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.
Based on the rent, the expense ratio, and the desired cash flow, this is the maximum payment the property will support. Then, based on the specified rate and term, row 12 is the maximum loan amount.
here is what I use, I posted on another thread
One of the things which earned me scar tissue as a new investor was not understanding cash flow
What I am sharing is what I use for me, nothing else, I appreciate any and all improvemts to it
Its NOI with the Debt service added as well
lets you know if you have to write a check for the honor of owning something
cause... if it does not pay you to own it, it owns you.
The way I view this 50% 2& rule---since I am not a math person. If I look at a property that is selling for 60,000 for example. I immediately double that and shave off two zeros. That gives me 1200. Then I see if this property could bring in 1200 dollars or anywhere near that. If it is a 60,000 house and rents are average at 600 dollars I know that wont work (for me, I think for some they figure out a way-with motivated sellers and getting a great deal on the ourchas price, etc.) . If the potential rent is not quite 1200 but around 1000, I try to see if there is anyway to get that number up to 1200, i.e could the rents be raised, are they low for the area. Well, just my 2 cents if it makes sense.
I know its not a hard and fast rule because different areas have different possibilites...
I am a math person, and I can tell you that averages are subjective, no matter how they are applied. A statistician will tell you that a person who has one foot in a bucket of hot coals and the other foot in a bucket of cold ice should feel average....
Mike's rule, while valid in some scenarios, is just that.....valid in some scenarios. Yes, Mike, you have tons more experience than I do (and most others) in rental situations. But, this 50% rule in my mind is the really applicable if you hold a property in perpetuity. If you buy, rent out and hold for 3-5 years, then sell for profit, the probability that the 50% rule will apply to your properties is diminished because 3-5 years is not enough time for things to go wrong that would have otherwise gone wrong if you hold a house for say 15-20 years.
You're correct that if you only own a few properties for a short time, the probability of your expenses being exactly 50% is diminished. That doesn't, however, mean your expenses are more likely to be lower than 50%. They could just as easily be higher than 50%. If the rent is relatively low, say $500, then one fairly minor unexpected expense can be very significant. A $400 drain cleaning or broken tree removal would be a 6.7% expense item for the year. A $3000 roof or furnace would translate into a 10% expense item over the course of five years. It doesn't take much tenant damage or just mess left behind to burn through a $500 deposit, especially if you're paying someone to do it so it stands up in court.
So, if you own only a few properties and hold each for just a few years, its very unlikely your expenses will be exactly 50%. Its entirely possible that you get lucky and have a single tenant who pays on time every month for five years. Have nothing go wrong and no maintenance at all. Its just as possible to discover a undetected sewer problem a month after you close that costs $4000 to fix.
You only have to read some of the posts here where people talk about their landlording troubles to see these bad things really do happen. People who bought into a deal where rent is $100 more than their PITI payment are really put into a bind when ANYTHING bad happens.
This is no different than gambling. The same math works, because we're dealing with probabilities and not with exact facts. Over the short term, you can win just as much playing a game like roulette with a high house edge as a game like video poker with a low edge. The edge doesn't affect the outcome of 10 hands very much. You could be a big winner or a big loser. Over the long term, though, the edge adds up and will have a big effect if you play long enough. Having rentals that only "cash flow" with very low expense assumptions is the same as playing a game with a high edge.
Tim I am looking at that listing you showed in Jackson TN for 13k.
Is that a property you would just buy in cash or would you finance. Then some money into paint and carpet and then rent it out?
I looked on cragslist and saw that rents for similar houses were around $450-600.
If you assume 50% exp.
You bring in $300 a month.
Then you'd need to pick up 20+ properties just like it to have a decent monthly income. How would you fund more propreties? You obviously cant keep buying them for cash, but no lender would lend on a 13k house would they?
I'm another guy new to this all and likely about to show my arse once again.
That said...
I'm looking at a condo that's in foreclosure. It's in a downtown area close to everything. It's small (a studio) and I can get it for about 43k.
Selling condo's is kinda tough because nobody wants to loan money using them presently so I have to approach this from a landlord position.
I should be able to rent it quite easily for $850 a month.
I have to pay $115 HOA fees a month and the property taxes are $2k a year ($165 a month).
The leasing company at the condo will manage the rental for me at a 7% of rental price (about $60 a month) and they only charge when it's rented.
This sounds like a good option as I barely even know how to change a light bulb.
Looking at past sales in the complex(using county website) prices range from 55k up to 150k
I know I could rent it in a heartbeat...especially since i plan on furnishing it...I'm just not too sure what the market is for reselling.
And I'm not sure how much money i'll actually be looking at making per month on a 50 k investment (43k to buy and a high estimate of 7k to update and furnish)
Hello, this is Tonya from Texas.
I wouldn't do the deal. $100 a month on a multi-family property is a big joke. If you want to make big money and fast, you should FLIP properties. Buy low, Sell high, using OPM (Other People's Money) and net profit that way. You can have thousands a month on that route and you won't be stuck with trying to locate management companies, etc. This is Tonya from Texas again, wishing you well as you slice that big old piece of Real Estate pie.
Jon! I know you wrote this a while ago but I was researching this 50 2 thing and you just clarified it! Thank you, and just to make sure I am understanding I have a duplex 130K purchase price, loan $800 including insurance and pmi ect. in payments, I get about $1600 rent right now (I know it is not ideal because I am not getting the $100 per door but thus far the place has treated me decently) So I make the 50% rule but not the 2% because I am able to get 50% toward expenses, but not the $200 cash flow in the door. Am I correct on these assumptions?
Here is my question and I think you have posted this before, but if I am doing all of my own repair work then we are closer to 40% or so, and then this IS a positive cash flow property. Granted it still puts me only at the $160 but for my first true real estate investment this is decent?
So, Don, with a $800 PITI payment, I'd guess the P&I part about $600-650. I'd look at the deal like this:
Rent: $1600
Expenses: $800
NOI: $800
P&I: $650
Cash flow: $150
Not quite $100/door, but close.
Now, in a number of posts I've said I typically use 40% for expenses because I will manage them myself, and I'm willing to do that for free, for now. I've yet to find any PM in this area that will do it for less than 10% of collected rents plus half a months rent for filling a vacancy. If you get a new tenant every year, that's 14% of gross scheduled rents. Further, I'm willing to go with little or no immediate cash flow because I see a pretty positive environment here. My goal is long term investments rather than immediate cash flow. Using those criteria, and assuming the property is in this area, this deal would be a go as far as I'm concerned.
Rent: $1600
Expenses: $640
NOI: $960
Payment: $650
Cash flow: $310
Thanks Jon I really appreciate it! And I agree I think the Denver area is on fire right now! We didn't take that huge movement like California but we still got hit which puts a bunch of properties in positive cash flow! And like you I am long term as well, I have not taken any cash from the property yet, nor do I plan on it.
My plans are to keep my real estate completely separate from everything else that I do, so therefore any dollars in go right back to the biz.
My investment strategy is to put what ever money I can personally into new units but then the goal is to never put money in again for that particular unit. So one day I am hoping that I will no longer have to put personal funds into my real estate account and I will be able to simply watch the well oiled machine do its thing.
Do you think this is a profitable strategy given the Denver Market?
I notice when people calculate the 50% rule they use 7.0% interest rate. I think that I can get a 5.5% interest rate on a single family investment property with 10% down. Should I stick with 7% or go with 5.5%.
This has a pretty signifcant effect on the price. For example
$900/mo 3/1 SFH gross rents
max offer 5.5%= $61,642.62
max offer 7.0%= $52,607.62
Difference = $9,035.00
This is a huge difference obviously. Feel free to check my math. (I made a nice spreadsheet on the 50% rule that gives me this data fast. If anyone wants to test it out pm me and ill email it to you.)
If you have a lender that will do 5.5% for investor properties, I'd like to hear about it. Owner occupied, yes. Investor, no.
You should speak with lenders and mortgage brokers in your area and figure out what you can actually get.
I have spoken with several local brokers, 5 in the last week to be exact. Mostly because I wanted to see if anyone is offering less than a 20% down payment.
One lender thought, based on my credit score and income, that he may be able to get me into a 5.5% 10% down on a SFH as an investor.
But the real question is not whether I can get 5.5% rate. Lets assume that I verified that I CAN for sure get that rate for the sake of this argument. Should I use the 5.5% in my calculation or 7.0%.
Use the rate you think you will get. I'm using 7% for calculations right now because I'm reasonably sure I can actually get a rate not higher than 7%. We wary of brokers who promise the world, and then leave you hanging when you need to actually close. 5.5% and 10% down sure sounds like an OO loan. Be sure he's not setting you up to have to claim its OO when you know its not.
Thank you for the reply Jon. I will get a more exact picture of the interst rate depending on the property.
My real estate agent is getting frustrated with the 50% rule. Today he broke out the laptop and showed me his investment spreadsheet. It obviously spewed out higher than 50% rule offers, with cap rates, 2% "reserve" expenses, and the potential tax benefits. I ma going to stick with the biggerpockets formula for now. In my area I think I should be able to score a property at 50% rule (not in a war zone).
Here is another question for the experts when it come to the 50% rule: Lets say I find a property that needs a roof in 5 years. Based on the 50% rule the max price for a duplex 500/500, 7.0%i = 45k (please check my math if you want). Lets say for arguments sake, everything else is "fine: in terms of repairs. What would your offer be?
Edit: I know that the cost of the new roof will be 6k.
IMHO, when someone starts using the tax benefits to justify a purchase, you know you're in trouble. Its reasonable to assume that the tax benefits, primarily the depreciation, will allow you to avoid tax on the rental income. Trouble is to many people who have a vested interest in selling something try to apply the passive losses to offset other income, and include that in the deal evaluation. You can only do that if your income is under $100K, and even then only for up to $25K in passive losses.
What they REALLY don't tell you is you have to pay it back. When you sell the property, depreciation recapture comes into play. Your "basis" in the property, which is the amount you subtract from the sales price to determine the taxable gain, goes down as you take the depreciation. So, your taxable gain on the sale increases dollar-for-dollar with the depreciation you take (actually, whether you take it or not.) And, the kicker is the amount of gain, up to the amount of depreciation you took or could have taken is subject to depreciation recapture tax rather than long term capital gains tax.
The "cap rate" is only as good as the expenses. What he's fundamentally arguing is that the expenses are less than 50%. If you've read through this and the other related threads, you'll see there are folks here who would agree with him. However, you might also observe that every time someone has brought real data to the table, its ended up very close to 50%.
Keep in mind that agent doesn't get paid if you don't buy anything. So, he has just a bit of interest in convincing you to buy something.
If a repair is needed immediately, I subtract it from the offer price. The "50% rule" include items like roofs and other expensive items. But five years may not be enough time for you to accumulate the $6K. I might say that roofs have a 20 year lifetime, and this one only has five left. So, I'd adjust the price by 75% of the $6K.
Speaking of cash flow, or the lack thereof in a rental deal.
I have purchased a few short sale rentals recently, from newbie's who listened to the Realtor who sold them their first and last cash cow investment property.
My last deal was a 3 unit sold to the newbie for $125k and bought by me for $35k. The tenants were great, they did the entire demo of the building before my rehab and all for free! :)
I have been doing this land lording thing for a while, I believe all tenants are the same.
Some have been trained properly, while others are still in need of obedience school.
Sadly some can never be trained and must be put down.
I'll send you some of the deadbeats from our area to put down! Obama really has this new euthanasia thing catching on. LOL!
Hi Matthew,
You mentioned that you attached the spreadsheet but I could not figure out how to find it. Would it be possible to re-post or pm me the spreadsheet you are using.
Thanks,
Nate
Trying to wrap my head around the 50% rule. I have the following items built into my financing. I know Principal&Interest are not operating expenses, but what about the other ones? I want to make sure I don't end up counting them twice.
Principal
Interest
PMI
Taxes
Homeowners Insurance