Appreciation, 50% Rule, 2% Rule, or a Mixture?

Question

I'm looking at buy-and-hold properties in Jacksonville Beach trying to determine if certain properties are worth looking into more. I've been reading about the 2% Rule and 50% Rule, both of which seem pretty unattainable in my area. This is mostly because purchase prices are almost exclusively over $200,000; which I realize deflates the 2% Rule, but I'm curious how much the 50% rule is effected by higher purchase price? Multi-family homes seem more investment-friendly in this area due to the 2% rule, or even 1-1.5% rule, being less necessary because most monthly expenses will be less of a percentage of my total costs in a duplex compared to a SFH.

Houses in this area will appreciate, especially since they are near the beach, and Jax Beach neighborhood is random ( Every other street is high-end, every other street is a bit run-down ), but over-all improving. If I'm looking for a long term buy-and-hold (+/-10 yrs) at the beaches, is the appreciation value more important than the 2%/50% rule? Is 1% too low if appreciation is probable?

Jeff B. · Answer

@Edward B. got it right - - it HAS TO CASH FLOW or you're wasting time, effort and $$$.  Appreciation is 'non-actionable' meaning there's nothing you can do to even make it occur, let alone become any percentage you might desire.  I consider appreciation as a 'gift from the RE gods' for trying to be a good landlord.

Russell Brazil · Answer

As you go up in price on properties often (not always) you do not need as high of a price/rent ratio in order to cash flow decently.  I try to target properties at the 1% rules as opposed to the 2% rule for my cash flow plays. The reason for this is as properties become more expensive, your capital expenditures and repairs will become a lower percentage of your property. Take for instance a 1500 square foot property in the midwest valued at $50,000. To replace the roof on that property it might be $5,000 or 10% of the total value of the property. Now take a 1500 square foot property in a major metro area like Boston or DC valued at $450,000.  Now there is might cost you $6,000 or 1.3% of the value of the property. So in many cases these expenditures will become a smaller percentage of the value of the property, thus the price/rent ratio can be lower but actually yield you a better return.

Charles Marshall · Answer

I ran a few scenarios to see what drives a non-cash flow property at fully leveraged to perform better than a positive cash flow property that required a down payment.  These scenarios assume that you have cash available for a 20% down payment.

Assumptions:

$260,000 purchase price

5% / 30 year fixed rate mortgage

$2000 rent

Expenses are equal to the net cash available from rent less mortgage payment (0% down).  Expenses are fully inclusive of vacancy, operating expenses, repairs and maintenance, capital improvements.

What I found is that the investment return and the desired exit year are the two factors that drive the decision of making a down payment or not.

As an example, if your exit year is year 30 of the mortgage, a 2.198% return on investments will yield the same net worth if you put 0%, 20% or 100% down, but ONLY at year 30.  If you're exit year is before year 30, it's better to put down as much as possible.

If the investment return on spare cash is more than 2.198% (let's say 4%), your net worth is greater at any point before 9 years with 20% down.  After 9 years, your net worth is greater if you put no money down.

Any investment return less than 2.198%, you'll have the greatest net worth at any point by putting the most down you can.

Remember that this is dependent upon the other assumptions.  What I'm trying to show that if you take out the mantra that "positive cash flow is required" and you're measuring your success on your net worth, it's possible to have no cash flow yet end up better than if you put money down just to get your positive cash flow.  But keep in mind that it depends on your investment return and your desired exit point.

Just food for thought.  If anyone would like the spreadsheet I used to determine this, please ask and I'd be glad to share.

Gino Barbaro · Answer

@Thea Linkfield

I remember all too well 2008.  If you bought in 2007, chances are you are not back to the 2007 levels.  Over there LONG haul, you will see appreciation, but more linked to inflation, around 3%.  If people focus on appreciation as a return, it is risky. You buy for cash flow and actual performance. DOn't make the same mistake I did back in 2007, very painful.   I now go by the motto "it's not what you buy, it's what you pay"

Gino

Edward B. · Answer

@Thea Linkfield,

I just read your question a little bit more closely. Is it naïve? eh, I don't know that I would go that far. You should at least know that you could be break even or even a little down in that time frame as well. I see houses around here that still are not getting what people paid for them 10 and 15 years ago. Personally, I don't think we will experience another crash like we did, but very few people saw that one coming too.

So theoretically even if you are beak even at least someone else has been paying your mortgage and building equity. However, with the illiquidity of RE and transaction costs so high you might not be doing as well as you think. Then we would have to get into a discussion about opportunity cost. You could have invested in CDs and not suffered any of the headaches or drama and done just as well.

Playing the appreciation game in RE is the same as trying to time the market in stocks. Very very few people are any good at it. But if you are cash flowing, that tends to change the entire dynamic of your investment.

Gabe G. · Answer

@Thea Linkfield

A few things to consider. 1. a very bad market could put a hurting on any appreciation or equity pay down, that's why most want cash flow from day one. 2 For that expensive of a house, 200 dollars is not going to be enough to take care of capex and repairs. General estimates are 8 percent for maintenance, 8 percent for capex, that would be $320 dollars, so you really aren't break even, you are negative cash flow. Add in some tenant damages, or lengthy evictions and you are  farther in the red. Sometimes rent's go down, what if rents go from 2000 to 1700 in that area?, now you are farther in the bed. While you can buy in places where you think appreciation might happen. Buying where the house stands on it's own two legs and cash flows from day one, gives you some wiggle room, when things don't go as expected.

But in general, yes appreciation(hopefully) and equity pay down are part of a buy/hold strategy.

Edward B. · Answer

@Thea Linkfield,

You can assume appreciation I just wouldn't bet on it. If your investment is dependent on appreciation to be successful then you are just rolling the dice. Many many investors have gone down in flames playing that bet.

@Charles Marshall,

Yes you are still building wealth but there is no room for error. Many a company and individual has gone bankrupt, not because they weren't worth millions, but because they couldn't pay there bills. They aren't bankrupt because they have a negative net worth, they are bankrupt because they are insolvent. If you are playing it that close to the wire where you are just break even, the slightest hiccup could sink you and force you to sell or liquidate at a much larger loss. I actually stole the "cash is king" line from stock investing where I stick to companies with lots of free cash flow. Sure companies like Amazon and others made it big by going cash flow negative. But for every one of those there are hundreds that went belly up. The same is true of real estate. For every investor that made it big with negative cash flow in the beginning there are hundreds that lost their shirt. The vast majority of people who have been in this business for a long time, let alone weathered the crash, know to make sure your investments cash flow.

Thea Linkfield · Answer

@Charles Marshall and @Gabe Gordon : You guys are having a portion of the discussion I was getting at.

If I hold a property in a good/growing part of town, and pay off the mortgage every month (for next to nothing, because of rental income), I would be growing my equity. I'm not talking about owning 30 properties. Let's say, for the sake of argument, I only have 1 at $260,000. I've put 10% down ($26,000 not including closing costs), so I'm paying mortgage, insurance, taxes, and repairs. Let's say it rents for $2000 a month - this will be reduced to $1833/month including 1 mo. vacancy/yr. Not including repairs, monthly costs: $1117+$291+$133+$100(PMI)= $1643 (accustomed to taxes/insurance in my specific area). This leaves about $200/month for repairs to break even (As taxes go up, rent will go up). I hold the property for 15 years, with net cash flow of $0.

Assuming no appreciation/depreciation: At the end of 15 years I've spent $26,000 but only owe $151,642 on a $260,000 home. If I turn around and sell it right there for the same price,  I've made $82,358. $5,490 / year.

Now, @Patrick Britton @Gino Barbaro and @Edward B. why can't I assume at least a level of appreciation? I chose this specific area because of the estimated appreciation value, being on the beach, in a developing block, and with a 15 year period. If there is a crash, I can ride it out and continue to rent. Am I naive in thinking this?

Assuming appreciation: Let's say at the end of 15 years, the property has appreciated 20%. I've now made $136,358 in 15 years. $9090 / year.

Gabe G. · Answer

@Charles Marshall

You are right equity pay down is a part of the equation. However, relying on just equity pay down, is a riskier game, than having a property pay you 200-300 a month after all expenses +equity pay down.

There are a ton of way to make money in real estate, some are riskier than others.

Charles Marshall · Answer

Thanks @Gabe Gordon.  I agree with your comments about bad times, vacancy, etc.  But I'm ruling out appreciation altogether between my two scenarios.  I'm strictly talking about equity earned by making mortgage payments (reducing your principal balance) versus positive cash flow.  So looking at both of my scenarios, they're both creating wealth.  I agree that you shouldn't rely on appreciation.  Don't get me wrong, a positive cash flow investment is desirable if you're looking for passive income.  But if you're trying to build wealth, it can be achieved by no cash flow and negative cash flow investments as well.  Thanks for the feedback.

Appreciation, 50% Rule, 2% Rule, or a Mixture?

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