Help me understand this deal and 50%, 2% rule
Real Estate Investor · FL · Member since 2008 · 38 posts · 3 votes
I hope I'm doing this correctly. Thank you in advance.
3-unit apartment complex
Asking Price = $119,500 (I easily understand that this is way too high)
Total Monthly Rents = $1,235
Using the 2% rule, I would need the house to be $61,750 (61750*.02=1235 or $1235/.02 = 61750)
50% Rule says that $617.50 of Total Monthly Rent will be used for expenses.
So a $61,750 mortgage (at 100% financing, 8% interest, 20 year payback) per month is $516.50. I think I'll be able to get 100% financing if I can prove my assets, etc.
Therefore $516.50 (mortgage payment) + $617.50 (anticipated expenses) = $1,134.
$1,235 (monthly income) - 1,134 (Total Expenses per month) = $101 net income per month
I thought I'm supposed to be making over $100 per door!
Am I calcualting something wrong? Please let me know.
Thanks again!
Matthew08
The 50% rule (expenses = 50% of gross scheduled rent, expenses mean actual operating expenses, capital expenses, and vacancy) is discussed in several other recent posts, so I would rather not take up that subject here.
The 2% rule (rent must be 2% of the purchase price) has several assumptions. One is that it tries to get $100 per unit. It assumes SFR type financing (e.g., 30 year note, not 20 year.) For a 30 year, 6%, 100% note, it is exact for a $25,000 unit that rents for $500/month. Expense are $250/month, payment is $150/month, leaving you $100 cash flow. At 7% loan rate, it works for a $30,000 unit that rents for $600/month.
With a 7%, 30 year loan, for a $100,000 house, you only need $1525/month in rent to get the same $100 in cash flow. That's 1.53%.
If you go to cheaper units and lower rents, you need more than 2% to get the same $100. Your rents average $412. Take out 50% for expenses, and you're left with only $206/month NOI. If you want $100 for cash flow, that leaves only $106 for debt service. That will cover about $16,000. That's a rent percentage of almost 2.6%. At 8% and 20 years, you can only cover about $13,000.
The 2% rule seems like a very consevative way to value real estate. I'm not sure I would have ever purchased any rental using that rule.
What is costing you $600+ per month per unit in expenses for an apartment building every month?
From what I've read here, the $617.50 refers to taxes, insurance, management, maintenance, entity maintenance, advertising, utilities (at least during vacancies), legal fees, damage done by tenants (over the security deposit), vacancies, setouts, lawsuits, and capital expenses (not technically an operating expense).
Matthew08
The 50% rule (expenses = 50% of gross scheduled rent, expenses mean actual operating expenses, capital expenses, and vacancy) is discussed in several other recent posts, so I would rather not take up that subject here.
The 2% rule (rent must be 2% of the purchase price) has several assumptions. One is that it tries to get $100 per unit. It assumes SFR type financing (e.g., 30 year note, not 20 year.) For a 30 year, 6%, 100% note, it is exact for a $25,000 unit that rents for $500/month. Expense are $250/month, payment is $150/month, leaving you $100 cash flow. At 7% loan rate, it works for a $30,000 unit that rents for $600/month.
With a 7%, 30 year loan, for a $100,000 house, you only need $1525/month in rent to get the same $100 in cash flow. That's 1.53%.
If you go to cheaper units and lower rents, you need more than 2% to get the same $100. Your rents average $412. Take out 50% for expenses, and you're left with only $206/month NOI. If you want $100 for cash flow, that leaves only $106 for debt service. That will cover about $16,000. That's a rent percentage of almost 2.6%. At 8% and 20 years, you can only cover about $13,000.
Should folks feel that if they can not meet this "rule" they should not invest period NO! not a rule, its a suggestion and an example of what is possible in some areas of some states, not many!
Ask any of the thousands of multi millionaire investors on the East and West Coast if their properties fit these suggestions!
:violin:
If I'm shooting for $100/door cashflow, I would have to offer around $42,000. He's asking $119K; he's slightly motivated but I don't think he's that motivated.
I'm not trying to bust anyone's bubble or sound like a pest. I'm just learning and trying to understand. There must be something wrong that I'm doing.
What would you guys offer on a house in good shape that brings in $1235/month?
Matthew08
Matthew08
You might also want to figure this deal from another angle -- the cap rate for the property.
Take the gross yearly rents and subtract from that the percentage you think it will cost you to operate the property: maintenance, taxes, insurance, etc. This percentage usually/maybe/sometimes averages around 50% depending on many variables. The one variable you have most control over is YOU. Will YOU be managing for free? Will YOU be doing repairs and maintenance for free? This is how many investors start out. Finding a wonderful tenant who will stay for years and years will also lower your overall operating expenses by minimizing vacancies. So you might actually be able to significantly lower that 50% average.
There's a nifty little property analysis tool on this very here website you can noodle around with, too.
So now you must decide what return you want on your invested dollars. And that's a decision with many variables that only you can decide on.
Personally, I like the advice of some of the wiser people here who only invest if they can get instant equity of 30% or more. That gives you a really good safety cushion, and, of course, will color your decision of what is a good return on your money.
But keep this is mind: deals are like taxis; if you miss one another will come along by and by.
Good luck and let us know if you get this deal.
Mathew,
Regardless of which rule/method you choose to evaluate this deal, the numbers just won't add up in your favor according to the figures you provided. 3 units totalling $1235 is an average of $411 per unit and a cost of almost $40k per door. My opnion would be to move on to something else.
Unless the rents are extremely under market and you could raise them to $600 per door, the units are fairly new and require little maintenance, the building is in great condition, and the cash flow gave you the $100 per door minimum, then you could take a closer look at this one.
Best of luck.
James,
I agree with you 100% that there are many ways to make money in this business. But if there are thousands of multi-millionaires getting rich on the East and West Coasts, why are you buying your rentals out of state? It seems to me that although not calling it the 50% or 2% rules, you are essentially doing just that by buying at a steep discount that will allow you to generate a positive cash flow.
I'm assuming that the thousands of multi-millionaires you're talking about on the coasts made their money on appreciation instead of cash flow. If that's true, why don't you just buy a bunch of rentals in California and become a multi-millionaire yourself?
What I'm trying to accomplish with the 50% rule, 2% rule, and the $100 per unit per month cash flow suggestion is to get new landlords to think about the realities of the business. If they want to speculate on appreciation, that's fine. However, they should at least understand the expenses that will be involved and the amount of money they will lose each month if they pay retail for a property in California in hopes of appreciation.
The vast majority of new landlords fail in a short period of time. That's true even here in Ohio, despite having a much better opportunity for cash flow than you do in California. They fail for 2 reasons: 1) they don't understand operating expenses and pay too much for their property, and 2) they can't deal properly with the tenants.
Mike
James, Yes, I think your statements are accurate. There are many ways to make money in this business. You certainly can buy property with a negative cash flow IF the market appreciates faster than you the money you lose and you can afford to hold the property until you sell. In addition, tax benefits/depreciation can help if you have other income.
Do all investors who don't follow these rules fail? Certainly not. I agree. However, the vast majority of newbies do fail, not only in real estate investing but in any business. In the rental property business, they fail because they don't have adequate cash flow (because they paid too much and didn't understand operating expenses) and they don't know how to properly deal with tenants.
That's very simple - I follow the lease and I insist that they follow the lease. If they don't follow the lease - I evict them. If they don't pay the rent in full and on time - I evict them. I would treat a $7,000 per month tenant exactly like I treat a $300 per month tenant.
In addition, as I've said many times before, 90% of our tenants here in Ohio are fine. They pay the rent on time and take care of the property. Another 9% of the tenants have some issues (such as calling me about personal problems, making noise, dirty, etc). Only 1% of the tenants need to be evicted and about half of those are the inherited tenants that came with the buildings we purchased. So, in total, of the tenants that were screened properly (that I screened), 99.5% of them are acceptable at any one time. Do you really think that is any different in California? I'm sure that there are a few nutjobs paying $7,000 per month in rent. I don't believe for a minute that no-one that has a $7,000 rental is a drug addict. People are people even in California.
Mike
I don't know - maybe riding your bike!
What is there to say about a good tenant? It would be a pretty boring blog to say that all the tenants did fine today. In addition, the troublemakers are always the ones that get the attention from the landlord and quite frankly those are the ones I am thinking about. If you're going to be getting into the rental property business, you'll realize this soon enough.
I don't think we were ever off-topic. In addition, I'm not really sure what your business is. I thought you were investing out of state so that you could buy properties that would cash flow. Is that not the case? If not, I'd like to hear what your business is!
Personally, I like the advice of some of the wiser people here who only invest if they can get instant equity of 30% or more. That gives you a really good safety cushion, and, of course, will color your decision of what is a good return on your money.
Good luck and let us know if you get this deal.
I'm almost thinking about this too much BUT in the case of multifamilies what is really 30% equity? I know what it is technically, but it seems like the FMV is a moving target.
Is FMV based on comparisons? how do you determine the 30% equity?
thanks for all the input on the subject by the way.
Matthew08
Spacewaya,
In reading through the posts, I did not catch an answer to the question, "Can you raise the rents?"
They do seem low. How many bedrooms per unit? What are you calculating for the rent of each unit? Are we talking about a 1st floor, 2nd floor, 3rd floor situation or something different?
Matt,
For kicks I did a quick search on Jackson, TN. Seems to me you have property there going for 12-20k per unit on the multi-unit side. Given that you probably should be buying 3 units at 60k, not almost 120k. Buying them at 60k and gettting roughly the same numbers solves your problem doesn't it?
BTW - I'd check the sfr market for your area. Again a quick search shows 3 bed sfr's running 12-20k per unit. In fact this one looks pretty nice and 58 years old puts it at a WWII era home which were pretty good and easy to maintain.
Can you get more rent per unit on SFR's? How does the profit figures of those work out?
Tim
P.S. A major difference between CA and flyover country cashflow property - you're not going to make money on equity appreciation. It just doesn't happen that way. You need to throw that out of your mind and focus on your cashflow and MAXIMIZE it.
I'm not disagreeing with you James just using the comparison to point out that my initial research of Jackson would lead me to look for property at half the price of the property Matt found. If it can be had at half the price then it needs to be for the sake of cashflow survival. I can't help but shake a feeling that with the 10 years of US inflating bad paper to good paper on the international market, US financing is only going to get harder and harder and "equity" will lose value with the goodwill loss of US paper. Remember that in the end equity exists only because we collectively say it does. If there is a loss of value in what we say, equity will have no value and the only thing that will survive is cashflow.
I hear what you say on sfr / multis. Personally I'm selling my multi's to reinvest into more sfr's. By the end of the year I'll probably be back into 100% sfr's. It's wild but sfr's are getting cheaper per unit than multi's, which really should not be the case but leads to higher profits on holding sfr's. Plus investors are still buying the multi's which gives me the market to sell them to. It's going to be an interesting year that's for sure.
"I am SURE NOT going to move to Kansas City MO to run a rental business! Not my idea of a decent lifestyle etc. I would need a massive rental portfolio to come even close to what my established CA construction BIZ brings in. "
I hear you on that. I just started a construction business and already it's bringing in more cash than rentals. It is, however, much more time intensive and there's no value to the company if I'm gone so anything I make in it is being reinvested back into rentals. Still working on e-mything the construction biz. Haven't found anyone yet who's been able to do it well outside of Paul Davis.
I think the e-mything is the myth. Even if you have 10 layers of management, the owner must be constantly providing direction or things will go awry!
C'mon Tim, don't be such a doom and gloomer. We all know that things can only go up! Housing prices go up, rents go up, income goes up, and net worth goes up. It just CAN'T go down - can it? If you guys don't have appreciation where you are, come to Ohio! It's like paradise here. THINGS ONLY GO UP! UP! UP! And I'm talking STRAIGHT UP, not at an angle!
Mike
I'll take one straight up. :beer:
Since it seems like the 2% and 50% rule (suggestion, dogma, opinion, etc) can't coexist, I think I'm going to try to use the 2% thingee. It just seems like right now devoting half my rental income to expenses without factoring in mortgage payments seem a little high.
Here's the kicker. The seller has two other properties on the market on the same street.
Here are the details:
Property #2
5-unit Apartment
Gross Monthly Rent - $2,610
Asking Price: $195,000
My top offer Price: $130,500
Property #3
5-unit Apartment
Gross Monthly Rent- $2,025
Asking Price: $179,000
My top offer Price: $101,250
All of the rents seem undervalued. I was looking at comparable properties last year, they charged approximately $485-525 per unit. Meaning the gross monthly rents for each apaprtment would be $2720 on Property #2 and $2650 on the second.
What do you think?
Again, thanks for your help. I don't think I have any more posts after this. This forum is incredibly valuable.
Matthew08
matthew using the 50% "RULE" you take your monthly rents divide those in half for operating costs, then you pay your rent from the 50% that is left and what is left is your cash flow.... Depending on the condition of the property 50% MIGHT be a little high right now, but what happens when you need to replace a couple of stove? and a water pipe breaks the same time?
the 50% is a very conservative number... I guess a good way to put it... an OH **** account
Here's the kicker. The seller has two other properties on the market on the same street.
Here are the details:
Property #2
5-unit Apartment
Gross Monthly Rent - $2,610
Asking Price: $195,000
My top offer Price: $130,500
Property #3
5-unit Apartment
Gross Monthly Rent- $2,025
Asking Price: $179,000
My top offer Price: $101,250
All of the rents seem undervalued. I was looking at comparable properties last year, they charged approximately $485-525 per unit. Meaning the gross monthly rents for each apaprtment would be $2720 on Property #2 and $2650 on the second.
What do you think?
Again, thanks for your help. I don't think I have any more posts after this. This forum is incredibly valuable.
Matthew08
The 50% rule and the 2% rule can and do coexist. Re-read my first posting where I lay out some of the assumptions behind the 2% rule. Your deals are right in the area where you're in line with these assumptions. Personally, I don't care for the 2% rule because of these assumptions. I'd rather make them explicit. Here's the math, step by step, for your first deal:
Rent: $2610
Expense percent 40% (because I'll manage it myself for free)
Expenses $1044 (40% * $2610)
NOI $1566 ($2610 - $1044)
Desired cash flow $500 ($100/unit/month)
Max Pmt $1066 ($1566 - $500, this is the max P&I payment)
Rate 8% (rate and term are based on commercial rates)
Term 20 years
Max loan $127,445
The only tricky forumla here is the max loan. Use the "PV" function. The formula is PV(rate/12; term*12; -Max Pmt)
Make yourself a little spreadsheet like this, and then you can plug in any numbers you want. You can get the rate and term from a broker. You can plug in whatever number you want for expenses. That expense ratio is the only plug in number involved here. There is no 2% rule to be applied.
Make your offer based on actuals for rent and occupancy, not what you might be able to get.
You want to find a deal that actually makes money. You can certainly fudge the number to make the deal work on paper. Assume 30% for expense (too low). Assume $2720 in rent (can you get it without creating a vacancy?) Assume 7% and 30 years (seems unlikely on a 5 unit building). Now the sellers price seems like a great deal. Unfortunately, reality won't match up with your analysis.
You want to be in this business, you need to be able to do this analysis yourself, AND you need to not fool yourself into taking a poor deal.
Matthew,
As Jon said, the 2% rule and the 50% rule are both meant to be used at the same time.
The 50% rule doesn't tell you what price to pay, all it says is that operating expenses are 50% of the gross rents. That's it.
The 2% rule is a SCREENING TOOL meant only to give you an idea of the maximum purchase price you can pay with an acceptable cash flow. If a property has gross rents of 2% of the acquisition cost or more, then it is worth spending another few minutes to do a cash flow analysis. If the gross rents are much less than 2% of the acquisition cost, then it's a waste of time if you're looking for a good cash flow deal.
On multi-unit properties, as the number of units increase, you may need considerably more than 2% to get $100/unit/month of positive cash flow.
As Wheatie said, I would strongly suggest that you NOT BUY ANYTHING until you understand cash flow and expense issues (even if you're inventing your own). The rental property business is VERY UNFORGIVING of mistakes. That is especially true of multi-family apartment buildings (like your 5-unit buildings).
Here is how I would evaluate your deal #2:
Gross rent: $2,610
Operating Expenses: $1,305
NOI: $1,305
Mortgage Payment ($130,500, 7%, 30yr): $868
Cash flow: $437 or $87 per unit per month
This is not bad, although I like $100 per unit per month. However, as Wheatie said, you may find that it is difficult to get a 30 yr loan for a commercial property. In addition, most commercial loans are ARMS, so you've got to consider what will happen if interest rates rise.
Good Luck,
Mike
mike why doesnt the "50% rule" tell you what price you can pay?
for simplicity here... if you know you are going to be getting $1000 per month in rent then why not say 50% of that is $500 and you want $100 cash flow per door so that is $700 so that will give you $300 per month in loan payments. So really all you have to do is work your formual backwards or sideway?
kyle
The 50% rule doesn't tell you what price to pay, all it says is that operating expenses are 50% of the gross rents. That's it.
$500 + $100 = $600, leaving $400 for the loan, just in case anyone new is trying to figure out what we're talking about here (just a simple math error).
Kyle, you are correct that you can subtract the operating expenses and desired cash flow from the gross rents, leaving the amount you have for acquisition cost. Then, you still need to carry it one step farther and subtract the rehab cost from the acquisition cost to get the maximum purchase price.
When I said that the 50% rule doesn't tell you what price to pay, I meant that it is not a formula. It just tells you that the operating expenses are 50% of the gross rents. You still need to do the math (as you did) to determine the maximum purchase price. We've had so many new people confusing this simple idea lately, that I'm just trying to set the record straight.
Mike
just making sure.. and sorry i was going with a 2 family, but still same concept
I'd rather make them explicit. Here's the math, step by step, for your first deal:
Rent: $2610
Expense percent 40% (because I'll manage it myself for free)
Expenses $1044 (40% * $2610)
NOI $1566 ($2610 - $1044)
Desired cash flow $500 ($100/unit/month)
Max Pmt $1066 ($1566 - $500, this is the max P&I payment)
Rate 8% (rate and term are based on commercial rates)
Term 20 years
Max loan $127,445
The only tricky forumla here is the max loan. Use the "PV" function. The formula is PV(rate/12; term*12; -Max Pmt)
Make yourself a little spreadsheet like this, and then you can plug in any numbers you want. You can get the rate and term from a broker. You can plug in whatever number you want for expenses. That expense ratio is the only plug in number involved here. There is no 2% rule to be applied.
Thanks Wheatie. I actually plugged this into my spreadsheet and I'll start using this worksheet to work on deals.
I have attached a copy to this message just in case anyone wants to see it.
With doing this deal, this is how I see it. I work the numbers to where I'll be comfortable and then make the offer. If they accept it, then we can do a deal. If they don't, I'll be moving on to find new property.
Matthew08
Matthew,
That looks good. That gives you the ability to adjust the numbers based on what you learn (e.g., what rate and term can you get for your loan.)
As you get more info, you'll make this more detailed. Adding in closing costs and repairs, maybe a second loan if you have money from more than one source. I honestly don't use any sort of template. I just invent one of these for each deal, and work through with what I know. This one backs into the price. Other times you'll want to work forward from price to cash flow. Just depends on what you know.
Interesting spreadsheet, what exactly does #9 (max payment) mean?