How important are the 50% and 1% rules when buying SFR

Question

After some studying on Austin area and biggerpocket's teaching on real estate investment I'm trying to screen some homes in Hutto,TX and Round Rock, TX.

The idea of a duplex seems to be the best solution for me and my wife and our new born daughter, but I find duplexes rare in Austin area and often overpriced. Do you guys agree with me? I don't know the market that well, so I might be wrong.

So based on that I thought we should buy a single family home for a year or so, buy another and rent out the first, etc.

My problem is that some of the rules I can use to screen properties before I get into a deeper research seem difficult. If I use the 50% rule non of the properties I looked at will bring in cash flow, but instead I will just be covering monthly mortgage payment (principal and interest). As far as I understand you don't count in taxes, insurance.

Here is one of the houses I've looked at in Hutto, TX.

http://austin.craigslist.org/reb/4316979690.html

The listing price is $160K, 2000 sq. ft., 3 bed/2 bath, build in 2003, 8000 sq. ft lot.

According to this site (http://www.austinincomeproperty.net/sellers/) principal and interest will be around $850 with a 3.5% down payment ($5.600), which means the rent should be $1700 if I use the 50% rule. With the 1% rule (because the 2% rules doesn't seem to work in Austin unless I flip) I should pay $170K for the property, which matches the listing price, but no one in this area would want to pay $1700 in rent in Hutto, TX for a 3 br. Or am I wrong?

Jon Holdman · Answer

There's pretty good evidence that for a large portfolio of properties over an extended time the 50% rule is a pretty close estimate for the expenses, capital and vacancy.  For any one property in any particular year, the results can vary dramatically.

The 1% rule and similar ones are just a derived value.  Do your own math and estimate your returns using the 50% number.

Taxes and insurance are part of the 50%.  The 50% number also assumes you're using a PM.  If you're self managing you can earn the PM's cut.  Around here that's 10% of collected rents plus half to a full months rent to fill a vacancy.  So that's a very significant piece of the 50%.

Your strategy of buying (presumably with a low down OO loan), moving after a year and buying something elses is a strategy people sometimes use.  IMHO it has a serious flaw.  You need to find a property that meets all your needs for a place to live.  That's not so bad, assuming you and your family aren't too picky.  But then it also needs to make a good rental.  Finding good rentals, especially in hot areas like Austin IS very hard.  And the houses that are good rentals may not fit your needs for housing.  This approach is likely to result in you owning crummy rentals (ones that don't generate profit) or having to live in a house that doesn't really meet your family's needs.

I suspect you're doing that strategy to avoid the 20% down payments and higher rates for investment properties.  That can result in you being overleveraged on the property, which hurts cash flow.

You're trying to use these rules backwards.  You need to figure out what rent you can get by studying the market.  You have ZERO control over this, you just have to figure out what it is.  Then find a candidate house.  From its price, calculate your P&I.  Use the 50% rule (or, say 36% if you're self managing) to estimate expenses.  Now you can calculate cash flow.  Is it acceptable? If it is, buy that place.  If not, keep searching.

Many times your best opportunity is a fixer upper that needs significant work.  Many folks will pass these by because they can't afford to buy the house and do the work.  So, these command a higher discount than the work needed.

As far as your residence its just another expensive doo-dad.  Its not an investment, though you do hope it has some value.  But if you add up all the interest, taxes, insurance, maintenance, capital items, major remodelling, etc. you'll find that its a loser for an investment.  If you go to a jewelry store and look at diamond rings, the sales folks will say things like "its an investment".  The real estate industry uses the same sales tactics.  They try to convince you to spend a large amount of money on "the most house you can afford".  Boloney.  Forget about "starter houses", "move up houses", "mini mansions" and "downsizing condos".  The only folks who benefit from that strategy are the ones collecting all those commissions and fees.  If you're buying a residence (or a car, a TV set, clothes, or pretty much everything else) buy the cheapest thing available that meets your needs.  If you're buying a house to live in, buy one you're willing to die in.  And realize that renting is very often cheaper than buying and keeps your options open.

Andy Luick · Answer

@Chris Frydenlund - the metrics you find some of us using on BP are just a quick test for whether a property is worth pursuing or not...you have to take what we might be using (and I don't use them actually) in our respective markets and adapt it for something that makes sense in your market.  Austin is a hot, hot HOT real estate market and for a ton of good reasons...if I weren't so tied to atlanta, I'd be living there myself.  I've been successfully...and sometime unsuccessfully...investing in real estate for about 26 years now and I'm happy to share my thoughts with you -

To me, by definition, every homeowner is an investor...and for most, the single greatest investment they will ever make is where they live.  Here, you are blending want to live in a home that also produces income....I create shared housing and work with homeowners, investors & JV partners every day to accomplish the same thing.  However, as a homeowner/investor alot of what we are talking about on BP doesn't apply to you and I would suggest you proceed differently.

If you haven't already, I would get pre-qualified for a 203k renovation loan.  There are a number of lenders who offer this program and it is really the only way....outside of a pure cash offer which I am assuming you can't do....for someone like you to acquire most foreclosures. Austin is what we call a very tight rental market....lot's of people moving there and rents going up....not a ton of vacancies.  Same on the buy side.  Distressed sales of any kind will offer your best opportunity to buy and most distressed sale properties will require some type of repair/improvement or updating which usually also means that they won't qualify for conventional financing.  That spells opportunity for you....or is should future real estate investor.

Once you are qualified for a 203..make sure that lender also uses the streamlined version of that loan.  The major difference is that the 203k...which you can use for cosmetic AND structural repairs...will require you to use a consultant who will be their to review the scope of repairs and the contractor bid you select to make sure that they marry up.  The consultant is there to make sure everything that was contracted to be done...is done but he or she is not there to hold your hand through the process.  There is no up front money to the contractor and no self-help on your part....meaning you can't do the work yourself.  This loan allows you to purchase a home needing repairs and have those funds included in your mortgage.  The streamlined version of the 203 doesn't require a consultant and you can do all kinds of cosmetic things with the proceeds.....paint, cabinets, carpet, tile......but termite damage, water restoration or a new roof would be considered "structural" and you'd need the full 203k for that purchase.  Realtors have always hated this loan....but for someone like you...and I teach people this all the time....it's the best way to buy investment real estate over time.

The 203 allows you to purchase a home with 3% down and sometimes as little as a $100....even in Austin.  You can use the loan every 2 years as long as you keep you credit good....so you buy a property, live in it (probably rent a couple of rooms if you use my program) then rent it out fully in year two so that the rents cover expenses....and you can use the same loan program again to buy your next home to live in and repeat the cycle again.

Once qualified, I suggest you find a HUD agent in the Austin market and chat them up to find someone you are comfortable with.  You should also get recommendations for agents and investors in your area for suitable contractors who specialize in this loan program....not all do and you don't want to waste your time.  Your lender will have pre-approved contractors that they work with....I was a HUD validated contractor using the 203 for many years here in atlanta.  The program is awful for contractors....but perfect for homebuyers.

You can use the 203 to purchase multi-family...up to a quad I believe but you will have to check into that on your own.  Start hunting HUD listings in your area with the HUD agent you have selected.  HUD listings are great for you because they are often exclusively available to you as an owner/occupied for a certain period to bid on before investors can take a crack at them.  HUD also offers some repair escrows which means, once you make those repairs, you will get the money reimbursed from escrow..not bad at all.

So here's one I found for you....a 5bed/2ba for $114k.....sounds like a steal in Austin:  http://www.hudhomestore.com/Listing/PropertyDetails.aspx?caseNumber=495-844246&sLanguage=ENGLISH&zipCode=&city=austin&county=&sState=TX&fromPrice=0&toPrice=0&fCaseNumber=&bed=0&bath=0&street=&buyerType=0&specialProgram=&Status=0&OrderbyName=SCASENUMBER&OrderbyValue=ASC&sPageSize=10&pageId=1

Once you acquire the property, you can then land one or two housemates to share the home with you and provide cash income to pay the mortgage with.  You could do the same this with a duplex if it was large enough and, if you do this with a SFH in your market, you have an asset that will appreciate in value...in that type of market.  Many of us in our markets won't see any appreciation at all....and we don't care.  In the model I use, we often have more in the property than its FMV but with shared housing we value the property on net cashflow not appraised values.  My front and back end JV partners don't care about underlying values as much as they do about returns....and when they are seeing 20% to 40% or more on their capital (front-end) or 10% to 16% on the back-end...the FMV is meaningless.  For you, it's important to purchase something with some equity and you'll do that using the 203 and leveraging the skills of a good lender and a good realtor....not all are create equal.  You'll also find that a SFH will most likely sell faster than a duplex or mult-fam unit.  Duplexes are often bought and lost by first-time investors who aren't cut out to be landlords in the first place.  That's a whole different conversation.

Hope this helps!  Happy Investing.

Jon Holdman · Answer

Assuming that $400 payment is P&I only.  Taxes and insurance are in the $450.  The $450 set aside by the 50% rule also includes a PM, and if you're self managing, you can earn the PM's cut for yourself.

But you are discovering a fundamental truth about this business.  Most properties do not make profitable rentals.  You may have to look in different areas or further out to find an area that works.  From what others have posted here, DFW or Houston may be candidates, too.

Andy Luick · Answer

@James Mudd - Austin is full of professional workers seeking affordable housing as it's in short supply and extended stays or apartments can run $1,500 a month and more.  We have had quite a few inquiries to bring our MRR model to Austin and I'm sure we will get there.  We have a number of couples like Chris and his young family where we have placed one or two fully screeened and vetted renters...and its worked out very well.  What works for you might not be the solution for someone else....what we've found is that shared housing, with full background checks & personality matching....is an excellent way for someone in Chris's position to pay for the expenses of a home or save one from foreclosure.  We've saved a good number of homes in metro atlanta and help some recent homebuyers afford their payments by placing a good roommate.  Just something to consider.  If you're just going to do something like this straight off of craigslist...then you are right....I would not consider it either.  We are meeting with a single Mom today who needs to share a 5bed/5 bath home in order to keep it.

Lynn McGeein · Answer

Some areas are just too expensive, and we had to go 3 hours away from where we lived at the time to invest in real estate and make it work even with the 50% rule.  We've given up on the 2% rule as we like detached single family with large fenced yards and garages, so too hard to make that one work where we invest, although several were possible if we could have paid cash at the time and done extensive rehab (which we couldn't).  We do like the 50% rule and try to follow it and it's working very well for us.  I would like to stress that early on before learning more we thought it was fine just having the mortgage paid plus $100 a month or so extra to cover problems, (they used to say, You need the tax deduction, anyway ... it will appreciate, etc....).  It's not worth it.  If our investment homes won't at least really pay for themselves while we're paying them off, which the 50% rule seems to insure, then we find alternate investments for our money, dividend stocks or mutual funds, until we find something that does work.

Rolanda Eldridge · Answer

@Chris Frydenlund...Consider purchasing a property requiring rehab work.  It's difficult purchasing at retail prices and making money.   You can buy wholesale  at a great price and add value by completing minor repairs.  You need a great deal to make it work..

Walt Payne · Answer

@Chris Frydenlund They are not really rules, they are guidelines.

You are also using them wrong. The 50% rule says that over time you will pay approximately 50% of rent toward upkeep. But the mortgage principle and interest comes out of the other 50% ( but taxes and insurance are part of the upkeep).

The 2% rule says you want to try to get close to a rent that is 2% of the total money invested (not just the purchase price itself). Again, more a guideline and not a rule. But it is not used to set the rent, rather the other way around. It is a very rough, first test for screening properties to see if it might be a good deal. If it passes that test, then you figure out the real numbers so you can decide.

But you have to consider other factors, also. How old is the roof, HVAC, plumbing, what kind of neighborhood is it, what kind of tenants will that property attract? Those are all things that can effect how safe it is to stretch these guidelines. And even if it passes that test, will it involve a lot of time and work to maintain and/or manage.

If none of the properties match, it may be a market where they don' t work. Or it may be that you are not looking in the right places, Or in the right way.

Walt Payne · Answer

@Chris Frydenlund it comes down to risk factors. The more leverage, the more you can gain, but the easier you can lose it. Like many things in life it is finding the balance that works for you

Chris Frydenlund · Answer

Thank you guys! Great input. I appreciate all the helpful information.

Unfortunately, my wife isn't willing to have someone staying in our own home sharing bathroom, kitchen, living room, etc. and specially not with a young child.

I will use the 203K loan for sure. Looking at the math it seems to be smartest with a low down payment, when ROI is based on my down payment and closing cost. I know my mortgage will be higher and my cash flow will be lower, but it seems to me that I will still make best ROI with low down payment and lower cash flow. And with a 203K loan I can start investing with a small saving. I don't understand why people want to put down 30% in down payment. The down payment is so much higher than the extra annual cash flow you'll gain as far as I understand.

James Mudd · Answer

@Andy Luck @Chris Frydenlund  I believe he has a young family...with a newborn.  I would never have someone renting out individual rooms, in that situation.  The duplex idea would be best for Chris.  You will have a little more wiggle room in the numbers if you plan on occupying the residence for awhile.  So the "best" deal is not inherent.  If you are going to buy a home for yourself anyway, you mine as well get someone else paying the majority of the mortgage.

You will have to look into "upper scale" duplexes in order to find one you will feel comfortable in occupying.  So, you will pay a bit more...won't be a homerun type deal.

Good luck in your search...and keep us updated.

How important are the 50% and 1% rules when buying SFR

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