Help me understand this deal and 50%, 2% rule

General Landlording & Rental Properties
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Help me understand this deal and 50%, 2% rule

Matthew Stover
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

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Jon Holdman
Rental Property Investor · Mercer Island, WA · Member since 2008 · 22k+ posts · 14k+ votes
18y

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.

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  • Michael Rossi
    Real Estate Investor · OH · Member since 2008 · 4k+ posts · 1k+ votes
    17y

    Taxes and insurance are certainly operating expenses. So are management, maintenance, utilities, advertising, entity maintenance, legal fees, evictions, setout, etc, etc, etc. Vacancies and capital expenses are also included in the 50% Rule as expenses, although they are not technically operating expenses (from an accounting standpoint).

    Mike

    0Reply
  • S B
    Member since 2008 · 18 posts · 0 votes
    17y

    thanks Mike.

    Just to be clear - "insurance" covers both Homeowners insurance AND PMI?

    0Reply
  • Jon Holdman
    Rental Property Investor · Mercer Island, WA · Member since 2008 · 22k+ posts · 14k+ votes
    17y

    Neither.

    You do not want homeowners insurance on a rental property. You want landlord insurance. Similar, but not the same, and if you buy homeowners your claim will be denied.

    No lender will do a investment loan for less than 20% down, so PMI is never an issue. Figure more like 25-30% down at the moment.

    2Reply
  • S B
    Member since 2008 · 18 posts · 0 votes
    17y

    Thanks Jon.

    I was trying to apply the rule post-facto to my current place, owner-occupied. And I bought it with 0 down so I have to carry PMI.

    So how does the landlord insurance apply to the 50% rule then?

    0Reply
  • Will BarnardPro Member
    Moderator
    Developer · Santa Clarita, CA · Member since 2008 · 15k+ posts · 10k+ votes
    17y
    Originally posted by S B:
    So how does the landlord insurance apply to the 50% rule then?
    It is part of the expenses, just as advertising, utilities, repairs, maintenance, property management, etc.
    50% rule just means that you take one half of your gross income and use it for outgoing cash flow (expenses), then what is left is for debt service and incoming cash flow (income).

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  • Jon Holdman
    Rental Property Investor · Mercer Island, WA · Member since 2008 · 22k+ posts · 14k+ votes
    17y

    You can't apply the 50% rule to your residence. For one thing, there's no rent to apply it to. For another, you will never have some of the expenses you have on a rental. You'll never have vacancies, evictions, or tenant damage. OTOH, you'll probably end up doing things like putting in nice bathrooms and kitchens that you wouldn't do on a rental.

    0Reply
  • Will BarnardPro Member
    Moderator
    Developer · Santa Clarita, CA · Member since 2008 · 15k+ posts · 10k+ votes
    17y

    Jon,

    The last question I responded to referenced landlord insurance and how it applies to the 50% rule. Obviously the 50% rule along with many other investor rules of thumb do not apply to owner occupied residences.

    Podcast Guest on Show #130
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  • Jim Wineinger
    Real Estate Investor · ten mile, TN · Member since 2009 · 1k+ posts · 374 votes
    17y
    Originally posted by nationwidepi:
    Originally posted by S B:
    So how does the landlord insurance apply to the 50% rule then?
    It is part of the expenses, just as advertising, utilities, repairs, maintenance, property management, etc.
    50% rule just means that you take one half of your gross income and use it for outgoing cash flow (expenses), then what is left is for debt service and incoming cash flow (income).

    Will, I seem to recall, either earlier in this thread or in another one the Property management is not included in the 50% expense rule since it was not a common expense to all those properties studied that gave rise to the rule. This would leave it (if one chooses to use it) to come from the cash flow after the rule is applied.

    Please correct my memory if it is faulty in this matter.

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  • Will BarnardPro Member
    Moderator
    Developer · Santa Clarita, CA · Member since 2008 · 15k+ posts · 10k+ votes
    17y
    No, property management is one of the many expenses INCLUDED in the 50% rule, just as vacancies and capital expenses are.
    Again, this is not a rule I follow or base final decisions on, and should be used accordingly (type of investment and type of strategy), but property management IS part of the 50% rule.

    One of the things that is stated is that some investors will use a 40% rule (Jon Holdman for instance) as he works for "free" doing his own property management, others will argue that their is a value to yoru own time - your own personal call on that one.
    Podcast Guest on Show #130
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  • Steve Babiak
    Real Estate Investor · Audubon, PA · Member since 2009 · 13k+ posts · 8k+ votes
    17y
    Originally posted by Kirk B:
    I made this as a quick reference for myself. If you find this useful/errors please let me know.



    Kirk,

    Good idea to chart this. I believe I have found a mistake in your chart. The first 4 lines - per $1, per $5, per $25, per $50 - all seem correct. The next line is where the trouble begins. You have the rent there as $300, but I believe that the correct amount should be $100; if you were to multiply the offer number on the per $50 line by 2, you would end up with that offer amount shown on the $300 line (more or less), but that would have been at $100 rent since we just multiplied by 2.

    And every line below that is also off by $200 in that original chart if my computation above was accurate.

    Please post back if you agree or disagree with my finding on this.

    If you are wondering how I discovered this, I had one I looked at recently where rent was $1000, and offer limit was around $70K for 7% rate; comparing that to the chart shows a big difference. Now I would say that the $60K number you have for 7% rate fits for $800 rent; and then I just worked backward.

    0Reply
  • Dennis Treacy
    Contractor · Philadelphia, PA · Member since 2009 · 85 posts · 65 votes
    16y

    This is a smart rule, I have unknowingly been following this rule based on the profit I need at the end of the month.

    This 2% rule is going to make my calculations quite bit easier.

    The 50% rule is spot on, I see it with all of my properties.
    There no sense fooling yourself thinking the expenses are not going to be 50%.

    It is sad but for the other guy, but several of my properties where bought with little or no cash-flow going to the original owner. One such deal was snatched out of my hand by a newbie investor with good credit, he paid $125k for a dilapidated property, spent $10 for improvements, and later lost the place to foreclosure. I bought this same building less the copper piping for $50k. I borrowed $70k and dropped $15k on improvements. So I have $65K into the property, which grosses $20,400 a year.

    According to the 50% 2% rule, the property could sell for $85K and the rents at $70k should be $1400, so I am more than good on these properties. Funny thing these three units sell for $125k in mediocre condition, and for $150,000 in good condition, go figure

    0Reply
  • Jon Klaus
    Developer · Garland, TX · Member since 2008 · 8k+ posts · 4k+ votes
    15y

    Spreading the 2% rule to regions beyond

    http://www.youtube.com/watch?v=OmozfQ8UinA

    2Reply
  • John Princinsky
    Lender · Saginaw, MI · Member since 2012 · 16 posts · 0 votes
    14y

    Oo! Here's a question... If my area has a higher vacancy rate than average should I estimate more than 50% for expenses?

    0Reply
  • Will BarnardPro Member
    Moderator
    Developer · Santa Clarita, CA · Member since 2008 · 15k+ posts · 10k+ votes
    14y
    Originally posted by John Princinsky:
    Oo! Here's a question... If my area has a higher vacancy rate than average should I estimate more than 50% for expenses?
    Good question. The rule or more accurately, the guideline is based on owning a large number of units in many different areas, in other words, diversified. So if you concentrate all your holdings in one small area where you have a higher vacancy rate or higher taxes, or higher anything, then you could very well see different results and have to adjust according to your market.

    With that said, does your area have lower thjan average property taxes? Does your area have lower costs of improvements, etc? If some things are higher and others lower, you will likely "average" back to the guideline.

    What you must understand is that this is only a guideline and not to be used as a deal making decision factor or iron clad rule.

    Podcast Guest on Show #130
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  • Lane Ewert
    Summerville, SC · Member since 2012 · 26 posts · 0 votes
    14y

    Ok brand new wannabe investor here. I have a possible deal that if I have worked out correctly will cash flow 2,000 a month. Please let me know if I am doing it right. I want to offer 200k on a property that brings in 4950 in rent. If I use the 2% and 50% rule I am doing ok (if I am understanding them correctly.) It's an older 8 Unit. The only thing I didn't quite understand is how to factor in the loan. I will be putting in 20% 40k on a 30 yr @7%. Is this good? What am I not seeing. Any and all responses are welcome. Thanks

    0Reply
  • Scott W.
    Real Estate Investor · chicago, IL · Member since 2012 · 1k+ posts · 231 votes
    14y

    how much is your principal & interest payment?

    0Reply
  • Lane Ewert
    Summerville, SC · Member since 2012 · 26 posts · 0 votes
    14y

    Hey scott I actually had not gotten that far. I just saw the deal yesterday and called to a bank so he just gave me a quote. What would be "good"? I mean to make something like this worthwhile? Thank you for your response and sorry for all the questions as I am just trying to get my feet wet.

    0Reply
  • Jon Holdman
    Rental Property Investor · Mercer Island, WA · Member since 2008 · 22k+ posts · 14k+ votes
    14y

    Lane Ewert better to start a new thread in the Real Estate Deal Analysis and Advice forum. A bug at the moment prevents me from moving your post there.

    P&I on $160K at 7% (ouch!) for 30 (nice!) years is $1064. 50% of 4950 is $2475. Less $1064 is $1411 a month or $16,926 a year in cash flow. Divided by the $40,000 up front investment is 42% cash on cash return. That's a very good deal, if that's the complete story.

    0Reply
  • Lane Ewert
    Summerville, SC · Member since 2012 · 26 posts · 0 votes
    14y

    Sorry failed to read payment. 1064 a month

    0Reply
  • Lane Ewert
    Summerville, SC · Member since 2012 · 26 posts · 0 votes
    14y

    john thanks, I will move it over there. And yes that is my question. "Is that the whole story?" One more question what "other" things should I be looking at? That a lot of new people fail to ask?

    0Reply
  • Scott W.
    Real Estate Investor · chicago, IL · Member since 2012 · 1k+ posts · 231 votes
    14y

    get an estimate. this sucker could be down to the studs & you've got a $100k rehab. doubt you'll get a loan for that so do you have the rehab $ to spend in addition to your down payment? figure 3% more for closing fees.

    how long will it take to do the rehab? you'll be stuck with the payment for that long plus insurance & utilities without any rent coming in.

    do you have cash reserves in addition to all this $ in a savings account, etc in case the furnace goes out in the middle of the night 7 months from now & BAM you owe $12k for a new roof or a costly eviction?

    the latter doesn't hapeen all that much but trust me the BAM can come at anytime...

    0Reply
  • Lane Ewert
    Summerville, SC · Member since 2012 · 26 posts · 0 votes
    14y

    thank you and I have my pen and paper out taking notes. I'm going next week to see it. It is currently fully rented and has a waiting list so he says. Which made me think it might be all good, however assumptions...... Which makes me wonder why it's being sold. thanks again for your reply's I'm already loving this site!!!

    0Reply
  • Mike S.
    Madison, WI · Member since 2012 · 9 posts · 0 votes
    13y

    I read a lot of these posts and I am still struggling with the exact calculation of the 2% rule. I apologize for being obtuse. What is the formula ?

    Is it ideally: Gross (..Emphasis on Gross) Monthly Income >= 2% of the Total Property Purchase Price ?

    Thanks.

    0Reply
  • Jon Klaus
    Developer · Garland, TX · Member since 2008 · 8k+ posts · 4k+ votes
    13y
    Originally posted by Mike Smith:
    I read a lot of these posts and I am still struggling with the exact calculation of the 2% rule. I apologize for being obtuse. What is the formula ?

    Is it ideally: Gross (..Emphasis on Gross) Monthly Income >= 2% of the Total Property Purchase Price ?

    Thanks.

    Yes, but make sure you add initial improvement and repair costs to the total property purchase price.

    1Reply
  • Mike S.
    Madison, WI · Member since 2012 · 9 posts · 0 votes
    13y

    Thanks Jon. This is very helpful.

    0Reply
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