50%/2% rules do not lead to wealth?

Question

I joined BP not long ago and learned about the 50% rule and 2% rule. Perhaps I don't understand these rules completely?.. Intrigued I sat down today to crunch some numbers:

Assumptions:

Expenses = rent*.5

rent = .02 * value of property

Debt Service (5% for 30 years assuming 25% down) = .2013 cents per dollar (constant amount)

Math:

per $1 of rent, expenses = $0.7013

$1 - .7013 = .2987 income per dollar of rent

I want to earn 100k/year on rental income

(X rent)*.2987 = 100,000

100,000/.2987 = $334,784 rent income per year to give me 100k income

Rents are 2% of value..so 334784 * 50 = $16,739,203 in real estate required to produce these rents

Down payment on all this property = 16739203*.25 = $4,184,800 cash required to purchase these

100k return for 4,184,800 invested = .02389 = 2.39% return.

Assuming 2% REAL appreciation (5% nominal - 2-3% assumed inflation)

Real Return = 4.39%

These rules suggest I need 4 mil in cash before I can retire with my goal income and the rate of return looks terrible. Stocks suddenly look amazing. Where am I going wrong? Is my math wrong or am I not understanding the rules?

Eric Bowlin · Answer

@Sharad M. Thanks for catching it. Though it was a rather silly mistake, glad I went through the exercise. I'm very analytical so it helps me really get deep into understanding the numbers and the general rules of thumb.

J Scott · Answer

Your math is wrong (I didn't dig in to find out where, but based on your results, it must be)...Think of it this way (without even having to use a calculator):If you're getting 2% of the purchase price per month and are spending 50% of that on expenses, that's 1% of the purchase price per month in cash flow. 1% of purchase price per month in cash flow is 12% of purchase price per year in cash flow, or a 12% cash-on-cash return. So, to generate $100K in income, you'd need to invest $X at a 12% return -- solve for $X and you get about $833K. In other words, without leverage, to generate $100K per year on a property that hits the 2% and 50% rules, you'd need to invest $833K of your own cash.Now, if you add in positive leverage, you can expect that cash infusion to drop...let's do the math:You assumed 25% down, 5% interest fixed for 30 years. That gives the 2%/50% property a cash on cash return of about 28.7% (I plugged it into a spreadsheet). Again, solve for $X at a 29% return, and you get an X that equals $349K.So, if you leverage based on your parameters, you'd need less than $350K to hit your $100K pre-tax income goal.

J Scott · Answer

You didn't fail...you succeeded in verifying (and critically thinking about) something as opposed to just accepting it because others say it's true.Something that a lot of people confuse about the 2% and 50% rules though -- they aren't UNIVERSAL rules...they are rules OF THUMB (the term "rule" is often confused). 2% rule of thumb doesn't say you need to buy 2% properties, just that if you buy a 2% property, there's a reasonable chance (see exceptions disclaimer below) of generating decent returns. 50% rule of thumb doesn't say that every property, every year, in every location will throw off 50% expense ratio, just that a long-term, diverse average is about 50% (see exceptions disclaimer below).Of course, there are of exceptions to both of these rules of thumb. For example, war zone areas won't necessarily get you great returns on a 2% property because tenants will be so tough. And high property tax areas will often generate higher than 50% expenses. There are certainly other exceptions as well.But again, when you think of them as rules OF THUMB as opposed to UNIVERSAL rules, it starts to make more sense...

Eric Bowlin · Answer

@Jeff S. I can beat the 2% rule very handily if I buy an REO that is really run down and I fix it up. I cannot get more than 1-1.5% if I buy anything at market value that needs little or no repair. I avoid these 'good' properties generally.I try to do well by controlling costs and managing my own properties.

Eric Bowlin · Answer

ok I couldn't wait to do it later. It was bugging meYes, I did 100k/year but the 2% rule is monthly.Really is should be calculated 8333/month...means you need 27898/month in income..this equals 1,394,900 in properties.Sounds a lot better now!

Sharad M. · Answer

@Eric Bowlin I didn't look to see if all your math is correct, but this is one big error:2% rule is based on monthly rent, but your $334,784 number is annual rent. You would need monthly rent of $27,899 and using 2% rule on $27,899, gives you value of $1,394,933. This will help your bottom number.

Ron Drake · Answer

@Eric Bowlin divide 334,784 by 12 then see what you come up with.

Jeff S. · Answer

The real question is can you keep 50% of rents using 2% properties and what does it take to manage them? @Eric Bowlin Are you getting 2% on the type of properties you are buying? If so then you are on your way.

Dawn Anastasi · Answer

The "2% rule" states that if you believe a property will rent for $1,000 per month, and it will cost $10,000 to fix up to get it "rent ready" then you should spend no more than $40,000 to buy the property.1000 / 50000 = .02

Eric Bowlin · Answer

@J Scott I agree. I don't like rules so I try to break them. Guess I failed this time. Better luck next time!