50% rule and the 2% rule

[N/A N/A]

I thought I had heard another investor say that the two rules were basically the same thing. Maybe I misunderstood, but if not could someone explain how they are the same thing??? And also, the 2% rule seems to work best when searching for properties under 100k. It seems that rents are a larger portion of the purchase price the lower the purchase price. Hope these make sense.

THANKS!!

[Jon Holdman]

They're related, but are actually two separate rules of thumb. The 50% rule is that operating expenses and vacancy are about 50% of the rent.

The 2% rule says if you can find a property priced such that the rent is 2% of the purchase price, it will cash flow. Note that you cannot use this to figure out what the rent should be. The market dictates the rent. Rather, you have to use it to determine how much you can pay.

The 50% rule is an emperical rule from observations of many properties. I've seen it other places than posters here. For any particular property, esp. a SFR, it may be less in some years. But, all it takes it one big expense to go way over and bring the average up.

The two rules do work together. If you collect 2% of the rent each month, you're collecting 24%/year. If expenses eat 50%, your NOI is 12%/year. Interest will probably run you about 8%. That leaves you 4% of the purchase price each year as profit. If you only collect 1% each monty, and pay 50% in expenses, that leaves you an NOI of 6%. Interest is going to take all that and 2% more. If you have an amortized loan, you'll have a bit less cash each month, but you'll get that back when you sell.

Sometimes people say, well, I'll put a big down payment on the property to try to make a higher price work. Say 50%, and assume 1% rent. You still have the same 6% NOI. But, now your interest cost is only half, or 4%. So, it looks like the property cash flows 2%. If you look at it that way, you've invested that 50% into an investment that returns nothing. Or, if you look at it as a cash on cash return, you're 4% on your money. Less than bank CD's.

Reflex, you say its impossible to find a property in your area that will cash flow using these numbers. I assume you really mean its very hard to find a property that meets the 2% guideline. True in many places, including right here. But, if you pay more, you won't make any money.

Jon