2% rule in los angeles

[Sarah Jones]

i dont think the 2% rule works in los angeles... how is it possible to find a $2000 per month rent place for $100,000 this just does not seem possible... could anyone explain whether the 2% rule or 50% rule works in los angeles or what rule i should use instead?

[Jon Holdman]

First the "2% rule" only works for a narrow range of rents. It derived from this equation:

Cash flow = (rent / 2) - PMT(rate, term, purchase price)

The first part, "rent/2" is applying the 50% rule to get to "net operating income" (NOI) from the rent. The second part "PMT(rate, term, purchase price)" is the payment at your interest rate and term and assumes 100% financing. Now, 100% financing is unrealistic. Doing the calculations like this is assuming that you want some return from the cash you put into the deal. Any deal with cash flow with enough cash put into the deal. But that return is coming from your cash and not from the deal.

So, lets try a couple of examples. Say the rent is $500 and the purchase price is $25,000. This is a classical "2% deal" and is available in a number of locations. Not here in Denver and not in LA, though.

Cash flow = ($500/2) - PMT(5.5%, 30 years, $25,000)
Cash flow = $250 - $141.95
Cash flow = $108.05 a month

Now, of course you'll really need to put in a down payment. Assume this is 25%. So now we have
Cash flow = ($500/2) - PMT(5.5%, 30 years, $18,750)
Cash flow = $250 - $106.46
Cash flow = $143.54 a month or $1,722.47 a year
Cash invested = $6,250

Lets introduce another concept "cash on cash return". This is your annual income divided by the cash you have invested.

Cash on cash return = $1,722.47/$6,250 = 28%

Most folks would consider that quite a good deal.

What if the rent is $1500? What can you afford to pay? Lets apply a little algebra to this forumla:
Cash flow = (rent / 2) - PMT(rate, term, purchase price)
to get to a forumla for purchase price. The tricky part is knowing "present value" is the function that gets you from a payment to a loan amount.

PMT (rate, term, price) = rent/2 - desired cash flow
price = PV (rate, term, (rent/2-desired cash flow))

That formula tells you what you should pay. Lets assume desired cash flow is $100 a month.

price = PV (5.5%, 30 years, ($1500/2 - $100))
price = $114,479.15

To convert that to a ratio:
ratio = $1500/$114,479.15 = 1.3%

Even that may be tough in LA.

Now, lets add back in the down payment and see where this deal ends up.

Down: $28,619.79
Loan: $85,859.36
Payment: $487.50
Cash flow: $262.50 a month or $3,150 a year
Cash on cash return: 11%

Not as good a deal as the cheaper one (often the case.) Good enough for you? Only you can answer that.

Now, say you're convinced properties are going to appreciate and you're willing to kick in (i.e., lose) $200 a month on this $1500/month rental. What can you afford to pay?

price = PV (5.5%, 30 years, ($1500/2 - (-$200))
price = $167,315.67

Now, if you're willing to put in a down payment in addition to losing $200 a month, you can pay $223,087.57. After a 25% down payment, your loan is $223,087.57. After ten years, your total cash invested is $79,771.89. If we see 10 years of appreciation at 3% annually, the house will be worth $299,811.03. You sell it and net $272,828.04. You have to pay off the loan, now at $138,107.02 and pay back your investment (the $79K and change). That leaves you with net earnings of $54,952.13 and cash in hand of $134,724.03. Honestly not a stellar investment, since you've not even doubled you money after ten years.

OTOH, if we get 6% annual appreciation (unlikely, IMHO) the place will be worth $399,515.85 and you will have earned $145,683.52 if you sell. And you'll have $225K cash in hand.

So, if you goal is to have a savings plan, and you think we'll get some appreciation, even a cash flow negative deal might get you to the goal.

This may seem long and complex. It only seems like that at first. This formulas are readily available in Excel or any other spreadsheet. I typed all these calculations into Excel in a separate window as I was writing this. This is the kind of math you need to be able to do if you want to be in this business.