Applying the 50% rule to determine value

[Jeffrey Gordon]

2% - 50% rule Question

Hi folks, I have heard this rule this week for the first time (THANKS) and have been reading all the forum posts I can find about how it is used to screen etc. Will bevery helpful in convincing my son what the true operating expense range actually is for rental properties.

I am modifying some excel models I also picked up here this week and converting to my own version of decision making tools.

I am not clear on when you back into the "value" by taking 50% of Scheduled Rental Income as Net Operating Income do you assume you are going 100% loan proceeds with no equity? Or are you using some other model to get to the value.

illustration:

Duplex

Scheduled mo.Rental Inc $2,000

Less Vacancy 5% 100

Less: Other Op. Exp. 900

Net Income 1,000

Less: Profit per door/mo 200

Available for P&I 800

Rate 6% 30 yr Term

"backed in loan amount" $133,433

If you were putting some cash in the deal you would add it to the $133,433 to get to the purchase price, or you would only offer
them the amount the loan is?

thanks

jeffrey

[Jon Holdman]

Yes, that method makes sense. Both your weighted cost of capital and the 100% finance calculation are tools to evaluate the deal. Neither will reliability tell you the actual returns in an particular year.

A key in both of these calculations is how the down payment is handled. Very often sellers and their agents will make claims like "this will cash flow with 20% down". What they almost always mean is "if you assume zero cost of capital for the down payment, this cash flows". Both your any my calculation make it clear you CANNOT USE 0% FOR THE COST OF CAPITAL FOR THE DOWN PAYMENT. The 100% financing calculation assumes the same cost of capital for the down payment as for the loan, where you're using a higher value. I think that's actually better, but simpler to just do the 100% financing. So, its a matter of the level of detail you want to put into what's just a screening tool.

Where I will take a slight exception is in the treatment of principle paydown. Your calculation accounts only for the interest payment. Most properties are purchased with an amortizing loan. Even with a 30 year loan, there is a small amount of money going to principle. Given the small returns on most rental property, ignoring this can be significant. On a $100K, 30 year, 7% loan, the principle payment the first month is $83 a month. If you do your calculation ignoring principle paydown (as if typically done on commercial properties with a "total yield" calculation), and you come up with $100 as your estimated cash flow, then you'll really only pocket $17 a month. So, even though you will (hopefully) eventually get that principle paydown back, I would ignore it for purposes of evaluating a rental.

I caution against doing any sort of modeling assuming rent appreciation or property value increases. Yes, every now and then I look at such a model. But I realize it is truly meaningless. Predicting the future is absolutely impossible. Rents may rise, they may not. Values may rise (historically, STRICTLY based on inflation), they may not. You can be fairly assured expenses will rise. If you by a deal that works with a simple calculation right now, you can be fairly sure you'll at least stay above water in the future.

If you're determined to do such modeling, I'd recommend scenario planning. Build several sets of assumptions and model each. If the deal works well with some sets of assumptions, and OK with the rest, you're probably OK regardless of what happens. If it only works if a very specific set of future assumptions come to pass, you probably don't want that deal.

Lumpy expenses are covered in the 50%. In any particular month or year, for any particular property, expenses will not be 50%. Many, many months they will be much less. Then, boom, the furnace blows up, the roof blows off, the tenant freaks out, or the sewer line collapses, and you have a month of 1000% expenses.