50% rule and the 2% rule
I thought I had heard another investor say that the two rules were basically the same thing. Maybe I misunderstood, but if not could someone explain how they are the same thing??? And also, the 2% rule seems to work best when searching for properties under 100k. It seems that rents are a larger portion of the purchase price the lower the purchase price. Hope these make sense.
THANKS!!
If you multiply the monthly rent by 50, that is the same as dividing by 0.02.
Also, there is the 50% rule of expenses.
I find it is nearly impossible to find a property in my area that will cash flow using these numbers, but will keep looking.
They're related, but are actually two separate rules of thumb. The 50% rule is that operating expenses and vacancy are about 50% of the rent.
The 2% rule says if you can find a property priced such that the rent is 2% of the purchase price, it will cash flow. Note that you cannot use this to figure out what the rent should be. The market dictates the rent. Rather, you have to use it to determine how much you can pay.
The 50% rule is an emperical rule from observations of many properties. I've seen it other places than posters here. For any particular property, esp. a SFR, it may be less in some years. But, all it takes it one big expense to go way over and bring the average up.
The two rules do work together. If you collect 2% of the rent each month, you're collecting 24%/year. If expenses eat 50%, your NOI is 12%/year. Interest will probably run you about 8%. That leaves you 4% of the purchase price each year as profit. If you only collect 1% each monty, and pay 50% in expenses, that leaves you an NOI of 6%. Interest is going to take all that and 2% more. If you have an amortized loan, you'll have a bit less cash each month, but you'll get that back when you sell.
Sometimes people say, well, I'll put a big down payment on the property to try to make a higher price work. Say 50%, and assume 1% rent. You still have the same 6% NOI. But, now your interest cost is only half, or 4%. So, it looks like the property cash flows 2%. If you look at it that way, you've invested that 50% into an investment that returns nothing. Or, if you look at it as a cash on cash return, you're 4% on your money. Less than bank CD's.
Reflex, you say its impossible to find a property in your area that will cash flow using these numbers. I assume you really mean its very hard to find a property that meets the 2% guideline. True in many places, including right here. But, if you pay more, you won't make any money.
Jon
The 2% rule says if you can find a property priced such that the rent is 2% of the purchase price, it will cash flow.
I would like to clarify one thing here. The 2% rule is intended to be a screening tool. It is not meant to be used as a stand-alone rule to determine purchase price. In fact, using the 2% rule on many multi-family properties will result in sub-standard cash flow. The 2% "rule" is only one step in a multi-step process.
Please - use the 2% "rule" as a screening tool, but still evaluate the cash flow by doing a cash flow analysis and also consider the equity at closing.
Mike
Jon, I did say "nearly impossible" because I will not give up.
I have been looking a multi-family properties (1-4), and none of the more desirable units will cash flow using these numbers.
Is there any numbers/calculations that one can use which eliminate taxes from the equation? As some properties would have higher taxes, they may not work even at 50%, while some with lower taxes may work with a lower percentage.
Originally posted by "reflex":
Is there any numbers/calculations that one can use which eliminate taxes from the equation? As some properties would have higher taxes, they may not work even at 50%, while some with lower taxes may work with a lower percentage.
That’s why the 2% “rule” is only a screening tool. You use the rule to eliminate properties that are way off. If something is close you do further analysis with a lot more detail. I invest in an area where taxes and insurance are very low, if I find properties at 1.75% I look at them because they might work.
8)
So the 2% rule is a screening tool, but is the 50% rule a screening tool too??
When using these screening tools, should one apply a down payment if they know they will need one??
Thanks for the replies everyone!
Chaz,
You do need to try to look at the actual expenses. But, it more a matter of looking for anything that pushes you way above the 50% guideline. If you see expenses much lower, you need to try to identify what's missing. Individual landlords don't always keep detailed records, and some things may just get done, paid for, and forgotten about. Some expenses are sporadic but large, like roofs, plumbing issues, or major tenant damage.
One approach is to assume 100% financing to evaluate the property. If it works at 100%, its probably a good deal. Another approach is to factor in your down payment, then compute a cash-on-cash return, basically annual return divided by total cash investment. If the rate of return meets your criteria, then its a good deal. For me, that means it has to be significantly above bank CD rates, or long term stock market returns. CDs may not pay as well, but they don't kick holes in your walls either.
Jon
Chaz,
The 50% Rule is nothing more than the historical average of operating expenses throughout the United States. If it were possible to use the actual expenses for a property, I would do that. Unfortunately, that is nearly impossible. Most residential rental properties in the United States are owned by mom and pop type owners. The have one, two, or a few rentals. Most of these owners don't have the slightest idea what their operating expenses are, and they certainly don't have detailed records going back many years. It is also true that the vast majority of newbies don't make it in the rental business and therefore there is a continuous turnover of rentals.
Since there is no way to determine the actual expenses for a property you're looking at, then the best way that I've found is to use the 50% rule, which simply means that you're assuming the operating expenses over time will be 50% of the gross rents. I have found that this is an accurate number but you should understand that expenses will vary for any particular unit in any particular year.
For example, I have one house that has had the same tenant for the past 4 years. In the first year, I replaced the water heater, but in the next 3 years I have had absolutely no maintenance. Should I conclude from looking at this house that vacancies are zero and maintenance is almost non-existent? My operating expenses for this house over the past 4 years have been lower than 40%.
On the other hand, I have another house that has had two horrible tenants in the past two years. The first tenant was an RN who allowed a friend to sell crack from the house. When it was raided by the drug task force, a LOT of damage was done. The front door was broken down; the NEW carpet was burned by the concussion grenade; all the light fixtures were torn down; the outlets were ripped from the walls; and all of this was in addition to the damage done by the tenant. Next, I had a Section 8 Tenant in there that lived like a PIG - a very lazy pig whose very last ambition in life was to clean. She and her teenage swine children destroyed the place again. All the new carpet is ruined. The front door is broken. The walls will need to be repainted. It is just simply a disaster. Should I conclude from this incident that operating expenses on SFHs in my area are 65% per year?
Of course, the answer in both cases is no. The operating expenses average 45% to 50%. That is the 50% "Rule". It just says that your operating expenses will run about 50% of the gross rents.
One more thing while I'm on this topic. The 50% Rule assumes that you are doing everything right as a landlord. The data behind these numbers comes from the large apartment associations, where you have a high percentage of professionals. If someone is making a bunch of landlording mistakes (like letting the tenants go months without paying or not screening the tenants), then obviously the operating expenses will be MUCH higher!
Hope this makes it a little clearer.
Mike
Mike,
A little off topic ...
In your two real-life examples, what do you do with the tenant in order to recoup your loss? Oitside of tagging them with a judgement is there anything else you can do?
Thanks,
Jason
Jason,
I get a judgement if I think I have a chance to collect (because they have a good job) or if they are on Section 8. If I get a judgement against a Section 8 tenant, they won't be able to get any future Section 8 benefits unless they first pay the judgement. Either way is fine with me. Of course, I'd like to get the money but that almost never happens. So, I'm just as happy to know that the deadbeat won't be getting any more Section 8 (my taxpayer) money.
I am not happy when someone steals from me. I will do whatever I can to make their life miserable and to prevent them from getting another rental. I will let other landlords know about the deadbeat and will do everything possible to have their Section 8 cancelled (which I've done many times).
If someone holds you up at gunpoint, they go to jail. I consider a deadbeat tenant to be no different!
Mike
Thanks Jon!!
ThanksMikeOh!!!
:wink:
Also, is the 2% on annual rents or just one months rent? Finally, with the 2% rule, what percent down payment is assumed. Thanks.
The 2% is 2% of monthly gross rents and has nothing to do with the down payment. However, I always assume nothing down because the money for purchase and rehab is coming from somewhere.
Mike
Thank you. One additional question - are leasing commissions included in the operating expenses factored into the 50% rule
leasing commissions?
I am trying to figure out the industry practice for leasing agents. Are onsite leasing agents salaried or do they recieve a commission each time they get a unit leased or re-leased. that's one question and then is that cost (salaries to leasing agent or commssions to leasing agent) factored into the 50%. thanks!
The property manager, whether you or a paid property manager, usually is responsible for finding tenants for residental rentals. The management expense is included in the 50% expense figure.
Mike
Hi All,
OK, when I first read about this 2% rule I thought - there is just no way - not in the area I have been looking!
Well, I think I found one! It is going for auction so in the "purchase price" I am considering the highest I could bid to still meet the 2% and estimated repairs.
I was thinking though, in my calculation shouldn't I also be including 5% bid premium they will tack on if I win, and any unpaid taxes? Also, am I supposed to be including insurance or taxes? no right, just purchase price and repairs...?
Also, the house I found is in a REALLY CRAPPY area... and it is just "one-side" of a duplex. Just hearing some of the stories I see in this thread - I wouldn't be suprised if it happend in this area.... does this type of area usually scare you guys away, or is it generally where you have long time renters anyway since they can't afford to buy.
Thanks for all replies!
steph
OK, when I first read about this 2% rule I thought - there is just no way - not in the area I have been looking!Well, I think I found one!
Steph,
Congratulations on finding a potentially good deal. It is not easy to find a great deal (and I'm sure that is doubly true in California).
As for your question, yes you should include the 5% bid premium and any unpaid taxes, in short anything it will take to buy the rental and make it rent ready. You will not need to include taxes and insurance because these are operating expenses.
Please remember that the 2% rule is a screening tool. You should also perform a cash flow analysis and consider how much equity you will have at closing. If you don't know how to do the cash flow analysis, post the numbers (gross monthly rents and purchase price) and we'll give you our opinions.
Good Luck,
Mike
I'd really appreciate for you guys to look at the numbers... I'm not sure if I am calculating right:
70,000 (purchase price, 5% premium bid, repairs, closing costs)
1,200 rent
Starting bid is 59,000... so it would seem I'd have to be the only one bidding on the place to still get close to the 2% rule.
What do you think?
Thanks!
Steph
Oh, and to your point about considering equity - it says it was previously valued at $239,000. I can hardly believe it and don't have any comps yet - but even if that is the high, I still have a lot of room to meet the other 30% equity rule I read about :-) I'm trying to get all these rules down and understand when to use them!
Thanks,
steph
Steph,
Here is the way I see this deal:
Gross Rents: $1,200 per month
Operating Expenses: $600 per month
NOI: $600 per month
Mortgage Payment: ($70,000, 30 yr, 7%) $465
Cash Flow: $135 per month
It looks to me like this is a good deal.
Good Luck,
Mike
MikeOH, I am so excited right now because... I actually think I understand how you walked through the analysis...
So... 1st, we use the 2% rule as a screening tool... I found one that is close so we do the rest of the analysis - using 50% rule for expenses to see if there is still cash flow after mortgage... wait this seems to simple!
This is so fun. I hope I am getting it like I think I am.
Hey does anyone have any comments on the fact that it is in a bad area? Should that scare me away or are some of the best deals in seemingly scary areas?
Thanks!!
steph
What do you consider a bad area? Are you afraid to go there during the day? At night? Do bullets regularly fly in this neighborhood? Are there regular murders? Do drug deals happen in plain sight? Do you have a handgun and are you willing to carry it while you're in the neighborhood?
Paint us a picture.
Mike