Stop Obsessing About All Those Damn “Rules” in Your Real Estate Investing

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I can’t remember exactly when I joined, but I’ve been a member of BiggerPockets for close to 2 years now, and I’ve been contributing to the blog for almost a year.  A lot of things have changed on BP in this time, but one thing never changes – at least once a week month a newbie wants an explanation of 2% rule, 50% rule, or some other rule…

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Here’s The Problem

These rules should not be used by beginners and should be reserved for highly seasoned people. 

Why – because these rules are not rules, they are, at best, guidelines, and application of these guidelines presumes many caveats which seasoned people know while beginners may not.  As such, these rules can be quite misleading, and focusing on the is a mistake.

Take the 2% Rule, for example, which stipulates that monthly Gross Rent should be approximately 2% of the value (purchase price) of the asset.  This would mean that if you paid $100,000 for a 4-plex with total gross income of at least $2,000/month you’d be in good shape, since $2,000 is 2% of $100,000.  Let’s look at this…

Two Buildings:

Let’s consider two 4-plex buildings.  Both can be purchased for $100,000.  One brings-in $2,000/month of gross and thus falls in-line with the 2% rule.  The other brings-in a whopping $2,400/month gross, which is 2.4% against the purchase price of $100,000 – you know you’ll be good with that one!  Well, may be – let’s consider these:

4-Plex #1:

This building brings-in $2,000/month of gross.  Electric and Gas are separately metered and passed along to tenants.  The building has a simple gable roof with 6/12 pitch and the asphalt shingles are only about 4 years old.  The building is in good condition and there doesn’t seem to be necessity for much capital expenditure in the next few years.  Thus, the Income & Loss for this building looks something like this:

Income (monthly)

Monthly Gross Income:       $2,000

Expenses (monthly)

Taxes:                         $200

Gas:                            $0

Electric:                      $0

Water:                         $50

Sewer:                         $50

Trash:                        $100

Vacancy (10%):         $200

Maint. (5%):               $100

Lawn:                         $100

Cap Ex:                      $0

NOI:                           $1,200

Financed at 100% on a 20-year note at 6% with a payment of about $716/month, this would produce Cash Flow of roughly $484/month ($120 per door).  And, if you finance it on a 30-year note with 25% down, the cash flow is that much stronger.  NICE – 2% rule is right on!

4-Plex #2:

This building brings-in $2,400/month of gross.  Unfortunately, the heating system in this building is radiant heat powered with an older gas boiler, which represents 2 problems.  First, the boiler may need replaced within a short time-frame.  And secondly, the owner has to absorb the expense of gas energy, which includes the central heat as well as the stoves in each of the units.  The electric is separately metered and the expense is passed along to the tenants.  The roof is a flat rubber roof which looks to be about 15 years old.  It can be babied for a few years but will likely need replaced with 5 years.  Both the boiler and the roof needing to be replaced have to be reflected in your withholdings for CAP EX.  Thus, the Income & Loss for this building would look something like this:

Income (monthly)

Monthly Gross Income:       $2,400

Expenses (monthly)

Taxes:                         $200

Gas:                            $150

Electric:                      $0

Water:                         $75

Sewer:                        $50

Trash:                         $100

Vacancy (10%):         $200

Maint. (10%):             $200

Cap Ex (20%):            $400

NOI:                           $1,025

Looking at the Numbers:

You can see right away that even though gross income is higher in the second building, the Net Operating Income is actually $375/month less!  Financed the same way with a payment of about $716/month, the second 4-plex would produce Cash Flow of only $309/month ($77 per door).  In my book, this is not a deal.  Naturally, you could open some room by putting down a large down-payment, but then you’d just be buying cash flow, which is not what we do as investors…

Conclusion:

On the surface, the 2% rule paints a very favorable picture of the second building, but in reality it turned out to be a much inferior investment opportunity.

Here’s the thing – if I were taking a quick glance at these numbers, I would automatically ask questions about roof, inutilities, condition, and much more.  I know that while the numbers are important, they do not tell the whole story; I know this because I am an experienced investor.  Thus, when I use the 2% rule, I do so with a very large grain of salt, and a lot of caveats – I know better.  But, a new investor might not know better; a new investor wants to rely on the 2% rule as a more definitive metric than it really is, which can cause significant loss of sleep down the road…

I quote James Bennis

“Don’t just learn the tricks of the trade.  Learn the trade”

Indeed, real estate investing is easy enough that if you are going to do it, then learn how to do it right!  There’s no room here for short cuts and rules of thumb, so quit looking for them, quit asking for them, and quit relying on them.  This is a precision sport and it punishes harshly ill-prepared minds!  Can you commit yourself to the craft?  Are you ready?  If not, the best thing to do is to stay out – you’ve got some mutual funds with your name on them…
Photo Credit: Kaptain Kobold

About Author

Ben Leybovich

Ben Leybovich has been investing in multifamily residential real estate since 2006. His area of expertise is creative finance. Ben works extensively with private as well as institutional financing. Ben is a licensed Realtor with YOCUM Realty in Lima, Ohio. He is also the author of Cash Flow Freedom University and creator of a cash flow analysis software CFFU Cash Flow Analyzer.

28 Comments

  1. Omg, the Guru of small commercial investments!

    Oh oh I said guru!!

    If more people would listen to u Ben in the multi area, they would save a lot of time and heartache by avoiding costly mistakes. Rules are friggin’ GUIDELINES!

    Well done, maestro

  2. There is really only ONE Rule when it comes to Real Estate Investing:
    1. ALWAYS BE LEARNING

    There are a plethora of GUIDELINES. The 2% Guideline comes with a myriad of caveats. The 50% Guideline comes with a cornucopia of exceptions. These guidelines differ from MH to Multi Family to SFR to land to Commercial to Retail and beyond. They also differ on the age of the investment, the location, the condition, the neighborhood, the city/county, and on and on.

    But for a brand new investor, having a few simple guidelines are extremely helpful. One guideline that I think is very helpful is this, if the Principle/Interest Payment is less than 50% of the rent, the investment has a good chance of being successful. Many, MANY other factors come into play, but if the P/I payment is 90% of the rent, it may not work out so well.

  3. It is so true that you can’t just stick to the “rules” of buying houses when analyzing deals. The only rule I go by is what will my buyers pay for the house? if they will pay more then what I can get it for I put the house under contract and sell it.

    Depends on the area and depends on your buyers, that’s about it for me.

  4. GREAT POST Ben!!! I never use these rules and in fact only came across them here on BP. My market doesn’t work if I were to follow these rules.

    I’m glad you brought this to people’s attention. I hope EVERYONE reads this post, especially the newbies.

    • You know Aaron – it literally amazes me how much people focus on these “rules”. I’ve literally never gotten out a calculator with the intent of checking whether gross falls into the 2% – it’s meaningless. Literally!

      Thanks so much for reading and commenting!

  5. I soooo appreciate this quote:
    I quote James Bennis

    “Don’t just learn the tricks of the trade. Learn the trade”

    So often people get caught up with “short cuts” & “tips” that they don’t put in the time and work necessary to make smart decisions. I had a manager I worked for (one of the plethora of reasons I left Corp America) who was a computer geek and would get so po’d if you didn’t know the “latest tricks.” I told him point blank one day, “If I don’t know the ‘real’ way the ‘tip’ or ‘shortcut’ does me know good, because I am lost. I had a math teacher who stressed, ‘show your work,’ there is a reason for that, because if you can find out where you messed up, you can redo it and go on. If you have no idea where you messed up, how can you rectify it?”

    I was going to create a thread about “The Rules,” but I think this post superbly show why, “The Rules”, while great, are not the end all be all!

    Thanks for a great post!

  6. Hi Ben,

    I have a question for you. I know the 4 plex example you used above is just that…an example. However, where in the world is there a 4 plex in a DECENT area that would go for only 100k?

    In my area (which is in the northern Midwest and not a high end city), a decent 4 plex hits the market for at least 200k if not closer to 300k. These aren’t in “fancy” neighborhoods either but rather just normal, safe areas. Are you really finding four units at the $100,000 mark? If so where at?

    I have trouble justifying a 250k four plex because the numbers just aren’t very good even with rents that are slightly higher than your $500 per month.

    Thanks,

    -Justin

    • Hey Justin –

      I have a friend whom I’ve helped for a couple of years in Ohio who as we speak has a 4-plex under contract for around 120k. The numbers look better than what I provided here 🙂 This is his second one in as many years and he loves it. I am currently personally considering a portfolio at $50,000/unit average which will be 10.5-11.5 CAP and will cash flow $150/door under 100% financing. If you want to talk more specifics, PM or call. Good luck!

  7. Great article, Ben! However, I am confused about some of the numbers in your example. I know its probably something obvious that I’m missing, as I am definitely a newbie. Example 1 showed a gross rent of $2000, but after you remove the NOI of $1200 you said that leaves $716 for the mortgage and $484 cash flow ($120 p door). Shouldn’t you in fact only have $84 cash flow ($21 per door?)

    Anyways I enjoyed your podcast episode and your other articles. Keep em coming!

    • Hey Andrew,

      You are thinking backwards I think. You don’t need to remove the NOI from Gross. NOI is Gross – Expenses. From there you subtract the cost of money from the NOI to arrive at CF: $1,200 – $716 = CF

      And thanks so much for listening to the podcast indeed!

  8. Hi Ben
    In regards to the 4 plexes and duplexes if you average a 30% expenses from your GI its a good deal right? Now I’m asking because I’m a newbie and interested in 11 duplexes going for $440,000.00 and I am also looking at 2 quadroplexes that are going for $109,000.00 which I want to try and get the vacant ones which are like 6 of them. So if my number crunching is right and I get a cap of 11.9 and a DCR of 1.2 on top of the 30% I’m doing good yes? I just want to make sure I have a good deal.

    And if you don’t mind me asking how can I get 100% financing on these deals?

  9. Ben

    I have been an admirer of yours for a year or so now. I must say I feel you hit the nail on the head. There are no set rules to any business venture, but instead what makes the business successful is the manager/owners ability to be creative. Adaptability as well as the ability to recover and learn from ones mistakes is what makes any endeavor succeed.

    I am however confused by your statement that buying down the loan is “not what we do as investors.” I believe ones end goal should dictate his actions as an investor. It has occurred to me that an investor Is no different than any other entrepreneur and achieves his goals by hard work, persistence and thinking out of the box. (yes I know you can get into trouble doing that) If a person has a retirement account invested in mutual funds already would it be incorrect for him to try to diversify his retirement by investing in real estate? And at a later stage in life if he could increase that income by buying down a note ( larger down payment) would that not only increase his income, but yield funds that did not diminish his original investment? Is my thinking flawed here?

    Ralph R

    • Ralph,

      First – thank you for following my thoughts on this blog. As to your comment here, you are not wrong and I need to clarify myself:

      As I see it, and as my father taught me, stock market investments should only be chosen if and when the possible loss associated with them would not change a thing in your life. In other words, if you can afford to loose, then go ahead and gamble.

      The more sophisticated way to synergize RE and paper markets is the other way around. First, make sure you have plenty of passive, recurring cash flow. Then, take some of that CF and gamble it in the market. If you loose, you’ll get more CF from your property next month, quarter, year which will make you whole – that’s the logic.

      Now, if I had mutual funds, I would absolutely invest them in RE. If I wanted to pull $20,000 to use as DP for a property, then at 20%-down I could buy 100k property. But, if it were me, I’d try to get that property with 5k down. In fact, I would try to get 4 properties for 5k down each – here’s why.

      An extra 15k down on 1 property might lower my monthly payment by $80/month presuming a 20-year note at 5%. But, I would have 1 solitary property with an investment base of 100k – poor diversification and poor focus.

      Instead, by buying 4 properties, I am sure to more than make up the cash flow of $80/month And additionally, my investment base would not be 100k but 400k, and I would be mush more diversified.

      Furthermore, if you presume 10% expandability, in the first case that would be 10% of property’s CF and Value, while in the second example it would be 10% of 4 property’s CF and value.

      Lastly, and this is where investment base is crucial, I believe that sooner or later we will experience inflation from hell. All things being equal, sitting on 100k of investment base/value is a lot better than 100k. 20% cumulative inflation upon 100k results in 20k gain, while on 400k of value the gain would be 80k. Once inflationary environment passes, I would rather to have 80k.

      Naturally, this is mitigated with your age. Yes, being fully leveraged at 60 years old may not be the thing to do. But in general, I disagree when people look at a cash flow deal which is skinny and decide just to put more money down to open up CF. It’s like saying – this investment isn’t good enough, so let’s put more of our money into it and at risk. That’s not investing; it’s idiocy in my opinion, and this is primarily what I am referring to in the indicated statement. Thoughts?

  10. Ben

    I too have always have been told never invest money in stocks you can’t afford to loose. I do get the point about building as large a base as possible, and using leverage to do it. Sometimes I get a bit impatient. You are correct it is the only sensible way to create a solid financial base.
    RR

    • I don’t know if i’s the only way, but it is the way I chose. The jury is still out; all I can do is share my thoughts and the logic behind them in hopes that either someone proves me wrong and I witch my methods, or I help someone see a better way. Either is a good outcome of sharing of ideas in my opinion.

      Thanks so much for your comments Ralph!

  11. Ben, good kick in the butt as some of us need it at times. Better this than learning the hard way. I often say that RE investing is an art and a science combined. One has to develop a flair for it (whatever the specific niche) and be passionate about it as well. Then and only then will a more complete and realistic picture be formed in the mind of the savvy investor.

  12. Sharon Vornholt

    Hey Ben –

    Your post really drives home the point that there is no “magic formula” or easy button in this business. There are formulas and guidelines, but those need to be put into place along side your knowledge and education. It is a combination of all of these things that makes a smart investor. Great post.

    Sharon

  13. I agree with your point that all of these “rules” are just basic screening guidelines.
    A “2% property” may or may not be a good deal, but if it meets that rule of thumb it is probably worth doing more due diligence on it, like you showed.

    While I know the hypothetical was done to make a point I can’t not mention a couple things that jumped out at me. First is that neither place had management in there. Have it no matter what, even if you are doing it yourself put it in there because you might not always want to or be able to so it should cash flow with it. Besides when you are managing yourself your time and effort is worth something, that plug in is your salary independent or your investor profit.
    Anyway neither place had that so it is a wash and doesn’t effect the relative conclusions.

    However the CapEx and Maintenance numbers skew the analysis quite a bit.
    I won’t address the convenient scenario in the 2nd place where there is some CapEx coming up but not needed right away since the proper use of the “rule” is to include those expenses with the purchase price (Oops I guess that I did address that 🙂 ).
    On the “bad” 4-plex you still had an okay cash flow despite putting away a full 30% for repairs/maintenance and capital reserves. That is pretty darn conservative!
    One of the GREAT things about reserves is you never know when you will need them. Sure you guess that the roof will need to be redone within 5 years, but maybe it hold on for 10. Then you are cash flowing WAY better than expected that whole time.
    On the other side you only budget 5% for that with $0 specifically going to reserves. That 4 year old roof will eventually need to be replaced and you didn’t mention age of the heating systems there but even assuming they are pretty new they will need it too as some point. Also as nice as it is that they are separately metered that also means you have 4 heating systems which means it is 4 times more likely one kicks the bucket much sooner than anticipated.
    One of the LOUSY things about reserves is you never know when you will need them ( 🙂 ). If you aren’t putting anything away for that in your analysis then your cash flow goes out the window if something semi-bad happens.

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