50% rule and Refi

[Bryan P.]

Obviously a wise person would put away 6 months to 1 year of operating expenses for any property. Assuming that one did this, when following the 50% rule, is the property then labeled "self-sufficient?"

If this is true, one would theoretically buy alot of properties with not alot of reserve/emergency cash and credit. (Oh wait, that's me.) Am I thinking correctly here?

I'm trying to determine whether I should refinance my two properties into longer terms so I can actually meet the 50% rule. Before I started reading BP, I didn't know any of this and I had already acquired the two properties on 15 and 10 year notes (stupid). So now I have two properties that aren't even meeting 25%, let alone 50%. I'll lose thousands of dollars by refinancing due to closing costs, but it might be worth it.

[David Beard]

Bryan -- you have great questions and should be commended. There are several rules of thumb here to keep up with, I think.

Gross potential rent - you want this to be at least 2% of your cost (purchase+rehab) per month if rents are in the $500/mth range. As rents go up, you can lower this target. A reasonable way to do this in many areas of the country is to subtract about .1% from the 2% target for each $100 that your rents are above $500. So for a nicer $1,000/mth property, you can use 1.5%. This reflects the flat reality that nicer properties are going to command a price premium when you buy, for a lot of reasons, and generally would be expected to hold their value better and attract better/longer term tenants, and offer easier resale to a retail owner/occupant buyer should you need to sale.

Expenses - assume these will be 50% of your gross rent (in this context, expenses includes vacancies, taxes, insurance, prop mgmt, repairs, replacement reserves). While it's reasonable to assume that the operating expense ratio will decline modestly for nicer properties with higher mthly rents, please always assume at least 50% to be conservative!! (Also keeps you out of arguments on this site!)

Net Operating Income (NOI) = Gross Potental Rent less Expenses. When taken as a percentage of your cost (purchase+rehab), this is the "cap rate", or net yield.

Debt Service Coverage Ratio (DSCR) - this is NOI divided by your P&I payment. For small residential rental property, you generally want this to be 2.0 or better (I target 2.5). I think you were confusing this with the 50% expense rule. This is where the loan payment comes into play. To protect your cash flow, you generally want your amortization term to be at least 20 years, and preferably 25-30.

Net Cash Flow = NOI minus P&I. This is where some say they want at least $100/unit, but obviously that should be scaled to the value of your investment in the property. If you keep your DSCR above 2.0, AND your Cash ROI above 20-25%, you’ll be fine.

Cash Return on Investment (Cash ROI) = Net Cash Flow divided by Cost. Keep this at 25% or more for $500/mth properties, and you can relax it toward 20% for 1,000/mth properties.

True ROI (ROI) = Net Cash Flow + Principal Amortization, then divide that by the Cost. This is your true economic return, but the Cash ROI is more important in KEEPING YOU AFLOAT should bad things happen.

Fully Indexed Cash Flow â€" if you’re using bank ARM loans, recompute Net Cash Flow assuming the highest possible rate on your Adjustable Rate loan (ARMs, see below), generally 6% higher than the initial note rate for most ARMs. For simplicity, just recalculate everything with the note rate 6 points higher (some banks actually force you to qualify at this higher rate), and see if you still have positive cash flow. The target is (you guessed it) that you still have positive cash flow.

Just put this stuff in a spreadsheet. It’s very simple. You need to specify minimum targets for Gross Potential Rent return (1.5%-2.0%), DSCR (2.0), and Cash ROI (20-25%), Fully Indexed Cash Flow (at least zero). The properties need to pass these tests.
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You can most definitely get 25-30 year amortization loans from both conventional lenders (secondary market, lowest rates but harder to qualify) and in-house bank lenders (banks keep these loans and have much more flexibility in qualifying you, lower fees, quick close, personal relationship with lender; BUT bank will generally not lock the rate for longer than 5-7 years). If you need to use an in-house loan, try to get an ARM that will remain in effect for 30 years.

A standard 5/1 ARM at a small bank would be fixed for 5 years at around 6.50%, then begin floating with annual resets at 1yr Tsy+3.50% for the remaining 25 years, would be limited to a 2% rate change each year, and 6% over the life. So it would never go higher than 12.50% for the 30 year term of the loan. That rate may sound shocking to you, but please consider that in a hyper-inflationary environment, you will be able to increase your rents due to the sharp growth in the renter pool. If you’re levered at 75% and your interest rate eventually goes up 6%, then to keep the same cash flow your cap rate needs to expand by 4.5% (6% * 75%). An increase in your cap rate from 12% to 16.5% is an increase of 37.5%. Thus if you can increase rents by 37.5%, then you have completely preserved your cash flow. And the loan rate can only move up 2% per year, so there is time to gradually push the increases through your leases. And note that to be conservative you should assume that your Fully Indexed Net Cash Flow is still positive with no rent increases whatsoever.