Does the 2% or 50% rule apply to new construction?

Question

I am thinking about building a 6 unit building. Each unit is 3br/2ba and would rent for 850.00. This is a little below market to be conservitive. I can build the project for an all in cost of $385k. This would be a cash deal as I am trying to get away from cd's and want to put no more money in the market.
If I use the 2% rule the rent would have to be $7700.00 so doesnt look good.
If I use 50% rule 3400.00x.50=1700.00
1700.00/385000=5% cash on cash. not bad but not great.
My Question???
With a brand new bulding, would the 50% rule be used?

Has anyone on here built a new project that didnt fit the rule and was it a good investment?

Bryan Hancock · Answer

50% rule deals generally chase people to tertiary markets in search of cash flow.  I have several blog articles about this for this month that describe why I think this is foolish.

Joel Owens · Answer

"I can build the project for an all in cost of $385k."

Even with the best experienced developers you will find over runs and delays constructing the building.This will run up over 385k and create a longer time before generating any returns.

This is why new construction unless an A location for a REIT etc. is not being built.The construction phase is the costliest and riskiest phase of a project.Your money would be better spent in value add existing buildings in good locations that can be bought at 50% to 65% of replacement cost going in.

Jon Holdman · Answer

There is no such thing as a "50% rule deal".  The "50% rule" simply says that operating expenses (per IRS regulations) plus vacancy (actual or economic) plus capital (expenses you incur in one year buy must amortize (deduct) over multiple years) will average out to about 50% of the gross scheduled rents.  Nothing more.

There are lots of reasons to buy rental real estate besides cash flow including long term appreciation and principal paydown.  Tax benefits are real (i.e., the income from rentals is largely tax free), but very often overstated.  Your ability to offset ordinary income with passive losses is often touted as a benefit, especially by those hawking junk deals, but is in fact very limited.

Just like playing a slot machine, its entirely possible to set down and play a few minutes and win a nice jackpot.  Its also possible to grind away for a long time while your bank roll slowly disappears.  Unlike slot machine, though, rental property cash flow upside is generally limited to rent - PITI (and, PM, if you're buying that.)  The downside, OTOH, can be very significant if you have a major expense.

The 50% rule does nothing more than give a more realistic estimate of the "expectation value" of the cash flow from a real estate investment.  It won't be accurate for a particular property in a particular month or even a year.  But its a heck of a lot more accurate than the "phony cash flow" of "rent - PITI" all too often quoted by sellers and their agents.

If I can save one newbie from buying into a deal that claims "this cash flows! rent - PITI is XXX" and then getting stuck with a property that sucks money out of their pocket and causes them to get into desperate financial situation, I'll continue to be myopic about this.

Bryan Hancock · Answer

I personally think the 2% rule is completely stupid...kind of like using a GRM.

The 50% rule should apply to all product types over the long term.  The capex expenditures will be pushed out on new product, but the long run averages will be the same.  A lot depends on how long you intend to hold the project and what you are trying to do.

Bryan Hancock · Answer

Here are a couple.  I guess the thoughts are more scattered than I thought they were.

RE Investing - A Solution For The Destructive Accumulation Mindset Part2

The Perils of The 50% Rule Myopia

BTW...You were wrong Joel.  We were issued a permit for a new SFR last week and are starting to move dirt this week.

Mike Cartmell · Answer

Bryan,
Can you direct me to which post this is in your blog?  I would like to give it a read. 
Thanks,
Mike

Jon Rood · Answer

All of your points are valid, however there are no repos or screaming deals in our area. The overall rental market is at 97% occupancy. Our economy has never boomed so we never have had a big correction. I have been looking for deals for 2 months and found nothing that makes the 2% or 50%. At least with a new build I know what I have. The rent might do 950-1000 per unit as other 3bd/2ba go for 900-1200 but I am being conservative. If I say each unit would rent for 1200.00 then everyone would say it makes sense. 
Thanks for all your input, it has made me think.

Joel Owens · Answer

Hopefully I am wrong.

I know she said they were on water rationing restrictions and have been for some time.

She also stated cities in Texas were growing like gangbusters.I believe 5 of the top 10 cities slated for growth are in Texas.

If there are water restrictions sometimes a temporary moratorium bill will be passed restricting new development.Also if the sewer system is running at or close to full capacity that can become an issue as well.

We are not having  these issue now but did have them about 2 years ago when we had a drought here in my area.

Bryan Hancock · Answer

Not that I know of Joel.  We are pulling a few permits for new construction in the next few weeks.  Hopefully you're wrong ;-)

Joel Owens · Answer

Bryan are they not putting limits on new construction in Texas??

My mom's sister came to visit recently and she lives in Texas.She said many major cities there are in big droughts and rain has been hard to come by.

When there is a severe water shortage usually the brakes are put on development to not overtax an already pushed system for demand.

Does the 2% or 50% rule apply to new construction?

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