Buying a Rental Property - Step 5 of 8

To think that one article from Brandon Turner on the Bigger Pockets blog about how to buy a rental property would inspire me to write a 9 part series on the topic! It helps that I'm very passionate about buying rental properties, getting good deals, and helping others.

In step 5, Brandon mentioned doing the math. Yes, there is some math in real estate. But don't worry, you don't have to do the math all in your head. You have the ability to do quick calculations on your smartphone or iPad while at a property, or run the Bigger Pockets Buy and Hold calculator.

If you've read the forums for at least a little while, you've probably seen some "rules" being thrown about. These are not really hard and fast "rules" but more guidelines that people go by when performing analysis. Just because a rental property doesn't fit one of the "rules" doesn't mean it's not a bad buy.

What is the "2% Rule"?

Back when I first started learning about rental real estate (before Bigger Pockets) I had only heard about the "1% rule". This meant that the purchase price was a good deal if the rent you could get for the property was 1% of that purchase price. Meaning, if a place rented for $1,000 a month, you shouldn't pay more than $100,000 for it. And if you could get it for any cheaper, you were doing well.

Then I started investing and found Bigger Pockets and found out that I was hitting the "2% rule" which is in essence double the above. If a place could rent for $1,000 per month, you shouldn't pay more than $50,000 for it. (Except that I was getting places that were closer to the "3% rule" or above.)

Now why isn't the "2% rule" a good idea if you're buying a rental property? It gives you a good metric when shopping, right? There are two main issues with the "2% rule":

a) You can't apply the rule in reverse. If you buy a house for $100,000, you can't expect and hold out for it to rent for $2,000 a month. You have to consider the market rent first, then look to the purchase price.

b) It doesn't apply in all markets around the country. The east and west coasts are the prime examples -- there, hitting the "1% rule" is gold and that is more of a bench mark. It primarily applies to areas with properties that are less expensive.

Now some people on Bigger Pockets seem to think that it's a myth, but it really isn't, it's just that it's rare or impossible to see in some areas of the country.

Some additional articles on the "2% rule":

The 2% Rule: Fact, Fiction, or Reasonable?

Why the 2% Rule can Get New Investors into Trouble

What is the "50% Rule"?

Quoted from Jon Holdman: "The 50% rule simply says that 50% of gross rents will go to vacancy, expenses and capital. This does not include the P&I payment, but does include taxes and insurance."

If you're more of a visual learner, here are some videos from J Scott and Jon Klaus that will explain the 50% rule as well.

Brandon Turner has his own article on the 50% Rule which includes a video.

How do I know what's an acceptable cash flow number for an investment like the one I'm considering?

If the property you're considering has a negative cash flow, stop considering it. I've seen several posts from new investors who are so desperate to get a deal under their belt that they'll even take on a bad one.

Slow down, cowboy (or cowgirl). Don't "settle". Keep looking for that good investment.

On the flip side, some new investors find a property that seems to have amazing cash flow ... on paper. Usually, it's because the properties are in really bad areas, and the price and expenses seem really low. Until you get into the vacancy, turnover costs, eviction costs, and so forth that come with those areas. So think of those as the other end of the spectrum.

For your first rental property, you may want to avoid the extremes. Go with something with a healthy return, around $100-$200 or more per door after everything is paid and you put aside a healthy amount of money for reserves.

In the end, there is no "magic formula" for real estate investing. If there was an easy road to riches, everyone would be traveling on it.