Real estate investor’s have come up with a lot of rules of thumb, most notably the 70%, 50%, and 2% rule. But how useful are these rules? Well, let’s put them to the test:
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The 70% Rule
This is my favorite rule of thumb. Basically, it goes as follows:
To figure out what your strike price on a deal should be, take the After Repair Value (ARV) and multiply it by 0.7, then subtract the rehab expenses (R), and that’s your strike price.
Strike Price = (0.7 X ARV) – R
Some include holding costs in the R number, some do not. Some also prefer to use the a formula that aims at getting a certain profit number, which is also a good way to go about it. But overall, this is still a really good tool to see if you are in the ballpark. Since you can run this calculation in your head, you can figure out almost immediately whether what a seller wants is close enough to move forward or the deal just needs to be dropped before you waste anymore time on it.
So for example, let’s say you estimate a property is worth $150,000 and the rehab is $20,000. So $150,000 multiplied by 0.7 equals $105,000, minus $20,000 equals $85,000. And let’s say the seller says they won’t take a penny less than $120,000. Well, you can probably move onto the next deal.
However, just because this rule is good doesn’t mean it’s perfect. As Will Barnard points out in his podcast with regard to luxury housing, the 70% rule doesn’t hold as well with really expensive homes. That’s because margins are so much bigger. The same could go for really inexpensive homes. So let’s break it out to show why. We’ll start with that $150,000 home.
ARV = $150,000
Purchase Price: $85,000
Commission = $9,000 (6%)
Closing Costs = $1,000
Rehab Costs = $20,000
Holding Costs = $4,000
Total Costs = $119,000
Profit = $31,000
That’s a pretty solid margin, and even if you go $5,000 over on your rehab, or sell the property for a little less than you think, you will do just fine. But as you can see, if you added a zero to each number for a luxury home, the margin would be a really nice $310,000. That sounds great, but it also means you have a bit more room. And in order to get the deal, you may have to go a bit higher than 70%. (Although be careful—there are rarely good comps for luxury homes, as they are all custom, so don’t get carried away with your ARV.)
But let’s look at cheaper homes. These are usually not very good for flipping because the margins are smaller, and that gives you less room for error. After all, a roof costs the same on a $50,000 house as it does on a $250,000 house. So cheaper homes usually make better rentals or wholesale deals than flips. But if you do flip one, you will want to use something less than 70% for the calculation, as you can see from this example:
ARV = $75,000
Purchase Price: $32,500 (70% ARV minus R)
Commission = $4,500 (6%)
Closing Costs = $1,000
Rehab Costs = $20,000
Holding Costs = $2,500
Total Costs = $60,500
Profit = $14,500
Using the same formula, your margin is substantially less than half. Now, what if you also needed to replace the HVAC when you originally thought it was fine and misjudged the sales price? All of sudden, you might have done all that work just to lose money.
The 70% rule should always be verified by running the hard numbers. But it should also be adjusted to fit the cost of the house. And in general, flipping in cheap areas isn’t recommended. It still makes for a solid rule of thumb, though.
Overall Grade: B+
The 50% Rule
The 50% rule states something like the following:
For any given apartment complex, the operating expenses (not including debt service) should be about 50% of the operating income.
I = 0.5 X E
The rule is ok at best. For one, cheap apartments often need to be turned over more because of higher tenant turnover (and more damage), which means that maintenance and turnover expenses will actually be higher on cheaper apartments than decent apartments, which goes opposite of this theory.
Older buildings also don’t have as good of insulation or HVAC and require more maintenance than newer buildings. And rents are usually less in older apartments. Furthermore, other cost-saving amenities or features (such as solar panels, small courtyards or parking lots, no interior common areas, etc.) are ignored.
It also takes property management as given. A property that is performing very well will not only bring in more income, but because you aren’t wasting money on vacant units, turnover, and utilities, your expenses will be lower too. So this rule neglects the major question of “how hard is this property to manage?”
Finally, expense ratios will usually vary based on how much of the utilities the tenants pay. Yes, if it’s all bills paid, you can usually charge more in rent. But I have found, and many others have said the same, that that increase is less than what the utilities cost in total. Therefore, the ratio of income to expenses will vary based on utilities.
The best tool to evaluate what an apartment’s expenses will be is an operating history from the seller. Failing that, trying to patch a pro forma together from every piece of information and experience you have is second best. The 50% rule comes in in a distant third. It has some use, but it should never be relied on.
Overall Grade: C
The 2% Rule
I’ve written about this abomination of a “rule” before, and the English language doesn’t have the words to describe my contempt for it. In short, it goes like this:
For a buy-and-hold property to cash flow well, the monthly rent (MR) should equal 2% of your total costs into the property (TC).
0.02 X TC = MR
The 2% rule holds everything constant to the point of absurdity. As noted regarding the 50% rule, the monthly rent and the operating expenses do not go up hand in hand. This is especially true for cheap houses. (And I should note, regarding cheap apartments, I would throw the 50% rule out the window as well.)
The problem is that you can have a very good, cash flowing house that only has a rent/cost ratio of 1.5%, or even less. But if you have a home in a war zone, it could have a 5% rent/cost ratio, but it doesn’t matter because the area is so bad, tenants rarely pay rent and often destroy your house. Such a property won’t cash flow, no matter what the 2% rule says.
This rule is also dangerous because unlike the other two, to hit it, you usually have to aim at the worst areas in town. For most investors, and new investors especially, this is investment suicide. Rent/cost ratios can be useful, but only when comparing like to like. When comparing across asset classes, they are not only useless, they are downright dangerous.
Overall Grade: F-
Investors: It’s your turn to weight in! Do YOU think these rules hold much (if any) validity?
Let me know your thoughts in the comments section below.