Rules of Thumb
In an older article, I wrote extensively sharing my views on conventional financial rules of thumb. In general, these rules are shortcuts allowing you to quickly analyze a situation (with an anchoring point) and determine if that particular situation merits further consideration. They should not replace the need to do research, do math, or evaluate if a short-term financial decision aligns with your long-term financial goals.
As I started learning about real estate investing, it turns out that many real estate investors use a number of rules of thumb to help them narrow down the number of potential deals and determine which ones they should spend more of their time focusing on. To give you an idea, the numbers showing up on our auto searches for one county are 182 (2 bedroom single family homes), 315 (3 bedroom sfh), 48 (4+ bedroom sfh) and 31 (small multifamily properties). That’s a lot of potential properties to go through! As our time is a limited resource, we will spend it on potential deals that can bring in the most profits. In addition, with the ‘buy & hold’ strategy, even putting 20% down on the cost of a property can be a lot of money. Thus, my husband and I definitely want to do our due diligence. During my research, such a process is very time and labor intensive.
In this article, I’m sharing two rules of thumb real estate investors use to sift through hundreds of potential deals. Just like other conventional financial rules of thumb, these guidelines are not “rules” per se. We use them only as screening rules to help us narrow (filter) our search. Even if a property meets one or both of these rules, it doesn’t mean we hurry to make an offer. This simply means that particular property merits further consideration (I’m currently learning about the more advanced and detailed strategies, and will be sharing them on the blog soon).
As aforementioned (and stated in the previous article), my husband and I are only interested in the buy & hold strategy at this point. So the focus here is on screening rules for investors who use the buy & hold strategy to build wealth.
The 50% Rule
As a buy & hold investor purchasing single family and small multifamily properties, one key factor to securing profits is being aware of the historical actual expenses of each property. Once you have the expense numbers, the 50% rule allows you to quickly and conservatively estimate the cash flow you can expect to receive from a certain property.
What is the 50% rule? The rule states that over time, the total expenses associated with operating residential rental properties (such as single family homes, duplexes or triplexes) will be about 50% of the gross rent(s). This expense number is before loan/debt payments.
What is included in the 50% rule? The rule factors in expenses that are common to most residential rental properties. They include the following items:
- Vacancy Loss
- Property Taxes
- Home Owners Insurance
- Repairs and Maintenance
- Owner Paid Utilities
- Capital Repairs
- Property Management Expenses
- Home Owner Association Fees
- Pest Control
How does the 50% rule work? The 50% rule is based off the total rent(s) that a property generates. To calculate the cash flow you would get from a property, you can arrive at this number one of two ways. On an example of a property that grosses $1,000 in rent on a monthly basis, setting aside 50% of the gross rent to pay for expenses would leave $500 to pay for mortgage payments. After subtracting the 50% expenses in addition mortgage payment from the gross rent leaves you your cash flow. On an annual basis, if a property grosses 18 percent of its value per year, and approximately half of this amount is consumed by operating expenses, then the property nets nine percent of its value per year. As stated earlier, the 50% rule is about long-term annualized average. Your expenses might be higher than 50% of the gross rent in some years and lower in others years.
The rule’s shortcomings: First, the 50% rule uses rent to determine expenses. That is, whatever your gross rental income is, 50% of that rent is assumed to go to operating expenses. Depending on the housing market and economy, rents can go up in some years and down in others. Yet, how likely do expenses on an annual basis go up or down following the same pattern as rent? If you can charge more for a rental, what’s the likelihood that your property insurance premium is also going to go up? What about repairs and maintenance or property management fees? If the rent drops, can you count on the property taxes dropping, too? What about utilities or other fees associated with operating the rental?
Second, the rule assumes all rentals will have basically the same expenses in every state and on every type of property. The reality is that different properties have different expenses, depending on who you contract out for services, liabilities, etc. Different states have different property taxes. States that don’t have income taxes generally have higher property taxes than those that have income taxes. What about the taxes you pay on rental incomes? In a state like California, where the state income tax is high, you would have to charge higher rent to get the cash flow you want. Whereas in states that don’t have income taxes (such as Florida), you might be able to charge lower rents to reach your cash flow goal.
And this brings back to the caution about using conventional rules of thumb. Use these rules as shortcuts to help you filter out bad deals and focus your time on the good ones. Then, I suggest you find out the actual historical expenses of the property you are interested in. Make sure all the potential expenses and returns are accounted for and the numbers are as accurate as possible. If the historical expenses are higher (or lower) than 50% of the rent, understand why. Were there major repairs recently made? Is there a whole bunch of deferred maintenance waiting to be done once the property is turned over to you?
I read that new real estate investors generally make the mistake of under estimating the expenses on rental properties. This is understandable. Unless you have done your research and run the numbers one by one (on a spreadsheet or calculator), you won’t know. And sometimes even if you’ve already done extensive homework, there’s still no guarantee on profits. As with any form of investments, there are potential risks.
The 1% (and 2%) Rule
The 1% rule says that the rental amount a property brings in should be at least 1% of the total purchase price of the property.
According to the 1% rule,
- A property that costs $50,000 should rent for at least $500 per month
- A property that costs $75,000 should rent for at least $750 per month
- A property that costs $100,000 should rent for at least $1,000 per month
The property cost should include both the purchase price and repair costs (if there’s any). This rule is not an accurate reflection of net income because it uses only the gross rent and doesn’t include any expenses at all. However, using this rule in combination with the 50% rule (along with many other formulas) can be a powerful tool.
The 2% rule says that the rental amount a property brings in should be at least 2% of the total purchase price of the property. According to my recent research, it’s not uncommon seeing the 2% rule popping up on search engines when googling ‘real estate investing rules of thumb’. However, such articles were typically written back during the Great Recession years when the housing markets in many parts of the U.S. (and across the globe) were under valued, while rents remained almost unaffected.
At the time I’m writing this article, housing prices have generally gone up. Nowadays, it’s much more challenging finding rental properties that meet the 2% rule (it’s not impossible in some areas though). A more reasonably guideline is the 1% rule (aka the sister of the 2% rule). Certainly, you can try to aim for meeting the 1.5% rule :). As for my husband and I, we’d be happy when the rental amount brings in at least 1% of the total purchase price.
Final Remarks
Earlier in the article, I already mentioned some of the cautions to be mindful of when using screening rules/guidelines to analyze potential real estate deals. In this section, I am sharing additional caveats on these rules. Doing so also serves as reminders for myself and my husband as we’re diving further along this journey.
First, think carefully before jumping on any property that looks too good (when using the rules of thumb). A property with an extremely low price compared to its rent may be a property with an immense amount of deferred maintenance, be in an undesirable neighborhood, or have any number of other issues with it.
Second, along with the first caveat, just because a property doesn’t come close to meeting the 50%, 2% or 1% rule doesn’t mean that particular property is not a good investment. The property might be located in a highly desirable neighborhood and have the potential to attract very qualified tenants. Once again, always do your research, gather information and plug in as many actual numbers as you can find on a spreadsheet or calculator.
Lastly, no rule or guideline can say for sure whether you can expect cash flow (or appreciation) on a property. So don’t use them for anything more than quick elimination of potential properties. The 50%, 2% and 1% rules certainly have their places in real estate investing. For most of us, our time and money are limited resources. Thus, be very strategic going about how you spend these two resources. These rules of thumb are here to help. Just always remember to supplement them with substance and due diligence. Real estate investing can help us reach certain financial goals if we do it right.
In the near future, I’ll discuss some of the more in-depth analyses and formulas real estate investors use to analyze potential deals and calculate numbers. In the meantime, I would love to hear from you if you have any insights to share with me and other readers.
Have you heard about the 50%, 2% or 1% rule in the context of real estate investing? If you are a real estate investor, do you use all or any of these screening rules yourself? What additional rules/guidelines/shortcuts you use to pre-screen potential deals?