How do I incorporate rehab costs into the 50% Rule?

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How do I incorporate rehab costs into the 50% Rule?

Carl M.
Investor · Wilkes Barre, PA · Member since 2016 · 54 posts · 10 votes
I'm trying to understand the 50% rule when it comes to houses that need work. I think the best thing to do would be to spell out the deal I have now and let people offer their input. I have a single family home under contract. The details are below. Purchase Price: $68,000 Purchase Costs: $ 2235 Rehab Costs: $25,000 Total Costs: $95,235 After Repair Value: $130,000 Projected Monthly Rent: $1300 Refinance $96,000 for 20 years at 5% Monthly Payment: $633.56 50% of $1300 (rent) is $650 650-633.56=$16.44 monthly cash flow Not a good deal at these projections. Now if I get a 30 year mortgage my payment will be $515.35 which gets me a monthly cash flow of $134.65. A little better but not great. I don't think a 30 year mortgage is a good idea for me because I am 47 years old and that doesn't make much sense. So am I doing this right? Based on this it seems my best exit strategy is to flip the property which is what I planned on doing in the first place with a secondary exit strategy to BRRRR this one and possibly sell it in five years. There is a chance I can get $1400 for rent but I prefer to be conservative on my estimates. Any thoughts, input, advice would be much appreciated. We have successfully flipped 9 homes and I am trying to expand my thinking when it comes to creating wealth. I would like to start creating some passive income. Thanks in advance.
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Nuhan Demirkan
Rental Property Investor · La Plata, MD · Member since 2011 · 216 posts · 117 votes
10y

Carl, I know some folks at Bigger Pockets are proponents of the 50% rule. I've been a landlord for over ten years with 20 SFH's in my portfolio and I have never experienced it. Especially if you are spending $25,000 on rehab. Your maintenance cost is reduced because most of the things that could go wrong are brand new and shouldn't. After the rental has some age on it you may experience higher maintenance cost. Plus if you are a good property manager, I strongly suggest you learn how to manage it yourself before giving it off to a property manager, your vacancy rate is minimal. I suggest you write your lease so the tenant pays the rent as a direct debit from their bi-weekly paycheck so you don't have collection issues either. As the number of rentals increase your cost to operate decreases per unit owned. Allow 5% of the rent as deferred maintenance and move on. Don't offer less than 12 months lease and raise the rent gradually at every renewal. And keep buying and holding...

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  • Carl M.
    OP
    Investor · Wilkes Barre, PA · Member since 2016 · 54 posts · 10 votes
    10y
    I neglected to mention that if we flip the property the holding costs will be $4464 based on a six-month holding period. That would give us a profit of $20,851.
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  • Nuhan Demirkan
    Rental Property Investor · La Plata, MD · Member since 2011 · 216 posts · 117 votes
    10y

    Carl, I know some folks at Bigger Pockets are proponents of the 50% rule. I've been a landlord for over ten years with 20 SFH's in my portfolio and I have never experienced it. Especially if you are spending $25,000 on rehab. Your maintenance cost is reduced because most of the things that could go wrong are brand new and shouldn't. After the rental has some age on it you may experience higher maintenance cost. Plus if you are a good property manager, I strongly suggest you learn how to manage it yourself before giving it off to a property manager, your vacancy rate is minimal. I suggest you write your lease so the tenant pays the rent as a direct debit from their bi-weekly paycheck so you don't have collection issues either. As the number of rentals increase your cost to operate decreases per unit owned. Allow 5% of the rent as deferred maintenance and move on. Don't offer less than 12 months lease and raise the rent gradually at every renewal. And keep buying and holding...

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  • Carl M.
    OP
    Investor · Wilkes Barre, PA · Member since 2016 · 54 posts · 10 votes
    10y
    Thank you so much Nuhan Demirkan I would agree with you. Another way to look at my deal is as follows: Rent: $1300 Mortgage: (634) Taxes: (200) Insurance: (66) Left over: $600 Tenants cut the grass and pay utilities. The roof is a lifetime metal roof. Heater is in great shape. Appliances will be new. If I put $400-$600 per month away for future expenses I should be in good shape.
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  • Nuhan Demirkan
    Rental Property Investor · La Plata, MD · Member since 2011 · 216 posts · 117 votes
    10y

    I am not following your math. Mortgage + Taxes + Insurance = $900

    Left over $400. if you put $400-$600/mo you won't have any cash or will be in negative cash flow.

    I suggest PITI - $900 plus $65 for deferred maintenance/vacancy - $965 monthly cost.

    $335 cash flow.

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  • Carl M.
    OP
    Investor · Wilkes Barre, PA · Member since 2016 · 54 posts · 10 votes
    10y
    Nuhan Demirkan You are right. I have no idea where I got to those numbers. Working too fast I guess. Your numbers make it look like a great deal! What does PITI stand for? Something, something, taxes and insurance?
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  • Michael R.
    Investor · Cary, IL · Member since 2014 · 124 posts · 95 votes
    10y

    Principal Interest Taxes Insurance

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  • Michael R.
    Investor · Cary, IL · Member since 2014 · 124 posts · 95 votes
    10y

    @Carl M. the 50% rule is really just a 10,000 ft view of a property to determine if it's worth looking into more deeply.  I agree with what Nuhan is saying as well, to some degree, but it's worth taking a look at the worst case scenario numbers to see how they compare.  

    Based on the numbers you provided:

    By this analysis the deal looks great, by my standards, even if you want to have someone manage it down the road.  Especially since you'll have some equity going in.

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  • Thomas S.
    Member since 2016 · 13k+ posts · 12k+ votes
    10y

    Your calculations need to be based on the ARV to accurately value the equity you will have in the property.

    You have an additional expense of $145 per month to pay the 5% return on the $34765 you have tied up in the property.

    The 50% rule is only a ball park number to assess if a property is deserving of further DD in a purchase situation. Your full actual expenses on this property may not appear for 5-10 years. They will be less to begin and although this property is tight it may actually show $100 or more per month positive cash flow when properly financed.

    Your age should have no bearing on the term of your mortgage, tenants pay the mortgage and if managed properly you do not want equity lying dead in a property.

    The actual interest cost/return  on $130,000 at 5% is $541.66/month. Take it from there.

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  • Carl M.
    OP
    Investor · Wilkes Barre, PA · Member since 2016 · 54 posts · 10 votes
    10y
    "Your age should have no bearing on the term of your mortgage, tenants pay the mortgage and if managed properly you do not want equity lying dead in a property. The actual interest cost/return  on $130,000 at 5% is $541.66/month. Take it from there." Greg S. Thanks for the thorough reply. I understood most of what you said except for what I posted above. 1. If my goal is to pay them down ASAP sonI can have passive income wouldn't it be better to have a shorter term on the mortgage? I would think in this case that my age does matter. Your thoughts? 2 what do you mean by "you do not want equity line dead in a property?" 3. Would you be able to explain what you mean by, "the actual interest cost/return on 130,000 at 5% is $541.66/month?" Thanks in advance.
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  • Michael R.
    Investor · Cary, IL · Member since 2014 · 124 posts · 95 votes
    10y

    @Carl M. The reason you are putting a mortgage on the property or refinancing is to create a long term cash flow asset and pull out the equity that you've created by rehabbing the property. It's called the BRRR method: Buy, Rehab, Rent, Refinance. The way this works is after you've purchased the property and rehabbed it you will have quite a bit of equity sitting in the property since it's worth quite a bit more than you put into it. At that point you will want to refinance the property for as far out into the future as you can (30 yrs being ideal) since this will increase the cash flow number you'll be bringing in each month. That extra ten years of financing from 20 yrs to 30 yrs could increase your cash flow by at least another $100/ month in this scenario. The length of time that the property is financed isn't going to matter here as much as the cash flow you pull in from the asset especially since the tenants will be making those payments for you.

    The other huge advantage to this is you can either do a HELOC or a cash out refinance once the rehab is complete to pull out the equity and recycle it into another property. This is what Greg means by "not leaving equity dead in a property". If you can find another great deal after this you can essentially recycle this original equity over and over to make more down payments and build your buy-and-hold portfolio. You'll need to own the original asset for 6-12 months to take advantage of either of those equity refi options, but it can really help ramp up your acquisition rate. Since the final value of the property is $130,000 that is what your new cash out or HELOC mortgage will be accruing interest on. You have to recalculate your cash flow at that new home value number and interest rate based on the option you choose (HELOC or cash out) to make sure it still makes sense.

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