Is it okay to flex on the 50% rule for recent improvements?

Question

I'm looking at a 2-unit property, and I want to make sure I'm not letting my emotions get involved. I LIKE this property, but I'm not sure if the numbers add up:

Since late 2008, the previous owner has replaced roof, siding, furnace, and A/C. The larger of the two units (where the previous owner lived for several years) is immaculate with good paint, new-ish bath and kitchen, nice carpet. The other unit needs a full aesthetic makeover, but the seller is realistic about adjusting his price accordingly.

If I applied the 50% rule, this thing falls short of my cash flow goals based on what I can rent for in the area (in 2-4 unit props, I consider less than $100/unit unacceptable). Of course, I can't use hard numbers, either, because recent maintenance records and/or Schedule E's would show an inflated maintenance cost average.

Would you consider it okay to factor maintenance and management costs at LESS than 50% for a recently updated, immaculately maintained property? Or would I be stretching numbers to make them work just because I want them to?

Jon Holdman · Answer

The 50% rule applies to a lot of properties over the long term. Over the short term results can vary a lot. I'm replacing the sewer line on one property right now and that bill alone will eat up 55% of the total rents for that property. Fortunately I've had a few years where actuals were considerably below 50%. My point is actual results for one year aren't very meaningful for the long term. If you assume a smaller number you will be in trouble when these large and irregular but inevitable bills come along. Now, if you self manage you can earn the PM's cut. That's significant. Based on filling one vacancy per year at half a months rent plus 10% of collected rents, that's 14%, almost a third of that 50% number. IMHO, though, its a mistake to attribute that income to the property. That's money you earn by doing the PM's JOB. If your intention is to scale up and live off the passive income, at some point you realize you've traded your day job for a PM job and your dreams of living off passive income are dashed.

David Morrow · Answer

Elizabeth Colegrove - surely I'm misunderstanding you. It sounds as if you base your ROI on NOI rather than cash flow? Or by "without debt service bring counted" are you simply omitting equity acquisition through mortgage pay-down from the equation? This will be purely NOO investment prop with cashflow the primary focus, and long term equity secondary. At the time of the OP, I was including taxes and insurance in the debt service part of the equation instead of the expenses part. I looked back at some older posts to find that I was wrong about that, and my adjust equation tipped to just barely meet my standards. Since then, negotiations have progressed so that I'm looking at just over 10% CAP rate, and over 25% Cash-on-Cash return, even with barely over $100 per unit cash flow.

David Morrow · Answer

Jon Holdman - excellent point about the cost of self-managing. I am currently employing a PM, since the travel requirements of my job relegate me to an absentee owner. I never would have thought, though, to consider a management s expense even when it is only my time being spent.

Elizabeth Colegrove · Answer

Depends on your plan/goals. We personally never meet the 50% rule. I personally base it on the interest rate of my cash is making. For example, if it was a $30k down payment and I made $6,000 a year after expenses than I am making 20% on my money. In that case, I am doing better than the stock market. This is without appreciation or debt service being counted. Yes I am doing the work myself regarding management. Yes it can be a headache. If I was investing in the stock market I would be doing the research myself (been burned counting on others). Are you buying this as a pure investment or is it going to be a personal property for a few years? If you provide more detailed numbers, we could look at it closer.

David Morrow · Answer

Thanks, Jon Holdman. Not what I wanted to hear, but very likely what I needed? Everybody else out there feel the same?

Jon Holdman · Answer

IMHO, no. Much of your maintenance and management is caused by tenants. So, new, newly remodelled or old, you have much of the same work. Management costs will creatinly be unaffected by the newness of the house. Paint will need to be touched up or perhaps redone between tenants. Carpets might last as little as 3-5 years. Hopefully you'll get some years out of fixtures and appliances. New roofs and furnaces will get you 20 years, so you have a nice long period to save up for new ones.