Eureka! The Missing Link! The 50% rule, the 2% rule and Cap Rates

I began my real estate investing education three years ago.  Since then, I've spent thousands of hours on BiggerPockets, listening to podcasts, reading books and analyzing deals.  Shortly after I began looking into real estate, I changed jobs and became an independent contractor, which apparently means my income isn't stable enough and banks slapped a scarlet letter on my forehead.  Surprise!

I'm in the middle of my first deal right now in my local area, but recently I've been looking at some larger properties in several different markets.  I'm in a smaller Midwestern market, and as I've been exploring these other markets, I come across some multifamily properties for sale for 2,3,4, even 5+ times the typical per unit asking price of properties in my area.  

For awhile, I just skimmed over these listings, because I was looking for properties that cost under X number of dollars per door.  But the more I thought about it, the clearer it became.  Rents obviously fluctuate from market to market, but in my mind, X number of dollars was a good deal, and that's what I should be looking for, but that thinking doesn't apply in some areas where what I'm wanting to pay per door might be what someone else is wanting to pay for 3 or 4 months worth of rent.  Obviously there was a connection.  I finally sat down and figured it out.  

This is a no-brainer for many.  But for me, this was the moment that the light came on.  I was told by my Spanish teacher in high school, it's much easier to learn a foreign language from someone who shares your native language, because they understand the difficulties of learning the new language, whereas a native of the language you're learning doesn't understand why you can't figure it out.  While many seasoned investors have an absolute wealth of knowledge, sometimes there can be a disconnect between what is understood and what is being taught to newbies.  As a newer investor myself, I've been blasted with the 50% rule, the 2% rule, cap rates, cash flow per unit, etc.  Until today, they were just obscure numbers, and I hope my struggle to figure this out can help someone else.

I know you can't go 30 seconds on BP without coming across one of these terms.  But, because this is a post about the three, I'll do a quick refresher. 

The 50% rule states that on average, 50% of your rental income will go out to pay expenses, not including your debt service (mortgage.)  

The 2% rule states that if you can buy a property that earns monthly rental income of 2% of the purchase price of the property, that property should cash flow well. (i.e. a $100,000 property that rents for $2,000 per month would qualify under the 2% rule)

The capitalization rate, or cap rate, of a property is determined by dividing the annual net operating income (NOI) by the purchase price of a property.  The NOI is the gross income minus vacancy expense, minus all operating expenses, excluding debt service.  The NOI is an indicator of how much cash flow the property will generate with no debt.  From the NOI, you can run a mortgage calculator and determine how much your monthly mortgage payment would be, and see if the deal is worth pursuing.  The cap rate is a determination of your rate of return if you use no debt, basically allowing you to compare it to other types of investments.  Cap rates are primarily used in commercial and large residential deals, but it helps to understand everything as a whole.

Now it's time to start making connections.  

The 50% rule is just a quick and dirty way to estimate NOI.  Say you find a property that will rent for $1000.  Just for quick analysis, we can figure that we will have $500 per month left to pay the mortgage, which multiplied 12 times during the year means our NOI would be $6,000 per year.  

Let's say we want to buy at minimum a 6% cap rate, or what's known as a 6 Cap, which is low for my market, but will often cash flow.  Based on our NOI above, we would take our $6,000 and divide it by 6%, meaning we can pay $100,000 for the property.  At $1,000 per month in rent and a $100,000 purchase price, we have earned a 1% rent to purchase ratio, or what you may call the 1% rule.  

Now lets say we want to buy at a 12 cap, which is a very solid buy.  Our $6,000 NOI divided by 12% gives us a purchase price of $50,000.  We have hit the coveted 2% rule and the crowd goes wild!  A 12 cap is almost always a good buy, as it's pretty much guaranteed to give good cash flow.  That's why everyone says shoot for the 2% rule.  Whether or not you can find 2% deals is another story.  

Putting the final piece together.  

In our 1% rule/6 cap example above, based on our quick rule of thumb analysis, a $100,000 property with a 30 year 5% APR mortgage will have a monthly mortgage payment of $537, a negative cash flow of $37.  There are some deals to be had with 6 cap properties, especially if your area has very low property taxes, very low vacancy, newer buildings that require less maintenance, great value appreciation, etc, but it's increasingly important to do your homework and know the actual expenses of lower cap rate deals. 

In our 2% rule/12 cap example, our $50,000 property with the same 30 year 5% APR mortgage will have a monthly mortgage payment of $268, for a positive cash flow of $232!

The exact cap rate or the right rent/cost ratio isn't all that important.  What's important is that you evaluate the deal and decide what you can pay to get your desired result.  More than likely, a property listed through an agent for $100,000 at a 6 cap isn't going to sell for $50,000, making it a 12 cap.  But say you want $100 per door in cash flow.  If you have $500 left to pay your mortgage, you can afford $400 per month on your mortgage, which means you can pay $75,000, equivalent to an 8 cap, or 1.33 rent/cost ratio.  That's something the seller might consider.  

Maybe I'm just the slow learner, but it took me a long time to come to understand how everything worked together, and now that I've figured it out, I hope other newbie investors can learn the ropes that much quicker.  Just keep in mind, the 50% rule and the 2% rule are just rules of thumb.  There are no two deals the same, and these rules are just for deciding if a deal is worth diving deeper into.  ALWAYS make offers based on actual financial information. 

Please leave me a message or comment if there's something I can help clear up!