Elements of the 50% Rule Applied to MFR?

Question

I need a numbers guru to help me un-tangle some math fundamentals. I have a deal in process that I can still walk away from and I'm hoping someone can help me validate whether this is a reasonable or unreasonable purchase. I'll give you the background and numbers first, then follow up with a couple specific questions.

Property details:

-- Duplex, in short sale status from probate (owner died without having his legal affairs in order so his estate didn't make the payments). Currently has a tenant on one side and the owner's side was just remodeled, so it's move-in ready. This led to a mild bidding war.

-- I am using my veteran's VA mortgage guaranty to buy it so I'll live on the remodeled side and pocket the other side's rent. Agreed price was $160k plus I took the closing costs, plus I have to pay a VA funding fee (about 2.3%) Total financed is about $168k with NOTHING out of pocket. This price is about in line with comps so I'm basically paying retail, but it's tougher than expected in my local market to find a motivated seller with a move-in ready duplex where one side is available (per VA guidelines I'm required to personally occupy the property)

-- Gross rent equivalent = $1,700 -- but for now I'll only be able to collect $800 from the renter's side. I'll be factoring in my portion of the rent for the sake of our math. In a couple years I will purchase a single family home for us to live in, then rent out both halves.

-- PITI expected total is $1,094 monthly (Mortgage + interest $781, property taxes $220, insurance $93)

-- Deferred maintenance estimated $8k total (non-urgent items like flooring, paint, kitchen cabinets) of which I have the skills and tools to do much of it.

The questions:

1.  The 'magic 50% rule' postulates that half of gross rent will be spent on maintenance issues averaged out over a period of time. Specifically, what then is the cash flow measured against -- PITI or PI or just P? Calculating against P and PI gives me cash flow, but PITI puts me in the red. I'm not happy about how close this deal is to the break-even point so I want to make sure I'm not wandering through a minefield; I earned the VA benefit that way and I'm not interested in doing it again.

2.  I plan to use a property management service since I don't want him harassing my wife about unclogging his toilet after dinner. Do I factor management into the 50% rule or is their fee above and beyond?

3.  Is the conventional wisdom to plan separately for Capital Expenditures and General Maintenance, or are they both included in the 50% rule? Perhaps the more precise question here is, What exactly does the 50% rule account for?

4.  What do you make of this deal? Is it a financial bombshell or can I proceed with some confidence? I know I'm not going to make a killing on this one but if it's a viable deal, then it's at least a start. I've been trying to nail this first deal for almost a year now. If nothing else I can slowly build a modest cash reserve and use equity to make a better deal with more speed and flexibility -- but it all hinges on this first one.

Thanks in advance for your guidance. The BiggerPockets community is great and I appreciate you all.

Matt Deibel · Answer

@Chris  K. I think its a great goal.  And continue reaching out as items come up, the folks on BP love to help.

Chris K. · Answer

Hi @Matt Deibel -- Unfortunately I have to agree that it's not the kind of killer deal that I'll be able to brag about in the forums :-) But you hit the nail on the head -- my goal at this point is to get a property in my portfolio so I can learn some of the hard lessons and get the experience I need to make the next deal a better deal. My main reason for asking for insight is that I don't want to go through closing only to find that I made a catastrophic mistake. So often we "don't know what we don't know" so I would rather ask for help now, while I could still back out, than carry a load of pride so heavy that it causes me to stumble. Thanks for your input, I appreciate it.

Matt Deibel · Answer

@Chris  K.

I'd have to see the actual operating costs from history to make a qualified judgement.  But I think there are better deals to be had elsewhere.  The only kicker is you are getting this with your VA loan for 0 down.  With that being said, I don't think this is a bad investment necessarily.  It will be great experience getting your feet wet and I think it will cash flow if managed properly.  The only other major concerns I can think of are the roof, the neighborhood, and the age of the property.

Brie Schmidt · Answer

PM me the details and I will run it with you.

Chris K. · Answer

Hi @Brie Schmidt @Ronald Perich and @Roy N. , Thanks for chiming in so quickly.

I should clarify that I read the BP Beginner's Ultimate Guide but had not found the one for rental properties; it's next on my reading list. I also should have noted that I used the Calculator and it indicated that I'm a little on the safe side of break-even. The numbers I'm using are from my lender and are within a couple percent of the actual figures (due to not having locked in the rate yet). The rental income I quoted is based on a market analysis as thorough as I'm capable of performing, and I always use what believe to be conservative numbers (I'm a worst-case-scenario type planner). I currently live in this part of town so I'm reasonably familiar with utility rates and operating costs, which I used in the Calculator tool. The tenant shared with me that his family has been there 3 full years and isn't planning to move out anytime soon.

I guess my underlying concern is that all the greatest tools and calculators in the world are only as accurate as the assumptions you put into them and that's where I'm stuck. I need more experienced investors to point out the minute granular details that I'm probably not aware of yet but need to be.

Roy N. · Answer

@Chris  K.

Firstly, a duplex is really still a residential property (anything from 1 - 4 units).   That pedantic technicality aside, Brie is spot on: the 50% rule is a simple a back-of-the-napkin or in-your-head litmus test to determine if a deal is worth further pursuit.

Before getting serious about an offer, you want to get *real* numbers for all the operating costs, along with vacancy/bad debt/eviction/turnover history, some knowledge on the area and the tenant clientele and perform a full analysis on the property.

Ronald Perich · Answer

@Chris  K. I'll point you to The Ultimate Beginners Guide to Real Estate Investing (at http://www.biggerpockets.com/real-estate-investing...)...

"The 50% rule is a great rule-of-thumb that helps you to fairly-accurately predict how much your expenses are going to cost you each month for a property. The 50% rule simply states that 50% of your income will be spent on expenses -- not including the mortgage payment. As mentioned above - most real estate listings will let you know what the monthly income of a property is. By dividing that number in half, you are able to easily see how much you'll have left to pay the monthly mortgage (principle and interest). Any income left over, after the 50% of expenses and the mortgage payment are taken out, is your cashflow. The 50% of expenses includes all expenses, including repairs, vacancies, utilities, taxes, insurance, management, turnover costs, and the occasional "big ticket" repairs that must be saved up for -- aka. CapEx or Capital Expenses like roofs, parking lots, furnaces. (emphasis added)" So only PI is considered in this rule-of-thumb.

You might want to quickly review The Ultimate Guide to Analyzing Rental Properties (CLICK HERE). It gives a nice breakdown of costs to consider when reviewing a property.

Hope this helped.

Brie Schmidt · Answer

The 50% rules is a guild line, but it is that 1/2 your rent will go to expenses less mortgage.  So that includes utilities, tax, insurance, management, repair, ect.  It is really just a quick way to estimate costs.  I suggest you put the actual numbers in the BP calculator

http://www.biggerpockets.com/real-estate-investmen...