low cap rate, 50% rule = negative cashflow?

[Stephen M.]

Hi BP community,

 I'm a new potential real estate investor in the Seattle area.  I happened upon the BiggerPockets podcast and found it to be very informative and am since hooked.  The discussion is fantastic and very engaging.  

I've since read a couple of books from the BP recommended list and have done some analyses of multifamily housing in my general area, including some analyses of recently sold properties. I am considering investing for cash flow primarily, and building equity secondarily. From my readings and discussion with a realtor, the cap rate in my area is in the 4-6% range. In my calculations I used the 50% expense rule and assumed the information on the MLS and various realty websites are pro forma, rosy, and best case scenarios. With this said, all that I have seen and calculated result in negative cash flow.

The example is below from a recently sold property, with financials from the realtor website, and my calculations:

Duplex

Sold price: $385K

With 20% down payment: $77K

Loan amount: $308K

With conventional 30 year 4% fixed loan, yields a monthly mortgage payment of $1470/month

Combined monthly rent (from website): $2350/month; $28,200/annual

50% expense rule : $14,100/annual

Thus, net operating income (NOI) $14,100/annualized; monthly is $1175

capitalization rate : NOI/purchase price : 14,100/385,000=3.7%

cashflow: monthly NOI $1175- monthly mortgage payment (1470) =-$295

I understand you can look at comparative rents in the area to see if the rent is below market value and do some forced appreciation.  However, for a new investor and landlord, it would seem a leap for me to think I can do better, or at least risk a negative cash flow monthly for this gamble.  

Are buyers hoping for appreciation to bail them out? Am I wrong in my calculations?

Thanks,

Steve

[David Faulkner]

CAP rates do not apply to duplexes. Those are considered residential real estate and trade based upon comparable sales, not a multiplier of NOI (CAP rate).

Don't use the 50% rule ... it is garbage. Expenses do not scale linearly with rent as the rule implies. This is especially true for expensive markets like the one you reside in. Instead, you need to determine the individual expenses based on actual expenses on that property if possible, or estimates that are derived from experience to that market (an experienced property manager may know if you do not) and/or validated with independent research.

Finally, cash flow does not equal profit. It is a small slice of it, but not the entire picture. Other factors contributing to (or detracting from) profit are ignored at an investors own peril.

IMO, you have some research and learning to do on fundamental financial analysis before you should even think about investing. That is not intended as an insult. We all started there at one time or another. It is advice, though, that you should understand the nuances of the statements above before putting your own and/or somebody else's capital at risk.