50% rule

[Jim McMillen]

noob here.....Can someone explain the 50% rule, 2.5% rule.....I can't seem to find a definition for it.

Thanks.

Jim

[Timothy W.]

50% of what you hear about real estate investing is crap.
Of that 50%, only 2.5% works in a down market.

Seriously, here's what it means. If you buy right - at least 50% of your rental income will be spent on expenses. The general guideline is that you want to get rental income that is at least 2% of the purchase price. I used to believe in 1% but 2% is certainly better....and 2.5% is even better than that. With REOs the way they are, I've been applying the 4-5% rule. :mrgreen:

[Ken Mitchell]

tim, i kinda liked your first scenario....

[Jeff Wilcox]

Tim,

What do you consider expenses? I.e. does it includes your debt service, taxes, insurance, + the all the other stuff (maint, advertising, vacancies, etc.), or does the 50% rule mean that in addition to your PITI you'll have other expenses that total approximately 50% of your planned rent?

Sorry to ask a basic one, but I'm still in the early stages of learning the property analysis bit.

Thanks
Jeff

[Timothy W.]

No sweat Jeff.

For me, expenses are everything that goes out of pocket (including mortgage) before income taxes are figured. Yes, PITI is part of that when I have it on a property.

That's the hard thing with some areas. Properties just cost too friggin' much to cash flow properly. I scanned Virginia Beach and saw that your cheapest houses there start at 150k. Unless rents are $3,000/month that's hard to cashflow. On the other hand, I've seen property that sells as low as $6,000 per unit after repairs. Not hard to cashflow that. Don't expect it to be a hot appreciation market though....lol.

Tim

[Michael Rossi]

Jeff,

The 50% rule is nothing more than the fact that throughout the United States, operating expenses run 45% to 50% of the gross rents for rental properties. Operating expenses include all the expenses that are associated with operating your rental business, but DO NOT include the mortgage payment (Principal and Interest). Operating expenses include (but are not limited to): taxes, insurance, management, maintenance, entity maintenance, advertising, utilities (at least during vacancies), legal fees, damage done by tenants (over the security deposit), vacancies, setouts, lawsuits, and capital expenses (not technically an operating expense).

There is no 2.5% rule. The 2% rule is simply a screening tool that says that you need the monthly gross rents to be about 2% of the acquisition cost of a rental (purchase price + rehab). Very simple math will tell you that if the monthly gross rents are not about 2% of the acquisition cost, the property will not cash flow properly.

Good Luck,

Mike

[Jeff Wilcox]

Tim, Mike,

Thanks for taking the time to answer my question. Tim, I've come to the same conclusion about Va Beach as well. The cheap properties aren't so cheap here.

Just to summarize my understanding. When I analyze a property, I should consider the following.

1. Can I set the rent at 2% of acquisition costs and have it be realistic/competitive in my area?
2. My cash flow analysis needs to consider....

Cash Flow = Rent - Debt Service (Princ and Int) - All other expenses (est at 50% of Rent)

So if you do a little math and want to figure a rough break even point on either the rent or the debt service, you can set cash flow = 0 and solve for one of the other variables.

e.g. 0 = Rent - Debt Svc - 0.5 Rent

0 = 0.5 Rent - Debt Svc

Concluding that .....

Debt Svc = 0.5 Rent OR Rent = 2 Debt Svc

Solving for rent will tell you what you need to charge given the acquisition cost of the home in order to break even. Or, solving for debt service will give you an idea (albeit subject to the details of your financing arrangements) of how much you can spend to acquire the property given the average/acceptable rents in a particular area.

I like bar room napkin math and this looks like a quick and dirty way to determine whether I should spend more time considering a particular property or not.

Please let me know if my conclusions are flawed.
Thanks again,

[Michael Rossi]

1. Can I set the rent at 2% of acquisition costs and have it be realistic/competitive in my area?

That would be great, but unfortunately you do not get to set the rent. The rent is set by the market. So, the real question is whether the market rents are at least 2% of the acquisition cost.

So if you do a little math and want to figure a rough break even point on either the rent or the debt service, you can set cash flow = 0 and solve for one of the other variables.

Why would you want a break even property? The point of being in business is to MAKE MONEY, not break even.

Or, solving for debt service will give you an idea (albeit subject to the details of your financing arrangements) of how much you can spend to acquire the property given the average/acceptable rents in a particular area.

THAT'S IT!

Good Luck,

Mike

[Jeff Wilcox]

Mike,

I couldn't agree with you more. I see no reason to get into this game to break even. It's a statement I've made to my wife many times before. My point was just merely stating the obvious that you can quickly draw the line in the sand with the simple math rule of thumb to determine where the (+) cash flow is and where the (-) cash flow is.

Despite the other sources of building wealth via REI (appreciation etc), I think the cash flow aspect will probably be my number one requirement. No (+) cash flow, no deal. While I think there are probably many reasons why one would buy an REI at a break even cash flow, I believe that I need to start slow and get a few wins under my belt before going there.

Thanks again for the education,

[Michael Rossi]

Jeff,

I would draw the line in the sand a little higher - at about +$100 per unit per month.

Good Luck,

Mike

[Richard F.]

MikeOH-

Do you include an exit value in the "income" side of your calcs? Why?

[Steve Shanes]

Jeff,

Personally, I'd rather distinguish (with rentals) like so, to create a method:

a. My policy: some parameters have to reach certain points before I buy.

b. My thumb rules: 2% is a bit higher but I've got mine, which I developed after a while and is still improving. The main thing about it is, let you determine if the property goes to step II - analaysing

c. Analysing - a complete analysis for the property that shows some scenarios, mainly the worse and exit strategies. Many times this varies a lot from what you have with the tumb rules. Analysis shows you what is your expected income, cashflow etc., but also shows you on a timeline at which point you are about to need a huge sudden amount of cash, and whether you've got it. It also shows you what's next.

d. Note: Important: your equations are correct but, most of the part of it are given! Of course, you can set cashflow = 0, but what does it mean, when the other parts are set by the market? So, you put everything in place and eventually get a couple of ratios. Then, you find the ones most important for you and check them. This is the right method.

e(and back to a - policy). What are these parameters? Depends on the scenario. Rental property usually what you are looking for is positive cashflow, of higher than X (personally, I'd rather include x in an early calculation and see if I got a positive value. This way I know I took everything into account, otherwise what's the meaning of this x?). You should also consider the following parameters as analysing basics: the return on invested capital ratio (it should be quite good, otherwise you could have invested elsewhere!), and the available financial resources left after considering the future plans.

Steve

[Michael Rossi]

Do you include an exit value in the "income" side of your calcs? Why?

No, because I don't intend to ever sell them. I'm in the rental business, not the slow-motion flip business. In addition, I can't eat future profits or go snowboarding with principal paydown, so they really aren't relevant to today's situation. If you doubt this, try taking a personal financial statement to Park City and see if they'll give you a lift ticket. I don't think so!

I am interested in only two things: CASH FLOW and EQUITY AT CLOSING. If you've got both of these, it's hard to go wrong.

Mike

[Timothy W.]

Originally posted by "MikeOH":
No, because I don't intend to ever sell them. I'm in the rental business, not the slow-motion flip business. In addition, I can't eat future profits go snowboarding with principal paydown, so they really aren't relevant to today's situation. If you doubt this, try taking a personal financial statement to Park City and see if they'll give you a lift ticket. I don't think so!

I am interested in only two things: CASH FLOW and EQUITY AT CLOSING. If you've got both of these, it's hard to go wrong.

Alright - EVERYONE MUST listen to this post. This post right here is the key to long term Real Estate investing success. Anyone who has made a successful career of real estate investing anywhere beyond 3-5 years and has been successful in both up and down markets employs these principles. Dynasties are built on these simple principles.

Ironically this is nothing new. Our system of real estate is built on the principles of feudalism that were founded by Charles Martel in the 8th century. These principles have been working for 12 centuries. (Where do you think we get the term "landLORD"?.) It doesn't take a brain surgeon to see that they will continue to work another century or two.

Great post Mike - hopefully one or two will listen.

Tim

[Mike Seluk]

Originally posted by "TimWieneke":

That's the hard thing with some areas. Properties just cost too friggin' much to cash flow properly.

So when you run into that, do you just move on to the next area, or try to put down enough to make it cash flow? Or is it a waste to tie up that kind of cash?

Where I am, things are still too expensive to make it work in my favor - and the market IS down. I'd have to be able to acquire something for ~40% below market value to get the numbers in the ballpark.

[Michael Rossi]

**********,

Here's an example of a property purchased for $50,000 with gross rents of $1,000 per month

Gross rents: $1,000
Operating Expenses: $500
NOI: $500

Mortgage Payment ($50K, 30 yr, 7%): $332

Cash flow: $168 per month

Hope this helps,

Mike

[Michael Rossi]

Cash down doesn't affect the quality of the deal at all.

Mike

[Timothy W.]

Originally posted by "FtMyersMike":

Originally posted by "TimWieneke":

That's the hard thing with some areas. Properties just cost too friggin' much to cash flow properly.

So when you run into that, do you just move on to the next area, or try to put down enough to make it cash flow? Or is it a waste to tie up that kind of cash?

Yes. I go somewhere else. I don't fish for trout in a bass pond. Do a radius check of about an hour and a half to two hours drive out from your location. Chances are you'll find a town that cashflows. If not, stretch a little further. I seem to recall some decent cashflow potential in Gainesville.

Tim

[Matt Batson]

How about investing in an area that is several states away?
I have a rental property in NC that is managed by a great company who I trust.
I am moving to FL this month.

This area of NC has lots of opportunities for cheap rental homes and we were thinking of expanding our rental investment there...despite the distance.
I may require a couple of trips up, but I could figure that into the cost.

Anyone else ever done this?

[Jim McMillen]

Originally posted by "TimWieneke":
With REOs the way they are, I've been applying the 4-5% rule. :mrgreen:

Tim,

When you are applying the 4-5% rule on REO's, is that based upon purchase price alone? I'm assuming with an REO you will have some pretty hefty rehab costs associated with it. Thank you!

Jim

[Jim McMillen]

Originally posted by "MikeOH":
Jeff,

The 50% rule is nothing more than the fact that throughout the United States, operating expenses run 45% to 50% of the gross rents for rental properties. Operating expenses include all the expenses that are associated with operating your rental business, but DO NOT include the mortgage payment (Principal and Interest). Operating expenses include (but are not limited to): taxes, insurance, management, maintenance, entity maintenance, advertising, utilities (at least during vacancies), legal fees, damage done by tenants (over the security deposit), vacancies, setouts, lawsuits, and capital expenses (not technically an operating expense).

There is no 2.5% rule. The 2% rule is simply a screening tool that says that you need the monthly gross rents to be about 2% of the acquisition cost of a rental (purchase price + rehab). Very simple math will tell you that if the monthly gross rents are not about 2% of the acquisition cost, the property will not cash flow properly.

Good Luck,

Mike

Mike,

I thought Columbus was potentially a good rental market but after looking at these 2 screening rules, I’m beginning to wonder. For example, here is a typical house that can be found:

Purchase price: $46,000
Gross rent/month: $600 (1.3% of purchase price – way below 2%)
Operating expense: $300
NOI: $300
Mortgage pymt: $306 ($46k, 30 yr., 7%), doesn’t include $82/month for taxes/insurance.
Cash flow: ($6.00)

Under this scenario, I’m guessing this would NOT be a good purchase. Any opinion with this “purchase”

Just so I understand the operating expenses, cash flow etc.

Operating expense= 50% or rent

Using my example above, the $82/month for taxes and insurance would come out of the operating expense bucket of money, thus this would leave me $218/month ($300 minus $82 = $218) to go towards expenses such as new roof, vacancy, marketing etc.

Cash flow =

Rent: $600
minus Operating Expense: ($300)
equal NOI: $300

NOI: $300
minus Mortgage pymt (principal/interest only) ($306)
equals: Cash flow ($6)

Am I viewing cash flow and operating expenses correctly? Thanks again for all your help!

Jim

[Timothy W.]

Originally posted by "all_star":

Originally posted by "TimWieneke":
With REOs the way they are, I've been applying the 4-5% rule. :mrgreen:

Tim,

When you are applying the 4-5% rule on REO's, is that based upon purchase price alone? I'm assuming with an REO you will have some pretty hefty rehab costs associated with it. Thank you!

Jim

I used to assume too. It all depends on the area you're in.

Tim

[Michael Rossi]

Jim,

Yes, you got it right! The only thing wrong with the deal you posted is that the price is too high. I wouldn't consider the deal unless the acquisition cost (purchase price + rehab) was about $30,000.

Good Luck,

Mike

[Dave Kennedy]

Originally posted by "MikeOH":
Jeff,

The 50% rule is nothing more than the fact that throughout the United States, operating expenses run 45% to 50% of the gross rents for rental properties. Operating expenses include all the expenses that are associated with operating your rental business, but DO NOT include the mortgage payment (Principal and Interest). Operating expenses include (but are not limited to): taxes, insurance, management, maintenance, entity maintenance, advertising, utilities (at least during vacancies), legal fees, damage done by tenants (over the security deposit), vacancies, setouts, lawsuits, and capital expenses (not technically an operating expense).

There is no 2.5% rule. The 2% rule is simply a screening tool that says that you need the monthly gross rents to be about 2% of the acquisition cost of a rental (purchase price + rehab). Very simple math will tell you that if the monthly gross rents are not about 2% of the acquisition cost, the property will not cash flow properly.

Good Luck,

Mike

I've heard these rules before. I haven't seen a single property in Mass(4 units or less) that have gross rents at 2% of acq costs.

I mean how can rental units be sold for cashflow up here? In any semi-remotely attractive area around Boston you are pay 300K minimum for a 2 family that might fetch 1500-1800 a unit. Thats not even close and the example I gave would be a "steal" in relation to some of the garbage I see out there.

Maybe all the sources I am looking at just have all the stale deals that are out there.

[Mike Seluk]

So what do you do in MA then? I mean, it's the same thing here in FL, and the only thing I can think of is to come to the table with enough cash to make the numbers work...but then you have a bunch wrapped up in it.

But I'm talking about putting ~30k into the equasion, not 100k+.

[Michael Rossi]

So what do you do in MA then?

If you can't make money in MA then I would either move to a location where you can make money or run a different business. Real estate is just one of thousands of ways to make money. It is not the be-all, end-all of the world. Someone is making money doing something in MA!!!

Good Luck,

Mike