Multi Family Numbers - Do they work?

Question

Hi Everyone!  I'm trying to run numbers on a potential duplex property i've been considering in NJ.  (One unit is a 2br/1bath that can bring in $1200, the other is a 4br, 2bath that can bring in $2000.)

[i]Purchase price: $300k (Can be purchased for this amount)
Appraisal price: $470k (Currently on Zillow)
Sold in '07 for: $500k (From NJ tax information)
Current comps: $450-475k
Monthly Rent: $3200
Monthly Mortgage: $2400 (Including all taxes/insurance)[/i]

I've been doing some homework on BP regarding ratios and percentages. Trying to learn but still confused.  Do the ratios take into consideration appreciation?  The formulas i've been running are specifically how rent should be 2% of the purchase price.  In this case, it's not; it's 1%.  Expenses should also be factored in at 50% of the rent.

Ideally (from what i've been reading)
2% of 300k = $6k/month (what the rent SHOULD be)
50% of 6k/month = $3k/month (what the expenses SHOULD be)

So...

If expenses are $3000, and my mortgage is $2400; the total monthly carrying cost would be $5400.

Factor in rent of $3200/month and you'd be left with a loss on this property of $2200/month.

This can't be correct, is it?  It seemed good, the mortgage was at least $800 less than rent every month, plus the property is in a good area, appraising for $175k more than the possible purchase price.

Am I missing something important in my math?  Any tips to help out?

Thanks so much.

Jon Holdman · Answer

I can tell from just the purchase price and the rents this is a bad deal.  $300K for $3200 in rent just won't work.

That said, the 2% rule doesn't work for $1200 and $2000 rents, either.

Rent: $3200
Expenses: $1600
Payment: $1798 ($300K, 6%, 30 years)
Monthly Loss: $198

You cannot figure the rent from the price.  You have to figure the rent from the market, then work out the price.   For this place to cash flow $200 a month, you can pay no more than about $230-235K.

None of this considers appreciation, which is purely a crap shoot.

Jon Holdman · Answer

The 2% rule works for about $500 in rent.  If you pay $25K for a unit that generates $500 in rent, you'll have true cash flow of about $100 a month.

For higher rents, that ratio can be lower.  If you pay $83K for a property with rent of $1200, you'll still get about $100 in cash flow.  That's about 1.5%

For lower rents, its harder to extract that $100.  At $300 rent, you can only pay about $8000 and still get that $100.  That's a ratio of almost 4%.

The $200 is $100 per unit.  That's just a rule of thumb.  Every tenant is roughly the same hassle and work.

The 50% seems high, but its reality.  Its not a worst case number.  Its what you can realisitcally expect for multiple properties over multiple years.  For one property, any one year can be pretty good (just taxes and insurance) or can be really bad (lengthy eviction and lots of damage.)

Eventually roofs and drain lines need to be replaced.  If you own 20 properties for 20 years, you'll average a roof every year or two.  Those big ticket items aren't just "things that might happen".  For a rental business, that is, not just one or two properties, they DO happen, and they DO happen routinely.  If you own 20 properties, you're going to have some big ticket item every few months.  And you're going to have small items and vacancies all the time.

Read the sticky threads in the rental property forum.  Everyone tries to argue with this number.  But every time any body produces a meaningful set of data, its been borne out.

John Romero · Answer

Jon,

Thank you for your time to respond to this.  You said that the 2% rule doesn't work for $1200/$2000 rents.  What does that mean?  When can the 2% rule be applied and with what properties will it be accurate with?

I figured you couldn't use the 2% from the price paid to figure rent for any give property.  Location will always be a factor.

Why do we use 50% from rent for expenses every month?  I've seen many threads on this rule; but why so high?  Perhaps it's just an insurance policy for yourself so incase a big item is required, you'll be covered.

And what does it mean to "cash flow $200 a month".  Does that mean for each unit to positively net $200, or each unit cash flowing $100 for a total of $200?

Thanks!