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 me

Yes, 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!

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

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