Is this correctly passing the 1% and 50% rule?

Question

First of all, feel free to read over this, Its mostly me writing out loud.

I've got a duplex I'm looking at purchasing. The basement is being very nicely remodeled and will be finished next week. The upstairs is rented by a cat lady (3+ cats) who doesn't bother to turn on her bathroom vent fan so she's creating some problems. The property is listed on the MLS but it has just gone into foreclosure and the attorney will take over any moment it sounds like. The asking price is 145k while comps are averaging 127k for the area. Rent currently is $690 but could probably match the $900 Zillow predicts.

Following the 1% rule: 1% of ARV is $1270 a month. Divide by half because I'll be living in it so one unit needs to pay at least $635 towards mortgage payments which is already covered by the current upstairs renter ($690).

Following the 50% rule: Half the 1% rent of $1270 is $635. I can bump up the current renter to $735 so I have $100 bucks extra over the monthly mortgage payment of $532. This is calculated on a $105000 loan with 4.5% over 30 years.

In reality, at the price of 105000, with the current rent bumped to $735 from $690, this deal passes the 50% rule and 1% rule. Almost no new repairs are needed. What else is missing?

Jon Holdman · Answer

Hey, nothing wrong with cats! We have three. A place you live in is nothing but an expensive doo-dad. That's OK, because you have to live somewhere. This is an OK deal in my book, if you can really get $900 rent for a price of $65,000. Actually better than OK, pretty good, really. If the rent is only $690, its not as good, but not horrible. Another way to look at it is as two separate purchases. You're paying $262 a month P&I for a property that rents for $690. Half that is $345, so you're ahead by $83. The other half is your residence. You have P&I on that of $262, plus all the other expenses associated with owning a property. So, as for any place you live in, its cash flow negative. If you want to be a landlord, cash reserves are key. At a minimum, six months PITI. Better is six months rent. That $6000 sewer bill was painful. But not really a big deal. The tenant is still there despite a few nasty (literally!) days. It was about 10 days from when they first called until the sewer line was fully replaced. And the only time they really had no service was during the initial clog when I was trying to get someone there and when the contractors were actually working on it. Having the cash in the bank is essential to dealing with these inevitable hiccups.

Steven J. · Answer

Well Dangit @Jon Holdman you are a great devils advocate but I've always appreciated your comments. You stand out as the stop-dreaming-guy which is needed in this industry. So again, THANK YOU! You definitely cleared up a lot of questions I had about how those rules worked when you intend to owner occupy. I think this is a case of me not wanting to see the obvious answer of "I'm paying $690 in rent PLUS the mortgage" because the numbers work in different scenario. I'm very thankful you pointed this out. I'll recheck this again to make sure I understand the rules and how I should properly apply them. And if it indeed doesn't work out, its okay, because the cat lady seemed like she's more of a cat lady than I can handle. THANK YOU!

Jon Holdman · Answer

For analysis of a rental property I would start by ignoring the fact you'll live in one unit. And forget about "I can bump the rent..." Maybe you can. Maybe you immediately generate a vacancy if you do. If that's want you want and plan accordingly, fine. But if the property already has tenant use the rents its currently getting. If you're willing to deal with a vacancy right away (and the resulting make ready costs) and you have strong research to support a higher number (i.e., something more than zillow), then you can do the analysis with a higher number. You're applying the rule backwards. The two inputs are the rents you can actually get and the price you will actually pay. Divide monthly rent by the price. What's that percentage. 1% is the classical threshold for an acceptable rental. I find its often too low. In the case, rent is $1380 (I think) and the price is $145K (until you actually negotiate something lower) so this ratio is 0.95%. If you can really get rents of $1800 the ratio improves to 1.24%. But you never, ever use 1% of the price as the rent. The 50% rule say 50% of the gross scheduled rent will go to expenses, capital, and vacancy. So if rents for the entire property are $1380, then $690 will go to these items. From the remaining $690 you have to cover your P&I payment (taxes and insurance are in the 50%). With the $532 P&I payment and you living in one unit, this actually looks like: $690 (collected rent) - $690 (vacancy, capital, expenses) - $532 (P&I) = monthly loss of $532. At the very least you will be paying taxes and insurance each month. At a guess, I'd put your PITI payment at about $650. So, if you collect the $690 and have no other expense that month you'll be able to keep $40. Some months, though, you will have some other expense. Maybe its small, like a $300 furnace repair. Maybe its big like a $6000 sewer line repair (back in the summer for one of my rentals.) You'll be out of pocket for any of those. Now, if you're self managing, you won't be paying a PM. So, you'll be earning that money by dealing with the tenant. So, the outcome is better than predicted by the 50% rule. You might say "I'm in one unit, so expenses will be less." There's some validity to that. I assume you won't trash the place and won't have to be evicted (in spite of being a complete deadbeat and never paying a penny in rent :-)). OTOH, we tend to do stuff to our residence that we wouldn't do to a rental. So, I'm not sure you can make any big adjustment here.