the same and variable will probably be the slightly less.
But as you stated in your last paragraph where you agreed with me a cap rate comes from market COMPS. @J Scott stated he would buy only based on the cap rate he computed on the subject and would ignore market cap rate comps. We both seem to agree that that is not a correct way to determine profitability.
But hey, made you guys do math!
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