50% Rule/ 2% Rule in expensive areas - is my reasoning correct?

Question

I'm looking at properties in Chicago and these rules of thumb are basically impossible. I've been listening to the podcasts and reading about the deals, and the numbers are always for these cheap areas, whereas I'm looking at reasonably good neighborhoods in Chicago.

My thinking is that while the property values will be much higher in Chicago, the rent won't be similarly higher (i.e. I can get 800/month rent on a $50,000 house in Texas, but there's no way I'm getting 8,000/month rent on the typical $500,000 property in Chicago, with 4,000 or so being more normal). I doubt this means nobody is making money in Chicago rentals.

My thinking is this: the 50% rule might mean I can expect 400/month in expenses in Texas, but I'm not going to see $2,000/month in expenses in Chicago. Fixing the same number of toilets isn't going to be proportionally more expensive, so that kind of expense will be lower as a proportion of the real estate value/gross rent.

Am I on the right track here?

David Faulkner · Answer

Congratulations! You have spotted early on that these rules of thumb are garbage by applying a bit of common sense and actual thought to it. Keep it up, couple it with some hard work, and you will go far in this business. The downside is that the apostles of these worthless rules of thumb and members of the church of cash flow on cheap low quality ghetto houses will constantly blast you on BP and label you a speculator for daring to suggest that money can still be made on more expensive, higher quality properties, in higher quality neighborhoods. To do that, you will need to understand what, how to analyze, and how to exploit ALL the profit centers of RE:

• Cash flow throughout the lifetime of the investment. Hint: rent and expenses do not stay constant.
• Appreciation throughout the lifetime of the investment. Forced appreciation in the short run and market appreciation in the long run. Hint: short term market appreciation is very hard to predict but long term historical averages can give you a good idea about long term market appreciation (over 10+ year hold periods), and it can be negative after inflation even in the long term so never ignore it even if you are in it primarily for cash flow.
• Tax savings. How you have the property financed will have a large effect on tax savings. Also, consider that with depreciation expense it is possible to be cash flow positive but still show a loss on paper for tax purposes.
• Mortgage pay down. Unless you are on an interest only loan, your tenants will pay down your principal balance for you over time and you will eventually be left with a free and clear property or the opportunity to tap the equity without selling via cash out refinance.

The beast way IMO to combine all of these profit centers in a single analytical framework is to make some fair, conservative projections over the life of the investment and compute IRR. Then make sure you buy, renovate, and operate in such a way that you have multiple profitable exit strategies in case any of your projections or assumptions are off. That IMO is how to play the game, and it can work really well in expensive, high quality, high demand, and limited supply neighborhoods if you learn how to invest there. Find somebody killing it with their investments in those neighborhoods, and find a way to add value to what they are doing in exchange for learning. Good luck and happy investing.

Aaron Vaughn · Answer

As a rule of thumb cash flow is for Class C and D neighborhoods

Appreciation is for class A and B neighborhoods

It seems you are attempting to gain cash flow in an otherwise expensive neighborhood

Jay Jasunas · Answer

@Nicholas Bailey

@David Faulkner is spot on with his assessment. I buy & hold in expensive areas with great schools. I rent no where near the 1% rule and yet I still cash flow nicely and make a handsome ROI.

There is less rent competition in this arena and the tenants are much higher quality. I rent to engineers, VPs in corporate, small business owners. The expenses are much lower and the appreciation is much higher.

If you have any questions just pm me and I will be happy to answer.

Andrew Johnson · Answer

@Nicholas Bailey  You're probably right about the 50% rule but (as with everything) there are those pesky "it depends" scenarios.  In a major metro vs. rural Texas you'll probably pay more for all of the labor that goes into those expenses.  Dumb hypothetical:  toilet costs the same from Home Depot but it's $49 to install it in Texas and $99 to install it in metro Chicago.  The same can be said for the quality of materials that you use:  laminate vs. granite counter tops.  The person paying $4K per month probably isn't going to want laminate.  Maybe they do, who knows, but you can bet that $50K house in rural Texas doesn't have slab granite.  You could go look at 4" floorboards in the $500K property and the 1/4" round in a rural Texas property.  I'm just making things up but you probably get the point.  It's not 1:1 proportional but it's also far from 1:1 cost-equivalent.  There's something there in the middle.

Not to mention you could be looking at a 5 year old property in rural Texas for $50K and a $500K vintage pre-war townhome in Chicago.  Again, just making things up with the expense profiles for both will likely be very different.

That's why the rules of thumb are just used for quick glances.

Dooreuhn Cee · Answer

@Nicholas Bailey The comparison of real estate types is apples to oranges, so it doesn't really speak to Texas v. Chicago.I have some experience in Texas with 50k houses renting at 700/mo, and also have experience in Chicago with 50k houses renting at 1,100/mo and 1,300/mo.  Also, there is little appreciation in Texas  (I sold for the same price I bought) while the 50k houses in Chicago were undervalued and have appreciated.  This seems to be more of an apples to apples comparison.

John Kraakevik · Answer

I couldn't agree more with David's points.  The only thing that matters is the cash on cash return.  Forget about depreciation as a relevant factor. I personally would not figure any appreciation since, as David pointed out, it's so unpredictable and cyclic.   A high quality tenant is essential since you will have to return the property back to rentable condition for your market so make your tenant happy.  It's amazing how that personal relationship is so important.  I had one tenant for 10 years.  That is huge for obviously keeping the vacancy figure low.  But there is another critical point which I haven't seen mentioned.  In 20 years I have never been able to re-rent a property in less than 2 months.  Almost everybody pays the rent or mortgage on the first of the month.  So you are guaranteed to lose 1/12 of your income, from your tenant leaves and the next tenant will move in.   But wait a minute, you have to get the property up to rentable condition for the current market and so you have to add that cost in as well.  Cost of paint, cleaning supplies, a dripping faucet, all those things your best tenant may have lived with and legitimately is not something they have done. Unless you can absolutely do everything yourself, you have to find some handyman who is cheap and available within say 2 weeks. Then it's getting the word out there.  If you use a re If he can do it right away, you have to ask why.  He's not busy.  Why?  If he's not busy you may not want him because the good ones will be busy, That's why they've gotten referrals.  A realtor will charge you one month's rent or you can find someone yourself. So will he/she be able to find a quality tenant within 2 weeks? It may be possible but you'll pay a month's rent and keep in mind that his goal is to rent the property in as little time as possible with the fewest showings so he is able to make some money. Put escalators in your lease but keep them low.  Realize that your goal is to keep the property rented.  Obviously, if they can find another property with a better price they'll move out.  So  I've kept  a lookout on Craigslist or the MLS for the current rental prices over the years.  Amazingly, I've been able to get a month and a half security deposit. You would be surprised.  If the tenant wants the property, they'll figure out how to come up with the money.  If they can't, I probably don't want them as a tenant. I've never varied on this over 20 years.  It gives the tenant pause for thought in keeping the property up. Dogs are an expense for you so I take a special security deposit for them usually right at lease signing because I don't want to overload too many things upfront. Take pictures before the lease and be absolutely clear about your expectations.  Remember that "normal wear and tear" is an expense to you so why should you have to restore the property to its original condition?  That is the tenant's responsiblity so make them aware of that.  Before and after pictures give proof of what you deduct from return of the security deposit.  Schedule a yearly walk through and let them know at the lease signing.

I hope this is helpful.

Jeff Burdick · Answer

I don't think you'll find anything that meets the 2% rule in Chicago unless you're willing to go into some of the rougher areas.  You can be cash flow positive on the north side though, especially if you get owner occupied financing and force equity from the property.  I have a two flat with a garden unit in Irving Park that rents for $3800 with a PITI of $1950.

Stephen Wiater · Answer

Nick,

@Nicholas Bailey

Nicholas Bailey · Answer

Thanks for the response.  For the record, in my hypothetical the 500k building in Chicago would typically be a triplex or duplex with an illegal "garden" unit, so the renter's expectations wouldn't be that of a super-luxury unit.Sounds like overall you agree with my back-of-the-envelope reasoning.  That is:  The same expenses aren't going to necessarily scale up at the same rate as rent or property value.

50% Rule/ 2% Rule in expensive areas -> is my reasoning correct?

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