I just had an idea, if we could figure out the maximum amount of dollars we could pay for a property per $1 of monthly rental income we estimate the property will bring, we would have a very easy way to figure out how much we could pay for a property.
For example if I estimate a property will rent for $600 per month, and I had pre determined that $66 was the most I could pay per dollar of monthly rental income, then I would come to the conclusion that I could pay $39,600 for the house.
$39,600 @ 7% 30yr fixed = $264/Month. So I am within the 50% rule
My question/idea is how do we figure out how much we can pay per $1 of monthly rental income.
I'm pretty tired, maybe I'm making things more complicated than they need to be...
Is this a good idea?
The point is that there is no reason to pay retail for a deal and lose money on it every month. You can buy property at a discount and actually make money while you're building wealth.
Good Luck,
Mike
How are you determining the amount per dollar of rental income?
If you are looking at the max price to pay for a long term buy and hold - take the rental income and divide it by 2%
Example - $600/.02 = $30,000
Your example based on your assumptions doesn't fit in the 50% rule - monthly rent = 600/2 = $300 - debt service of $264 = $36 of monthly cash flow.
Not to say you have to follow these rules, but I don't know what you are trying to accomplish. I'm sure someone else will chime in.
What's your investment strategy?
The formula is pretty simple, but it doesn't work out to a specific amount you can spend per dollar of rent. That's because you want a certain amount of cash flow, regardless of the rent. A tenant is a tenant, and has about the same amount of effort whether they're in a $500 rental or a $1000 rental.
If you just want to hit break even, you can come up with a number. The answer is $75. Here's how I got that:
Rent: $1
Expense: $0.50
NOI: $0.50
Desired cash flow: $0
Max payment: $0.50
May loan: $75 (7%, 30 years)
If you pay that, you'll be break even.
However, if you want $100 per unit, then for $1000 in rent you can pay only $60K
Rent: $1000
Expense: $500
NOI: $500
Cash flow: $100
Max payment: $400
Max loan: $60,123
At $500 in rent, though, you can only afford to pay $22,546 because you max payment is only $150. $100 out of $250 NOI is a much bigger hit than $100 out of $500 NOI.
That's why I don't much like the 2% rule. It works OK at rents of about $500, but puts the price too low at higher prices.
The 2% Rule is merely a screening tool. It allows you to screen a property in your head in about 5 seconds. If the gross rents are close to 2% of the acquisition cost (purchase price + rehab) or more, then it is worth spending another 60 seconds to do a cash flow analysis. If not, then move on to the next property.
You can compare that to the old 1% Rule that used to be bandied about. The 1% Rule (monthly rents of 1% of the purchase price) will virtually guarantee that the property will not cash flow.
Mike
How much down payment are you guys talking about in your examples ?
In my calculation a 1% property is good and will cash flow with 20 to 25% down.
Or are you guys talking about 100% financing ?
I've always found the same thing as Jon. I've never used the 2% "rule" and have posted so many times here. I don't buy the lower rent properties. Normally older properties and weaker tenants.
Michael- you're going at the numbers wrong. There are many on here that will explain which #'s to use on the 2% method.
Michael,
The 2% Rule is very easy and has nothing to do with the financing. As I said, it's a screening tool, but it is very effective at giving you an idea if a rental is a potential deal or not.
Very simple, the 2% Rule says that the monthly gross rents need to be at least 2% of the acquisition cost (purchase price + initial rehab).
So, to determine the maximum acquisition price (purchase price if no rehab is needed), you divide the monthly rent by .02 or multiply the monthly rent by 50 (which is exactly the same thing). For example, if the monthly rent is $600, you multiply that by 50 to get a maximum acquisition cost of $30,000. Subtract any initial rehab from the $30,000 and you'll have the maximum purchase price.
As I've said, the 2% Rule is a screening tool. If you use the 2% Rule to come up with a $30,000 purchase price and you can get the property for $32,000 - then it's worth doing a cash flow analysis. If you use the 2% Rule to come up with a $30,000 purchase price and you will have to pay $50,000 for the property, I wouldn't even give it a second glance!
As for the downpayment, even the worst property will "cash flow" if you put down a big enough downpayment. Putting down money to buy cash flow doesn't change the character of the deal or turn a bad deal into a good deal. There is an opportunity cost to your money and you definitely should consider that!
Mike
Mike and Rich, thanks for the clarification, I understand that it is a screening tool and that the ultimate properties should meet the 2% rule.
Now there are a lot of areas where that's not possible and I am thinking that even at 1% you can become rich with cash flow if you put about 20% down each time.
I am pretty sure I fully understand the 50% rule. It states that if your gross rent is $1000/ month, you should count on only $500 a month income after taking out expenses such as maintenance, tax, ppty insurance, ppty management fees and vacancies. From that $500 you deduct your mortgage payments and what is left is your true positive cash flow.
Now I still maintain that a ratio of 1% can be pretty good if you put 20% down, you will have in most cases true positive cash flow.
Am I missing something ?
By the way, I am new to this forum, but I love this place and love being around pple who share my interest.
Scan this board often, and you'll get a lot of differing views. That is healthy. Rich in TX.
The point is that there is no reason to pay retail for a deal and lose money on it every month. You can buy property at a discount and actually make money while you're building wealth.
Good Luck,
Mike
MikeOH, that was the best explanation I could hope for. While I already understood that concept, now I really understand what you guys were talking about.
I guess I didn't think that it was actually feasible to do much better than a 1% ratio.
I now will have higher expectations and try to learn from you guys to make those 2% deal happen without placing large down payments. That would indeed fast forward my way to bigger returns, maybe infinite returns if no downpayment at all.
Every new purchase I realize I could do it better and expect better on the next purchase, learning as I go, I love your explanation of opportunity cost..
This site really inspire me.
Thanks
Another way to look at the 1% rule is to go to an annualized basis. 1% monthly rent means the annual rent is 12% of the purchase price. If 50% of that is expenses, etc., then your NOI is only 6% of the purchase price. One way or another, you have to come up with the entire purchase price, and there is a "cost of capital" for that money. If you finace 100% of the purchase at 6%, then your cost of capital is 6%. So, you'll spend the entire 6% NOI on the capital, leaving you nothing for cash flow. In reality, cash flow is even less because you'll have the interest payments.
If you consider your own money is worthless, and you put 20% down, then your cost of capital become 80% of 6% or 4.8%. That gives you a return on the deal of 1.2%.
Personally, I don't think my money's worthless. For sure I can get 2-3% in bank CDs. With hard money loans, I can get up in the double digits. Further, my cash is hard to come by and I don't want to invest it in just anything. So, with a 20% down payment I'd consider my cost of capital to be over 6%.
Not to mention I think getting a 6% loan right now for investment property would be stupendous. Heck, I'm beginning to think getting any loan is a miracle.
Jon, you mentioned hard money loans, and they are in the double digits. Do you use them successfully and if so, how would you structure a deal to make money on a property that cost for example 50k before rehab, needs 10k or rehab and would rent for $1200 a month after rehab. I am interested to know how to make money on such a deal without using conventional financing or seller's financing ?
a break down please.
Michael
In your area deals that meet cash flow are almost non-existent. The average price house in the area is lucky to get 1/2 of 1% per month rent. So I would avoid making buy and hold my base activity unless your going to do business elsewhere where it makes sense..
And from an investors viewpoint on any money i put down I want a return on it too, it isn't free, it would produce income elsewhere if it wasn't sitting as equity so you need to figure the lost income on a down payment as a cost factor too.
Brian,
Yeah I don't buy in my area, too expensive, I have 2 rentals in Austin cos' I thought Austin was both good for cash flown and a strong univesity white collar city.
Now as I m not satisfied enough with the cash flow in Austin, so I am about to start investing in Dallas Fort Worth area where cash flow in superior to Austin. I am happy to learn as I go.