Sanity check: 50%/2% rules fail. Could this still be a good investment?

Question

I am looking for some input on one of my first (potential) deals; I am currently under contract to purchase but wanted to see if the #s below make sense to other more experienced investors.

I am asking because I just came across the suggested 50% / 2% screening methods and at first look it does not meet their criteria.  However, my due diligence (what I have used until now) shows it making more (not a lot) cash flow.  Are these designed for certain types of investments?

FYI, I am planning on managing myself and making repairs/remodels (should result in higher rent) myself as well as needed.  I saw that if this is the case you can get away using 35% which is closer to my assumptions.  I have received historical expenses from the seller e.g. utility bills, management fees, new taxes based on sale price…and used it in my own spreadsheets but no not want to end up tweaking it to my favor (I do not think that I have if anything I have overestimated expenses).  These are the #s “as is” but like I have mentioned there is untapped potential that makes it slightly more attractive to me.

Please let me know your thoughts, or if more info is needed…

Using 50% Rule:
8 unit (prime location poorly managed, definite room for improvement and higher rents)
Sale Price = $250,000 (30% down $175,000 loan amount)
Equity = ~$85,000
Gross Income (-5% vacancy) = $47,424
Operating  Expenses  (50% Rule) = $23,712
NOI = $23,712
Debit Service = $17,721
(So far our best financing looks like 30% down, 6% for 15 yr fixed for 10)
Cash Flow = $5,991  
($62 per door shouldn’t I be shooting for $100+ ?)
Cash on Cash:  7%

Using 2% Rule:
Sale Price = $250,000
Total Monthly Rent = $4,160
= 1.6%

My Calcs:
Cash Flow = $826/month
Cash on Cash = 13%
Cap Rate = 11%

Do these seem out of the question, or within reason?  Is this a good investment, I know that it is not great...but could it be good?
I just need some reassurance or warnings (this deal s*cks), my nerves are acting up...

Kenneth LaVoie · Answer

Jon
I have a spreadsheet I use that lets me input actual known expenses, like insurance, taxes, oil, elec., sewer, water, etc. and then lets me input my own percentages for (self paid) mgmt, repairs, etc. I also add INITIAL cap. improvements to my purchase price. Even if I'm going to spend 6k per year for 3 years, I'll add 18K to my purchase price to add some padding. I don't know if this is "right or wrong" but it seems intuitive to me.

I then factor vacancies and repairs based on building type (i.e. low income, might need more work than my cap. imp. allotment, vice versa). So for lower income distressed building I might go 10% vacancy and 15% maint. For nicer, "low mgmt" duplex I might do 7% vacancy, 10% maint. I NEVER go lower than 10% maint. becuase I do very little work myself and I sometimes over spend due to inexperience (getting better though!)

This usually ends me up in the 60-65% expense/gross income range vs. the 50% rule for multis and 40-45% for SFH's.

I'm happy to share the spreadsheet with you. Just email me and I'll "send er' along".

Final note: the 2% rule does "skew" depending on # units, rent, etc. I use it only as one more test to make sure I'm at least on track.

Joel Owens · Answer

Jonathan what is the age of the building?? If it's over 30 years many insurance companies won't touch it or the policy will be really expensive.

Insurance companies see the 30 year mark as a key indicator of plumbing,electrical reaching life expectancy along with roofs etc.
Many won't write the policy unless electrical,plumbing,roofs have been completely replaced and NOT repaired.

The 50% suggestion ( I choose not to call it a rule ) because there are many other factors I consider is based on normal repairs over time. It is NOT based on going in with a bunch of deferred maintenance to the property.

You might look at less of a percentage in maintenance costs with showing bumped up cash flow by the seller.Do not be deceived by this as the seller has let things go and patched things to increase cash.The problem is then fixing to be dumped into your lap.

7% vacancy is very,very light.Have you looked at the sellers Schedule E tax returns??

An older building with the repairs can wipe out any cash flow for years.If you are investing this kind of money you really need to partner with someone in your area to be your advocate and show you things you do not know to look for.

If any utilities are paid by the landlord is a huge one.With inflation coming around the corner utilities could spike and annual rent increases would not follow at the same pace.This would make you have diminishing returns over time.It would be better to have utilities on the tenants paying it as the cost would be paid by them and you preserve your margins.

Joe O · Answer

Sure, that's a good idea for him to upload it here, if he's willing.   :mrgreen:

Mike McKinzie · Answer

Here is the way I use the 50% rule, others on the forum can correct me if I am wrong.

You take the TOTAL MARKET RENT that the property would bring first, NOT the collected rent.  Then you take 50% of that and include in that expense your vacancy.  For instance, if the total market rent is $50,000, then your expenses, including vacancy factor, is $25,000.

Things to consider when using the 50% rule.
1.  If you manage it yourself, that is still a 10% cost, YOU MUST PAY YOURSELF FOR YOUR WORK.  You can't manage your own property and say that your expenses were only 40%
2.  You have to use Fair Market Rent.  Charging lower rent does not reduce your expenses and charging higher rent will usually skew the vacancy factor.  Using collected rent will really skew things as the years that there are more vacancies are usually the years that you do more repairs.
3.  You have to be honest with the actual expenses.  Many landlords have spare parts in their garage that they use to make repairs, and then they don't count the cost of the materials.

As for the total return on the property, you have to also calculate in your Tax Benefits.

Someone else mentioned the 2% rule.  To me, 2 percent usually means 2 sidearms to collect the rent.  For some folks, that is their niche.  For me, I prefer rentals that go for more than $1,000 although I do have some that fall between $700 and $1000.

If there isn't too much DM, then this looks like a fair to average investment.

Raymond B. · Answer

Joe O.:

This site has file sharing.
Click on resources, at the top of the page.

Raymond

Joe O · Answer

Kenneth, I'd love to see a copy of that spreadsheet. Any chance you can upload it somewhere (Google Docs or a file sharing site like Dropbox) and post a link?

Brian Kilner · Answer

I understand the math behind including future possible tax hikes etc.  But wouldn't there be an industry wide rise in rent due to market changing expenses?  Wouldn't you be able to account for those kinds of changes in the market with raising rents and not have to account for them now in current rents?

Jonathan Sowinski · Answer

Yep, have them in there, I figured X amount set aside per month until I hit the estimated replacement cost by the time I anticipate having to do the work.  I just wanted to see if anyone factors these larger individual expenses differently in their analysis.

Kevin Yeats · Answer

Jonathan, If the county announced that it would raise property taxes on all properties, would you factor that into your calculations?

The same applies to known future expenses like roofs, electrical wiring, heating and water heaters.  If you know that you will need to replace/repair these items in the next few years, factor that expense into your calculations.  Neglecting these future expenses cuts into your profits or lowers the property values.

Jonathan Sowinski · Answer

Yep, every unit has its own separate gas meter and in unit furnace/heater one has a fireplace that is rated for use as a heating device.  So they pay their gas bills that covers heat, cooking, and hot water.

Sanity check: 50%/2% rules fail. Could this still be a good investment?

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