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…
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:
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:
Monthly Gross Income: $2,000
Vacancy (10%): $200
Maint. (5%): $100
Cap Ex: $0
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!
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:
Monthly Gross Income: $2,400
Vacancy (10%): $200
Maint. (10%): $200
Cap Ex (20%): $400
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…
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