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.
Originally posted by "smclaughlin":
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!
Well said. The rules are tools for how you can screen in and out the deals you put time into. It sounds like you have it sorted. The way you described things should help other readers in the future understand. Well done.
Originally posted by "smclaughlin":
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?
Bad means what to you? Are you the one who will be managing the property? If you expect to hire that out call around to property managers to see if they will work in the area and what they will charge. Some have specific areas they focus on and others want to avoid areas too far away. Some will charge extra to manage property in rough areas as they can be a lot more work.
OK.. what do I consider a bad area - well, really it might just be "low income" - I mean there are 3-5 cars in front of one house... you know people working on their cars in the drive way - actually the street I am interested in I would say is probably filled with Mexican working class... but a couple streets over it seems scary, like Sunday afternoon gang banger looking guys hanging in their front yard with pitbulls.
My dad is familiar with the area, and says yes, back in the day (10 years ago) there used to be shootings in that area, he is not sure now...
I would go to the local police department. Ask them about the street and request the police reports for the last year for the property you are interested in. Also, talk to any neighbors that look normal (non-druggies, non-gang bangers) and ask them about the neighborhood. They will have a good idea about the neighborhood.
You need to run and hide before they hurt you. :shock:
Just kidding. You need to run and hide before that deal hurts you.
That property has NO cash flow. Its showing a $1,000 NEGATIVE cash flow per month in your numbers.
I'm not sure about some of your other numbers either. Will $250 a month cover taxes and insurance? How is it showing a $1000 tax refund on your loss? I think there's a glitch in your software.
I haven't looked through your spreadsheet, but only the posted numbers. Here's what I get. My results are different than yours, so I've laid out how I calculate them.
First, though, I always use before tax numbers, not after tax. I'm not a real estate professional. The special deduction is limited to $25K and only applies below specific AGI limits. So, while it might affect you for your first property or two, it has no bearing as you scale up. However, since the passive losses offset any income, there's effectively no tax on the passive income. Therefore before tax is the same as after tax. Yes, when you sell, it changes, and you can take that. But, that doesn't affect its income as a rental.
Here's my evaluation
Loan amount $172,700 (80% of ARV, so I'm assuming a rate and term refi)
Payment $1064/month (30 year, 6.25%)
Expenses $725 (50% rule)
Cash flow -$339
Depreciation $6284 (80%*216000/27.5)
Before tax cash flow -$4068 (NOI - payment)
Income -$8326 (NOI-depreciation-interest)
Tax -2082 (25% of income)
After tax cash flow -$1986 (BTCF - tax)
Now if you mean to use $170,000 and take 80% of that on the mortgage, it gets better. I calculate (same formula) annual after tax cash flow of -$173. But, you have $34,000 invested. That would earn you $1700 in a bank CD, $1275 after taxes. So, by my reckoning, this loses you $1448 after taxes.
Using the 2% rule gets you a allowable price of $72,500. With 100% financing, that results in BTCF of $278/mo or $3343/year, and ATCF of $2822/year. That would be a really good deal.
In addition to what Wheatie said (which I agree with), I would also question getting the money for a NOO rental at 6.25%. This is especially true if the property will be held in an entity, and I certainly would not hold rentals in my own name.
Moreover, I find it interesting that you assumed that rents would go up 2% each year while expenses would only go up 1%. If that were true, that would be great, but that is not my experience.
Okay, are you looking at the deal as a rental or as a flip? The property is NOT a good rental. That's the bottom line. There may be some room in there as a rehab to retail, but if that's your exit strategy then there are a whole other set of things to consider.
I would highly recommend that you unteach yourself to ignore before tax income. You are rationalizing buying a property with a negative cash flow so that you can have the tax write off, while there are thousands upon thousands of deals out there that will give you POSITIVE cash flow before AND after taxes. Yes you won't have the write off, and yes you would be paying more in taxes, BUT you would be making more money!!!!!
Point being, I think you are analyzing yourself into a trap. As an investor looking to buy rentals the name of the game is CASH FLOW, and let's be clear, POSITIVE CASH FLOW. Buying negative cash flowing rentals just for the write offs is a losing game, but if you have the money to waste then have at it. Just make sure that you can pay for that extra $1,000 you will be losing every month to make it through to the end of the year to get your tax deduction.
Let me try one more time.
Ryan is absolutely right, this is a TERRIBLE rental.
What you have here is a property that LOSES money each and every month if this deal stands alone. Much like counting on appreciation, you are counting on an external factor to make this deal seem good. That external factor is other income that you can offset with your losses from your rental property (the key word here being losses). So, as a stand alone deal - this one stinks. If you have other income that you're offsetting, it LOOKS better, but it is still a terrible deal.
The 2% rule is meant as a screening tool that will find properties that will actually cash flow. It doesn't count on offsetting other income; appreciation; or the position of the sun to make money.
If you think this is a good deal, then by all means, I think you should do it. The technique of doing something to create losses that will offset other incomes is valid, just as is speculating on appreciation, or putting it all on Red in Las Vegas. If your strategy is to lose money on your rentals so that you can offset other income, this deal is ideal. My strategy is to make money on each deal.
Originally posted by "MikeOH":
My strategy is to make money on each deal.
Mike makes a good point concerning every deal being able to support itself. It produces results where there are few if any dependencies on other factors (like keeping a day job).
Mike does his own maintenance and therefore is fully able to operate on thin margins. Yet he does not. The 2% rule is pretty clear that it covers the cost of external property management and maintenance. Even if Mike likes being on call and prefers to be hands-on stuff happen which might not allow Mike to respond to the next call. Illness, the need to be somewhere else or you just want to take time off for a holiday.
Note that Mike's model (self-management) breaks down when the portfolio is large. At some point no one person can manage everything. Budgeting to have external providers is the only solution for dealing with size (assuming you do not change the focus on 1-4 unit rentals). The book Weekend Millionaire makes a great case for not even handling the management when you have a small portfolio (focus on the large profits and not on managing the marginal expenses).
Screening using the 2% rule is only there to help identify properties that could make sense all other things being equal. Deals that are worth the time to check the details. The rule helps to focus the investor's attention on property that can be held long term without any other dependencies like a job. It is a sustainable model.
Sean - losses to help reduce one's taxes from a traditional job has a declining value. By this I mean that most people have rather limited incomes compared to the losses you could acquire from RE deals. I think focusing on growing your income is a more scaleable way to go. If you pay too much in taxes focus on making so much that you can hire out the problem. If you grow your income by investing there will be paper losses that help but they should not be the focus.
I think i've got a good grasp of 2% and 50% rules, and I know they are just guidelines and "rules of thumb". BUT - just based on the numbers, there are many properties that will theortically cash flow under the 50% rule but do not meet the 2% rule.
$175,000 Asking price for quad - decent neighborhood
$2,000 monthly gross rents
2% RULE - comes out to 1.14%, not even close really
50% RULE -
$24,000 yearly gross revenue
$12,000 operating espenses & vacancy
$12,000 cah flow for debt service
$1,000 monthly Cf for debt service
Being conservative and assuming you buy at full ask price with no down payment at 5% - 30 years leaves a payment of about $950.
So this thing may hold its own, no cash cow but slightly positive CF.
Also, i know guys will adjust and maybe will accept 1.75% for a nice home in a nice area, etc., etc.
This being an example of the 2% rule being harder to achieve - is it the case the the 2% rule is a better and more conservative "rule of thumb".
In other words, are intelligent investors more focused on meeting the 2% rather than the 50% because if you find a good SFR or duplex in a good neighborhood that satisfies the 2% rule - that is like the holy grail of rental investing.
I understand these are guidelines, and I use both in my analysis - but is the 2% the more stringent and desirable of the two guideline rules? Because usually if a property meets the 2% rule its probably gonna cash flow using the 50% guideline.
BTW if you use 7% interest on the same scenario above it makes the payment around $1150, doesn't quite make it, but still i believe i've demonstrated my point that if it meets the 2% it should well cash flow under the 50%.
I also understand the 50% is used as a cash flow estimation tool and the 2% is a screening tool
I'm not at all a fan of the "2% rule". Beats the heck out of the traditional "1% rule", which is a guaranteed loss-generator. But, as you can see with your math, the higher the rent the lower the percentage. Why? Because taking $100 for desired cash flow out of a $300 rent payment is a huge hit where taking $100 out of $2000 rent is a much smaller hit.
I work the math backwards. Start with the rent, which is the factor you control the least. Subtract off the 50%. Subtract off your desired cash flow. What's left is your max payment. Use your terms to compute a loan amount. I wouldn't use 5%, since I don't think you can get that for a NOO loan right now. Maybe 5.5%, though even that might be tough. After you've computed the loan amount, use that as the price. Now, kick in your down payment and get an estimate of your actual cash flow and cash on cash return.
You have to consider the desired cash flow per unit, not per property. A quad is four tenants. That's four leases, four places to show, four possible sources of trouble. The value of a quad with $2000 a month in gross rents is MUCH lower than a SFR that rents for $2000 a month.
The 2% rule works very well for $500 in monthly rents. So, yes, I'd say that quad is worth about $100,000.
Here's my math:
Gross rents: $2000
Desired cash flow: $400 (for that quad)
Left for payment: $600
Loan $100,075 (6%, 30 years)
Closing costs: $3,000
Total cash invested: $28,000
Actual loan: $75,075
Actual payment: $450
Actual cash flow: $550
Cash on cash return: 24% (nice!)
What if its an SFR:
Desired cash flow: $100 (only one tenant to deal with)
Left for payment: $900
Max loan: $150,112
Down payment: $$37,528
Closing costs: $4,503
Cash invested: $42,031
Actual payment: $675
Actual cash flow: $325
Cash on cash return: 14%
So to answer my question in simple terms from an experienced investor like you, Jon, it seems you actually value the 50% rule much greater than the 2% rule - is that the case?
50% seems to be very consistent and conservative and good rule of thumb.
In your calculations you assume I want a cash flow of $400. Which i like how you approache dit backwards about what you want to get out of it. Although determining that the property is worth about $100,000 if you want $400 per month CF is helpful, that method is also very dependant on what CF minmum you set, for exmaple if i desired only $200-$250 CF, that house is then worth probably around $130,000 or so (didn't calculate just a guess) Point being that the value your willing to pay fluctuates very heavily on what CF you want.
I like that - unless your investing primarily for appreciation
But i am looking for CF opportunities out there, and the numbers look good at $100,000 but probably not going to come that low from $175,000
Yes, I like the 50% rule and dislike the 2% rule. But at $500 in rent they are really the same thing. Not so for $2000 in rent nor for $250 in rent. That's why I dislike the 2% rule.
Paying $175K for this fourplex makes it, IMHO, a loser.
Closing costs: $5,250
Total cash: $49,000
Cash flow: $213
Cash on cash return: 5.2%
Too low, IMHO.
There are lots of other reasons to invest, though. Speculating on appreciation is one.
Betting that rents and expenses will rise (preserving the 50% rule over time as inflation escalates both rents and expenses) while your payment stays fixed is another.
Yet another is to be break even while your tenants pay off the mortgage. Then, after its paid off, refinance to a point where your tenants are again making you break even. Live off that cash. Let your properties pass to your heirs when you die. They get it at a stepped up basis and guess who pays the capital gains taxes? That's right - NOBODY!
Originally posted by MikeOH:
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.
Although this post is a few years old, and from reading lots of MikeOH's posts - I'm sure he'd agree that his statement here is in need of clarification.
The 2% rule states that if the monthly rent is at least 2% of the total purchase price, then the property is worth considering. The stuff in the post I quoted just isn't stating things clearly.
An easy way to use the 2% rule comes from knowing the market rent. Multiply the monthly rent by 50, and you'll want to pay less than that for the total of all acquisition costs.
Steve, I understand the 2% rule and how it works. Your post provides clarity.
But the question I have posed now is essentially this:
Do you those experienced investors out there prefer to use the 2% or 50%, i know they can be used in conjunction.
Do you use one, not the other, neither, or both? and why?
Jon has givenme some good feddback and we have been demonstrating how the 50% rule is ultimately the better of the two is it is more universally applicable. I tend to agree with this as well.
2% rule is decent for just a very basic rule of thumb when browsing an MLS or something.
You have to pay closer attention to the other posts :wink:
I think Jon already stated it fairly well: the 2% rule really is only applicable to being useful in a very narrow range of market rents; the $500 figure was used. If you know that the market rent is in that narrow range, then the 2% rule makes the math easiest without a doubt - at least for the initial screening.
The 50% rule is intended to apply to all types of property in all price ranges and all market rents. Again, this is something that was gathered in several statistical studies; one extensive study was performed by a BP member called "Taz" (who is no longer as active here as people would like to see), and he initially made that study public - now it is only accessible to those who pay for memberships at the investing site that Taz has.
I am more focused in higher rent areas, so I am applying the 50% rule.
Note that if you are in really low rent areas (say $300 or less), then you will likely need to see 3% or more of the acquisition costs as your monthly rent.
Sometimes when you browse the MLS you will see something called the GRM (Gross Rent Multiplier) - the lower the GRM the better the cash flow. But you still need to examine actual expenses to be certain they fall in line with 50% target; if expenses go higher than that, you will not have as good of a deal as you would hope for. And you still need to be 100% certain that the rents being used are real market rents (and not imaginary numbers that will never come to be).
Now, in my area, looking on the MLS for good rentals is almost a waste of effort; it's rare to see anything there with numbers that look worthwhile IMO.
I think the primary purpose of the 2% Rule is being overlooked here.
The 2% Rule (or how I prefer to look at it, a monthly GRM of 50; rent multiplied by 50) is not a way to calculate IF a property will cash flow. The 50% is a rule for figuring that out.
The 2% Rule is a general rule to determine IF something is a good deal in terms of Risk Vs. Reward (RVR). Just because a $175,000 property cash flows $325 does NOT mean its a "good" deal.
The 2% Rule insures not just positive cash flow as the 50% Rule does, but goes a step further with insuring adequate reward (cash flow) for the risk (purchase price). The 2% Rule guards your exposure in only allowing you to risk $100,000 for that amount of gross rent. Its a preset babysitter for RVR.
Now whether the 2% Rule prescribes a RVR ratio that is too conservative for your preferences, is a personal decision on your part, but let's not confuse the 2% Rule's APPARENT weakness with its true built in strength.
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Originally posted by @Jon Holdman:
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.
Thank you for explaining these rules so they're EZ to understand!
What if you are paying cash for the properties? Single family homes in my area are renting for $1200 - $1600 for 3 - 4 Bedrooms. That would be about 1% of the purchase price. I plan on buying and holding these for long term appreciation. Is this a viable strategy?
Originally posted by @Michael Rossi:
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.
I had one HORRIBLE tenant, a "real estate agent" with good references, which turned out to all be his friends and family (collected by my ex LAZY real estate agent who wanted the listing on the property). The tenant turned out to be a professional squatter and knew how to play the system. He paid a deposit and one month rent and never paid again, it cost me $6,000 to get him out. I had to literally WRITE HIM A CHECK TO LEAVE, (I was lucky I didn't get arrested in the driveway when I had to hand him the check.) I freaked out, became real estate skittish, and even though the property had been profitable for three years prior, I sold it at a tremendous loss and haven't re-invested since (8 years). I'm getting back into real estate now, have a great inspector, a fantastic agent, who negotiated an excellent deal on my own house, 40k in equity in 16 months, I joined BP, and have become a due-diligence fanatic, so I will hopefully NEVER make the same mistakes again.
Please explain: (Vero Beach, Indian River County, FL) $340k purchase price, 3 single family and 1 efficiency (not permitted) on 2 acres. Seller refunds $6k in closing cost, $15k in repairs, total net to seller $319k. DP 10% ($34k). Monthly income $3750, monthly expenses $3167, monthly cash flow $582, C on C ROI 20.57%, that seems good, but when I click on the 50/50 rule, monthly cash flow is only $324.54. Does this mean my expenses that create the $528/month are too low? With cash out pocket of $34k, $324/month is fairly decent ROI, but which number is correct (or should I rely on)... my estimated expenses or the 50/50 rule? Also, if I use the 2% rule my income is WAY off, based on the selling price of $319k OR $340k. Why such a big difference in the 50/50 compared to the 2%? Thanks!