Let’s Buy A Foreclosure Episode 2 – What is the 50% 2% Rule?

While we were all sitting around anticipating the upcoming closing on the bank-owned house down the street, a comment came in on that first article in the series. A guy named Joe told us this:

 

“This house is cash flow negative with 100% financing (and the many issues you are ignoring like maintenance/repairs, vacancy, management, etc), meaning forcing cash flow by paying cash is a low return on your investment.”

“What!?”, I thought, “This is the best rental house I’ve ever seen so far in my own area!”. I wrote a big BZZZZT, WRONG!! comment to him in response, which I will now admit was actually a Complainypants move on my part. Also, it was midnight on Friday at the time. And I was drunk. I did, lucklily, ask him to elaborate further, and he shared an enormously detailed comment which I have brought in to become the subject of this article!

While I still disagree with the wording of of Joe’s comment (I’ll present an alternate way to express it later), it turns out he is part of a Secret Badass Bigtime Landlord Community – something that I didn’t even know existed until he told me about one of the forums where they gather – a website called Biggerpockets.com.

Badass landlords are people who are even better at making money from rental houses than me – and therefore I must bow down and listen to their ideas rather than rejecting them because they know something I don’t. These are people who deal with the stuff so much, that they call a house an “SFR”, and they have so many rental units, they refer to them as “Doors”. They rack up these metaphorical doors faster than I can install finely crafted physical doors, and with the right techniques they can end up with nearly unlimited cashflow and equity over time. Here’s what Joe wants to tell us:

Okay, I’ll explain.

There’s something called the 50% rule and the 2% rule.  There are many, many discussions, evidence, etc. on BiggerPockets for these two rules of thumb.  I won’t go into detail to back them up, I’ll just explain them.  I assume you can use Google or their forum search to find the, literally, dozens of threads discussing them.

The 50% rule says that over time, 50% of your gross rents will go towards ALL your expenses.  This means taxes, insurance, maintenance, repairs, vacancy, management, etc. etc.  Obviously some areas have higher taxes, some houses will have lower maintenance, and so on, but studies and tons and tons of anecdotal evidence (from hundreds of people with hundreds of properties) have shown that about 45-50% of gross rents go to cover all that.

So the first problem with your post is that you are way under accounting for repairs and maintenance by spitballing a number.  Sure, your personal residence doesn’t have that much per month (because you take care of it and fix a small problem before it becomes big), and maybe you’ve had great tenants in your other house.  But the wear and tear tenants can make can be huge.  When you have to replace the carpet for $2k when a tenant moves out, or repair holes in the wall, that can get expensive.  No, the security deposit that they tried to use as the last month’s rent (so they didn’t pay that month’s rent) won’t cover that.  Yes, you can get a judgment against them, at lots of time and hassle.  Good luck trying to collect.

Will this always happen?  NO!  I’ve had GREAT tenants so far.  Do I account for these things due to knowing many, many, many other landlords deal with it, and I will have to eventually?  YES.

The second problem is you haven’t accounted for vacancy: the months where it sits empty.

The third, and maybe biggest, problem is that you’re way undervaluing your time.

See this recent Get Rich Slowly article: http://www.getrichslowly.org/blog/2011/10/07/remember-to-value-your-time/

And in YOUR recent commuting article, you put someone’s time at $25/hour.  I manage my rentals… but when evaluating a deal, I always calculate in the cost of someone ELSE managing them.  Then when I do it, I make more money, sure, but that’s not a higher return on my investment.  That’s a side job as a property manager.  You aren’t calculating in any management costs, therefore you are valuing your time at $0, and putting the “profits” of your management side job into your overall return and claiming an 8.3% return.   Further, rehabbing it will take time.  You count in the cost of materials and the purchase into your total expenses to calculate your return, but again, not any of your time.  Calculate what it would cost to HIRE someone to do the rehab you’re going to do, then do it yourself, but count that amount that it would cost WITH the cost of materials and purchase price to actually value your time.

On to the part I mentioned about this being cash flow negative.  With the 50% rule, you take 50% of the gross rents off for expenses.  Then you calculate the property at 100% financing.  If it cash flows then (usually most investors want at least $100/unit), then you’re good.  If it’s not cash flowing at 100% financing, then you’re essentially FORCING cash flow into the deal by paying more for financing. For example, if it’s cash flow negative at 100% financing, and break even at a 20% down payment, you wouldn’t want to put 30% down and go “Hey! I’m cash flowing $50/month, this is a great deal!” because you forced it to cash flow. You then could purchase it 100% cash and say “Hey!  I’m making $300/month, great!” when in actuality you forced te cashflow in, so you’re getting less of a return than you would putting the money elsewhere.

Now do I have anything against a cash purchase?  Heck no!  I’m in escrow right now on a cash purchase for a SFR.  But run your calculation AS IF you’re getting 100% financing, even if you aren’t, to evaluate it.

So let’s run the numbers on yours.  You likely aren’t getting 4.5% right now as an investment (non owner occupied) home.  Likely more like 5%.

Cost (with rehab): 140,000.
Annual rent: 1320.
50% rule: 6600 will be your cash flow.

The monthly payment on a $140k loan (this is counting the rehab, not just the 115 purchase price, because then you’re putting your own money in, and we want to compare as if you put no money in so you aren’t forcing cash flow) is:  751.55.  This doesn’t count taxes or insurance (which are typically included in a mortgage payment) because those are counted already in the 50% rule.  751.55 x 12 months = 9018.6 per year in principal and interest.  You’re losing 9018.6 – 6600 = 2418.6/year.  The novice investor would go “1100 rent – 751.55 mortgage = 348.45 cash flow!! YAY!!”  They forget all the other expenses.  You at least added in taxes and insurance.  But you forgot all the other expenses beyond those. Now sure, most months that investor WILL bring in an extra $350ish.  But then a pipe bursts, and they have to pay $1500 to repair it.  Then the tenants move out, and they have to spend $800 getting it move in ready. Then it sits vacant for a month, costing them $1100 in rent. ANd so on, until they end up losing approximately that 2418/year (it may even take a few years, when they have to replace the roof, or whatever).  But long term, over time, 50% of your gross rents go to costs.  Now YOU, MMM, paying cash, will immediately see cash flow.  And it will make you money over the year, because you forced cash flow into it.  You could be earning more on that money elsewhere.  Your real return would count in all those other expenses (including management, which IS calculated into the 50% rule), to show a cash on cash return of 6600.  That’s a return of 4.7%/year, and is not counting the rehab labor (or the denominator of 140k would be larger by that amount of the cost of the labor).

An 8.3% cap rate, without counting vacancy, way underguessing maintenance, and not counting management (plus any utilities that will be owner paid, like sewer), is way too low for the hassle you’re getting.  This is not a deal.  You CAN find a deal, however.  Today’s market is amazing.  This is not it.  Your cap rate should be at least 10-12% when counting the above things you missed, even in a cash purchase (easily double that with financing).

The 2% rule says, roughly, that you should be able to get 2% of the purchase price per month in rent.  It doesn’t mean to CHARGE that much in rent (because then your property will sit empty, as people won’t pay above market rates), but find what houses rent for there.  If the purchase price is more than 50X that rent (50X is the inverse of 2%), you’re overpaying.  If your house will rent for 1100/month, you shouldn’t pay over 55,000.  Now that one is hard to do, and many are a little more lax on that.  I personally shoot for a 1.5% rule on single family homes and 2% rule on multiplexes.  But basically your house purchase fails all the rules of thumb of real estate investors.

You might argue that this is different, the 50% rule won’t apply to you, your house won’t have as much maintenance, taxes are low in your state, etc etc.  And that’s fine, you might nitpick numbers here and there.  Whatever.  My point is that you are way underestimating some costs, and that your return is negligible with this “deal”.  (And if hundreds of people have come up with the 50% rule independantly, maybe look more into it before arguing against it, like the whineypants would immediately do.  Literally dozens of forum threads with hundreds of comments discussing it.)

You mention in your comment: “But I know many millionaire landlords, including myself, who have gotten quite wealthy with properties with considerably lower cap ratios than the one described in this article.”  Sure, with appreciation.  With markets poised to stay low for quite a while, cash (flow) is king.

This article is dangerous, because you’re telling your many followers this basic math is valid:
“Annual Property taxes and insurance: $1600
Expected annual rent @1100/month:  $13200
Net annual cashflow:  $11600″

You took your rent, subtracted off taxes and insurance as your ONLY expenses, and said that was your cash flow.  But you didn’t account for all of the above.  YOU can handle getting it rented and managing it, cause you’re retired.  YOU can handle all the repairs, cause you’re fucking MMM.  But you’re valuing your time at 0 then.  But what about your readers that can’t handle repairs? Can’t do management?  They’re suddenly losing money on this deal. That’s just dangerous for anyone reading this and not knowing enough (e.g. EVERY above commenter).

Plus what about vacancy, with even your MMM skills can’t totally avoid?  The one month it sits empty costs you $1100, GREATLY reducing your cap rate.

Again, 8.3% at 100% cash without accounting for many, many things, and paying yourself 0 on rehab and management is forced cash flow.  Bad.

I’m not a complainy-pants. I’m very bullish on Real Estate.  But there are better deals to be had.

I doubt you’ll listen to this.  You are excited (and should be!) about this new, fun project.  You have a partner you don’t want to let down.  You’re already in escrow, and likely already paid for a home inspection, and possibly appraisal.  (Any earnest money deposit you can definitely, 100% guaranteed get back right now, don’t worry about any EMD you’ve paid to a title company.)  You’ve told all these readers, who you don’t want to disappoint.  Likely you’ll plow ahead and get some cashflow from it, less returns than you could on a better deal, but hey, you don’t need the money, so it’s not a big deal.  Hope you do consider it and read more.  I have some good real estate books I could recommend.

Sorry if this comment was a little repetitive, there was some things to hit from different angles and reasons.  Hope you got something out of it.

And again, would be happy to discuss more. Sorry to burst your bubble, cause it is such an exciting project, and you’re usually right about things, so I’m sure it sucks to be wrong.  I haven’t experienced such a thing yet, but I feel for you.

—–

First of all, nice work Joe. You made fun of Mr. Money Mustache and lived to tell about it, and brought up some very good points . I am still Super Effing Excited about this particular deal, and I am more confident than ever about its profitabilty, but I’ve learned quite a bit from your Fancy Landlord Community, and we do need to add some cautions to help prevent beginners from getting in over their heads.

Let’s start with how I would have written the critique, knowing both sides of the argument now:

“Dear Mr. Money Mustache.. this sounds like a fun project, but did you know that it would actually be considered “cashflow negative” using something called the 50% rule that large-scale landlords use to evaluate properties? This is mainly because most landlords experience much higher carrying costs than the ones you described in this article.”

First of all, I do have some immediate corrections to your assumptions that brighten the picture.

For the renovations, the $25,000 number I budgeted is not just for materials. That’s the all-in number, paying for materials AND paying myself a generous $35/hour for construction work, as well as paying a separate painting crew (my investor friend also runs a small painting company) for the extensive paint work.

Regarding ongoing maintenance costs for the house – this is a place where I do benefit from being “fucking MMM” as you so aptly put it. To a large-scale landlord who refers to properties as “doors”, a rental property is just a black box, where you put in monetary input to get an expected output. For me, a house is a living and breathing work of art. I feel the grip its foundation has on the soil, and the strength of its wooden skeleton and backbone as they flex when people walk across the floors. I hear the breath of its furnace as it sucks in outside combustion air and exhausts steam out the flue and circulates the heat extracted from natural gas around the interior. I feel the congestion when the house gets atherosclerosis in its supply or drain pipes and I lovingly slice out the damaged bit of its circulatory system and splice in a clean system of PEX and ABS piping which will last another hundred years.

Because of this, maintenance costs me very little. Just as I live a middle class lifestyle on 75% less than a comparable large-scale consumer, I think a Mustachian can make much more from any given rental house than an average landlord. I never assume my labor will be free – I do budget in paying myself at an hourly rate that would be $70,000-$80,000 on an annualized basis. But when it comes to repairing a house – your own or one of your rental houses, in many cases it is drastically cheaper to do things yourself. I can hire a furnace company to replace my furnace for $4,000, or I can buy a kickass 90%+ efficiency furnace online for $995, and install it with 8-12 hours of labor (under $500 which I gleefully “pay” to myself). I remember receiving a $1200 quote from a plumber to replace a 12-foot run of clogged cast iron pipe from a toilet to the rest of the drain system. This is about $35 of materials and 4 hours of work.

There are simply no expensive mysteries in a rental house when you enjoy home maintenance. For example, you used the example of a $1500 burst pipe repair. Coincidentally, this rental house came with THREE burst pipes which I discovered when doing the inspection. We repaired them in 5-10 minutes just in order to test the rest of the plumbing. As part of the renovation, I’ll be replacing most or all of the entire supply piping system with nice clean burst-proof PEX pipes, for only a few hundred dollars in materials and labor.

I could go through the other issues of the management budget and the vacancy rate, but damn, this article is already over 2600 words! So let’s wrap it up with a summary:

Joe has a great point – if you follow his 50% rule, it will lead you to only buy fiercely profitable rental properties, because you’ll insist on getting the property at an incredibly low price.

However, this rule, and its partner the 2% rule, mean you’re looking for a $100,000 house that you can rent for $2,000 per month. Or that my other rental house, worth about $480,000, should be getting me $9600 in rent each month. The $9600 figure is Not Gonna Happen in my town, or even in the entire United States, seeing how you can rent a 4,000 square foot seaside compound in Hawaii for that price. I’ve watched every listing and property sale in my neighborhood for about six years. This particular deal is probably in the top 1% in terms of value for the money, which is why there was such fierce competition from other investors and potential homeowners for the house.

You’re more likely to get these kinds of price-to-rent ratios in very low-price areas (deepest foreclosure-hit neighborhoods in Las Vegas or Florida), or with higher multi-unit buildings. Which is exactly what the Big Time Landlords are suggesting you do!

So why is the MMM approach different? Because it’s a small-time, holistic approach. I’m not interested in owning 10 or 100 rentals, just as I’m not interested in earning $10,000 per month in retirement income, or ever accepting a job that requires sustained car-commuting. I like to do everything in my life myself, or with friends, and I don’t outsource anything. This lowers my peak efficiency in dollars-per hour, but I feel it greatly improves my average efficiency in Laughs Per Day. By learning as many skills as possible, you gain adaptability that pops up throughout the rest of your life in the form of unexpected opportunities, solutions to problems, and ways to save or earn money for yourself and others.

I am interested in going through this project where we will practice a huge variety of skills, from general market research and Landlord Theory (which we’re doing right now), through the various stages of materials shopping, interior design, and renovation, up to the marketing and tenant interviewing process.

Then it’s up to you, if you want to hold out for higher-cashflow houses or apartment buildings, or make a project out of a less-cheap house right in your own area as I’m doing.

My friend and I have over 25 property-years of rental house management experience together, and we’ve been through several dozen successful tenants, as well as an educational number of disastrous ones. Not as many as the Biggerpockets landlords, but enough to know how to continue building our ‘Stash nicely.

So the project goes on – 15 days until closing!

 

* What’s that photo? No, it’s not the house we’re buying (alas, you can’t get a giant victorian beauty like that for 115k in my town). Just an in-progress shot of the latest vibrant and high-end paint job from my painter friend who is the main investor in this project. Hopefully the little rental house ends up with a similarly cool paint scheme. 

 

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36 Responses to “Let’s Buy A Foreclosure Episode 2 – What is the 50% 2% Rule?”

  1. Chris October 10, 2011 at 6:54 am #

    Awesome discussion.

  2. JJ October 10, 2011 at 7:14 am #

    This is probably the best post I’ve read on this blog. Was reluctant to read the first post about buying a rental specifically because I’ve always had trouble when thinking about my time, and surprise expenses. This 50% rule seems like it would help a lot.

    This is something I’ve considered for years but the timing never seems right. With my spouse still working a full-time career and me responsible for the kids, it’s difficult to justify the time it would take finding, fixing, and renting most houses.

    When the youngest gets into 1st grade it’ll be a better time for us (assuming prices don’t rocket higher before then). Plus, by this time, my oldest will be old enough for me to take him along for the ride and learn a little bit about plumbing, electrical, roofing, water, etc.

    It’s almost tempting to buy the house now (with prices and rates low), and just sit on it for a year until the youngest starts kindergarten. The problem is, I know enough to know that there is no such thing as “just sitting on a house”.

  3. Chris October 10, 2011 at 8:27 am #

    Good discussion. Glad you put up the opposing viewpoint, I’ll have to run that against my rental and see what I come up with.

  4. GardenGal October 10, 2011 at 8:27 am #

    I’ve learned a lot reading your discussion with Joe and realize that I am in a negative cash flow situation with a rental house (well, I already knew it, but these 50%, 2% rules spell it out more glaringly). Thanks for sharing this and for opening up about your own complainypants issues; I guess we all have them.

    I would be interested to read what Joe’s response is to this post. Do you think you would let us see it? I think there is a lot to be learned here.

  5. Marcia @Frugal Healthy Simple October 10, 2011 at 10:22 am #

    I really enjoyed this post. Both the detail from Joe and your response. Having a 50% “rule” or at least something well-thought-out like that is really a good idea. I used to be addicted to the various HGTV flipping style shows, and was amazed at what people did and didn’t do.

    The kind of rules you have as a big-time investor will be different from a smaller investor. If I ever become a “landlord”, it will only be because we move and decide to rent out our existing house (which at current rental rates and our superiorly bad timing in buying, would be at a loss of about $2000/month including taxes and insurance). In our town, competition is fierce for foreclosures. Unlike a 2% rule, there is nothing “cash flow positive” about buying a house here. You can’t break even period, unless you pay cash.

    The whole housing industry is fascinating to me. I look forward to your updates. I also like your “do-it-yourself” attitude.

  6. Brave New Life October 10, 2011 at 12:35 pm #

    The 50% rule is a rule of thumb, nothing more. Rules of thumb can be dangerous if followed religiously, without understanding the science behind them.

    As I read your response to Joe, I thought to myself “MMM is making a mistake. Not because he won’t be profitable, but because he’s overpaying and could be *more* profitable.” But then you mentioned that you’ve been watchnig the local market for years and this is in the top 1% of deals. That’s all that matters – you’re local market. If the market is following a 20% rule or an 80% rule, that’s what you’re forced to follow if you want in the game (and you want to stay local).

    I don’t know your local market, and I doubt Joe does either.

    By the way, I think you owe Joe some of your home brew.

    • MMM October 10, 2011 at 12:59 pm #

      Yup.. I’d have to say we are both right in this case.

      In some markets, like Marcia’s, there may be NO rational way to buy a single family house on the open market and make a profit as a landlord. I believe this condition exists right next to me in Boulder, where small homes are over $400k, and yet rents on those places are only $2,000 (which would be only 0.5%, a quarter of the 2% rule).

      In other places, the profit margins are fantastic, and the profit-minded landlord will choose to buy only there. In my neighborhood, the average price is in the low 200s, which is not a good enough margin to make it worthwhile to me. But to get a house of almost average rentability, for only $115k, pushes it into the profitable range.

      Also note that we will end up with 40-50k or more of potential profit just from buying and renovating the house (even after paying for renovations in full). Instead of renting, another option is to immediately sell the house and run with that nice profit.

      Finally, just as I might be understating maintenance costs for most people, Joe might be understating appreciation. As a rule, house prices keep up with inflation. So over a longer holding period, you can add 3% per year to the nominal cap rate of our investment. The rent should also increase at this rate.

  7. Chris October 10, 2011 at 5:56 pm #

    I should say that just because you “can’t get a house following the rules” that it means you should ignore the rules and buy a house anyway.

    If you can’t follow the rules, then you can just not buy a house.

    Many people have driven up prices around Canada as investments simply because they can’t follow the rules and generate positive cashflow but still buy anyway. Then they just can’t ignore having to follow the “you need to invest your money in real estate to become wealthy rule.”

    So for now, my rules don’t allow me to buy rental property in Canada. If you can follow some other rule you invent that works for you, then do it for that reason.

    • LH October 10, 2011 at 10:39 pm #

      It is possible in Canada, just difficult.
      In Toronto the rule is more like 70% and 0.6%.
      However, 0.6% * 12 * 0.70 ~ 5%, still higher than floating rate mortgages in the low 2′s. But it does suck up lots and lots of time (which I admit, is being way undervalued in this calculation). Also, watch out should rates ever go up!

      On the other hand, I know people who enjoy renting out and managing houses as a second job. If you like it as a hobby, then it allows one to own much more “house” than one’s first job would normally allow. And “house” in a neighborhood you want to live, as MMM suggests, in the long term is an inflation-linked asset.

  8. Larry October 11, 2011 at 11:07 am #

    I have run a few scenarios that definately support the 50% expense ratio, yet I have never seen any houses or multi unit buildings for sale at a price would create the ability to earn 8.5-10% ROI with that conservative of an expense ratio.

    It sounds like Joe has found some that meet that critera. I would love to know where he is finding these investments and if the average investor could put these deals together.

  9. Brandy October 11, 2011 at 3:46 pm #

    Yikes! I was thinking about renting out my current house and buying another property. It would cash flow now per my old way of thinking, but now I am thinking I am underestimating stuff.

    • MMM October 11, 2011 at 8:47 pm #

      Excellent point to bring up, Brandy! .. that is how many of us end up with rental houses. If you’d like, send in the relevant numbers and we can discuss them here on MMM. There are very interesting considerations that come up when it’s a house you have already lived in.

  10. kasia October 11, 2011 at 9:49 pm #

    Thanks for the follow-up post. I did go to biggerpockets.com, created an account, and had a hard time digging up worthwhile information on the 50% rule and 2% rule. I agree it seems extraordinarily difficult to find properties that meet these criteria. If Joe was willing, it would be awesome to see more guest posts from him as well as to how this is done, and common “newbie” mistakes.

  11. Gerard October 12, 2011 at 12:12 pm #

    Nobody else has said it, so let me be the jerk: if you’re buying properties at low enough prices for the 2% rule to work, and if you have enough damage and vacancies that you need the 50% rule, you’re kind of a slumlord.

    • Mrs. Money Mustache October 12, 2011 at 12:59 pm #

      That’s exactly what I said to MMM after reading this article. :-)

      • Lee Lau October 12, 2011 at 10:22 pm #

        But the 50% 2% rule is a good way to think of the downside risk. Not a guide to being a slumlord. The rule shouldn’t paralyze you but it should make you think. And it definitely made me think.

        I’ve used that rule to model housing in Vancouver BC (where I live) and it doesn’t make sense to buy rental houses right now using that rule. Using that rule as it was modified for Canadians (slightly different tax situations) I actually sold two rental properties when my cashflow from the properties didn’t meet projected future expenses. But I dunno if I was right or wrong or in selling when I did – it just fit my strategy of keeping risk low.

    • jlcollinsnh January 7, 2012 at 9:14 pm #

      I’m pretty late to this party, but here’s my 2 cents anyway.

      Joe’s numbers and logic are compelling. While it has been decades since I’ve messed around with owning individual properties the 50% rule rings true to me. Things always cost more and there are more surprises, than expected.

      While Mr. MM has the time and skill to reduce many of these costs, Joe is absolutely correct that, in evaluating a given property you need to take the full weight of costs into account.

      Having done that, if you then want to (as Mr. MM does) consider the value you can personally bring to the deal I have no problem with that. But when I was doing this I was lacking in the handy skills and the inclination to do that work. So things had to work solely on a financial basis.

      The 2% rule is where I really stubbed my toe. Certainly if you can make this work, even at 1.5%, you are looking at a sweet deal. However, like Mr. MM I haven’t seen deals like this.

      I ran the numbers on several sample houses, including my current home, and couldn’t even come close. Then I read Gerard’s comment and the light went on.

      I ran the numbers on the big old run down house in which I rented a room during college, a slum if there ever was one.

      !st floor apt #1 = $140
      1st floor #2 = $150

      2nd floor, 6 rooms sharing a bath down the hall (I had one of these) @ $60 per = $360

      3rd floor #1 = $75
      3rd floor #2 = $60

      Total = $785 per month/ $9420

      House value = $15,000 (this was a long time ago) x 2% = $300

      $785 x 50 = $39250

      To make matters even sweeter:
      With 10 ‘apartments’ vacancy wasn’t much of a concern.
      High demand kept them full and even if one sat empty she still got most of her monthly rent.
      Tenet damage? Who’s cares. She rented them ‘as is’
      Maintenance? What maintenance? ;)

      Slum lording is where the real money is. If you have the stomach for it.

      Even with my

      • jlcollinsnh January 7, 2012 at 9:19 pm #

        Oh, and she had 5 other houses just like it. :)

  12. elias October 14, 2011 at 8:07 am #

    Talking out of my ass here, but -

    The 2% rule and the 100% rule are horseshit.

    Very few people would BUY a house and pay 2%/month mortgage plus t&i, let alone rent one. I can see following the rule in large multi-family units, but in a SFR situation, you are preying on the stupid.

    Second – the 100% financing portions aren’t investing – that’s leveraging. “Forcing capital” is investing. Leveraging by folks who would happily charge 2% rent is what accelerated us into the crapper that we are in.

    • MMM October 14, 2011 at 10:01 am #

      Well, yeah – if you phrase it that way you are talking out of your ass – i.e. displaying complainypants disease :-)

      The key thing to learn from the 50% rule is, “Some smart people have made this work for them”.

      The key thing to learn from Mr. Money Mustache is, “I can make loads of money on a house that doesn’t necessarily sink to that level of cheapness – and I will teach you how in this article series”.

      Another thing I will be sharing is my experience in dealing with higher-end rentals. I find that by offering premium and stylish rental houses that that appeal to university-educated tenants who have owned houses themselves before, I end up with far less hassle in terms of damage, vacancy, financial problems, etc.

      In other words, I only rent out properties I’d be happy living in myself. These attract people similar to me – who have never been a day late on any sort of bill or payment in their lives :-)

      Also, regarding the 100% financing issue – you are misreading the article. Joe doesn’t say you actually DO finance properties 100%, you just do the calculations that way to see if it would be cashflow-positive even in that situation.

      • elias October 14, 2011 at 11:14 am #

        Only a little complainy, the 2% figure is just not reasonable, and relying on 100% leverage doesn’t seem prudent to me.
        I don’t have a problem with the 50% rule.

        As an aside – I work as an engineer and was recently involved in a job assessing water damage for an insurance company. The water damage was caused by cracked PEX tubing in hot water lines. The plumbing “expert” said that pretty much all PEX failed in fairly short order, but there were very clearly bad batches that failed almost immediately. (The house was ~4 or 5 years old.)

        • Rich Schmidt October 15, 2011 at 7:06 am #

          elias, maybe you need to re-read MMM’s reply to you. No one is suggesting anyone should rely on 100% financing. No one. Not in the article, not in MMM’s reply. It’s just a method of evaluating a deal.

          FWIW, the 2% (or 1.5%) rule doesn’t make sense to me. Any house I could buy that cheaply would need significant repair/remodeling/expansion to rent anywhere close to that level.

          The 50% rule? I’ve not been a landlord long enough to know if that works or not, but if it pans out that way for so many, then I’ll pay attention to that rule of thumb going forward.

          • Dan April 15, 2012 at 7:42 pm #

            Very interesting read, he brought up a TON of great points. The 2% rule isn’t one of them (at least not in my city, or any city in Canada). I own a multiplex, a single family and I’ve had a number of conversations with a gentleman who recently bought 16 foreclosed units in my apartment. He got these places at a deeply discounted price and even if you don’t consider any of the renovations he has done the rentals are follow a 50%/1% rule. This was a great read, I would’ve read another 4000 words on the topic!

  13. Bullseye October 14, 2011 at 10:59 am #

    My rule for valuing rental properties has always been to use 0% financing for calculation pruposes, and assume 50% expenses. This way you can judge what the actual return on the asset is, before applying any leverage (financing). If the return is at least 7.5% based on a cash purchase, then I can decide how much leverage to use to boost that return.

    To use 100% financing for calculating value is to hide your true return on the asset behind current mortgage rates. Rates change, sometimes quickly (here in Canada, at least), so your ‘good value’ property today could be bad value tomorrow if rates go up. This might be more of a Canada issue, as most mortage terms here are 5 years, and getting a locked rate for more than 10 years is not even possible. I want to know what my return is going to be FOREVER, not just the next few years.

    So before looking at cash flows, ensure that your asset is actually worth the hassle. I use 7.5%, because less than that, I might as well just buy REIT’s, or high dividend stocks. The return has to be in line with the additional risk and hassle of putting a large chunk of money into one asset, that is very illiquid and has high transactional costs.

    • Rich Schmidt October 15, 2011 at 7:11 am #

      Wow. Things would definitely look different if 30-yr fixed-rate mortgages were uncommon/impossible!

  14. Alex | Perfecting Dad October 14, 2011 at 11:06 am #

    I agree with YOU not JOE. I don’t know about his 50% and 2% rule, but I’ve rolled my own rule of thumb and filter my deals by using the 0.6% rule. That is, divide the rent by 0.6% to get the price you should pay and will get you a minimum 10% return excluding appreciation with positive cash flow covering 60% mortgage and property management with modest vacancy.

    Using that calculation, your property is worth $1100 / 0.006 = 183K. Since you are spending only $140K then buying this property just made you $40K. It is a smoking sweet deal, not a shite deal.

    Now, since you’re investing all cash without debt then you’re going to drop your return WAY down to low single digits. Also, the renovation time during which it’s empty is going to drop your return. You also have to consider whether this $1100 rental rate is sustainable, but I presume you have a view on that. In Canada where I’m from, typically deals this good are found in strange markets, but I guess practically all of the US is in a strange market right now.

    Don’t worry about Joe’s comments, other than to learn a few things. I never buy a property that isn’t cash flow positive, and I never buy hoping that appreciation makes up for bad rental returns. In my mind, if there aren’t long-terms risks in the rental income or the reno cost ballooning then closing this deal is worth $40K and will be a safe investment that throws off cash every month. I’ve bought and sold almost 10 rental properties and valued hundreds.

    • GregK May 2, 2012 at 9:51 am #

      Real estate is local… I just used your rule on a property in my area and found it was undervalued by 59%! I bought my own home at a 52% discount according to this rule. I already know this area is an awesome area to buy and landlord in, but that’s probably an overestimate of how great…

  15. Gerard October 15, 2011 at 4:22 am #

    I definitely see the point of erring on the side of caution in any investment, but presumably when people are deciding whether to buy a rental property, they’re comparing the risk and returns to the risk and returns of some other investment. So what you want is a likely scenario, as well as a worst-case. It was obviously crazy for people to expect housing prices to go up forever, but appreciation has to work into the equation somewhere. When people buy stocks, they don’t expect dividends to be the only upside, they figure there will be capital gains, too.
    Or is that a bad comparison because houses are less liquid?

  16. Thomas October 23, 2011 at 8:26 pm #

    As the son of a self-made, small-time landlord, I appreciate your openness and realistic resistance to outside information. I have helped my father with crazy renovations of repo houses and maintenance of duplexes (I grew up in one side of a really nice duplex [middle school-high school] that was less than 1000 square feet). My father put himself through grad school with basic construction and rough carpentry jobs. My primary job out of college was a continuation of a dorm maintenance job that I convinced some people to create for me. It’s not quite the same doing the work yourself (or teaching your son) as it is to pay someone to do it. When you pay someone, they generally pay taxes and also want to make a profit. When you teach yourself and then do the work, you cut out a ton of inefficiency (you don’t pay the government for the work you do). Beyond that, when you secure excellent tentants for your properties (through extra effort), you cut out further the inefficiencies of people not vacuuming their carpets for two years. As I’m not in the position to look for properties in my area, I can’t speak from direct experience as a landlord, but I know enough to respect the fact that the “fucking” great MMM has the resources to make this profitable. Rock on, etc. etc. I have a lot of respect for your motivations accomplishments. Much like Jacob at ERE, your words stand up to the well thought out scrutiny of others.

  17. Eben Marascia | Outeast Real Estate Investment Group March 8, 2012 at 8:48 pm #

    Gentlemen,
    Great blog and great discussion! Both Joe & MMM bought interesting points to the table. Allow me to stir the pot a little more…..
    Joe is spot on with his suggestion to add vacancy, maintenance and management to your operating expense projections. These are often overlooked and can crush an unsuspecting investor’s return. All three expense items will vary by market and local property managers are a great resource for this info.
    My company generates much of its revenue by buying foreclosed homes, renovating them, renting them to qualified tenants, putting a property manager in place and selling them to investors as turn-key rentals.
    MMM, I would suggest using this approach in your future due diligence. Even as a do-it-yourselfer, subtracting for management expense will benefit you in two ways:
    1) Your ROI will be higher than expected if you choose to self manage, and more importantly . . . .
    2) Keeps your options open. Should you get sick, injured or just tired of managing rentals at any point, you’ve left room in the budget to hire a manager and STILL turn a great profit with FAR less work.
    My method strays from Joe’s here:
    I suggest first analyzing your potential ROI as if you were purchasing all cash. If a property can net a respectable return with NO leverage, you can always enhance your ROI WITH leverage, but please use wisely. High leverage can greatly increase your breakeven occupancy and your exposure to market downturns. With that said, it can also “leverage” a higher return out of the property with less of your own cash at risk – to me, that’s forcing a return out of a property, not he other way around. Here’s an example using actual #’s from a single family rental property that we just purchased, renovated and leased in Cincinnati, OH. This property is now for sale to an investor as follows:

    Scenario 1) All cash purchase:

    Purchase price: $50,000
    Gross Rent: $ 9,000 ($750/ month)
    Vacancy (10%): $ 900 ( $75/ month)
    Maintenance (10%):$ 900 ( $75/ month)
    Management (8%): $ 720 ( $60/ month)
    Taxes: $ 500 ( $42/ month)
    Insurance: $ 364 ( $30/ month)
    Reserves: $ 600 ( $50/ month)

    Annual NOI: $5,018
    All cash Return: 10%
    Breakeven Occupancy: 40%

    In scenario 1, you net a 10% ROI after subtracting all actual expenses, as well as projected expenses (vacancy & maint.) AND a reserve cushion. This property can be vacant for nearly five months out of the year and STILL won’t cost you a cent. Please keep in mind this property was just renovated and requires VERY little of your time because it is professionally managed. Now let’s look at the same deal with some leverage:

    Scenario 2) 20% down payment, 7% APR, 30 year amortization:

    NOI before debt service: $5,018/ year
    Debt service expense: $3,200/ year
    NOI AFTER debt service: $1,818/ year or $151.50/ month
    Breakeven Occupancy: 79.8%
    Annual return WITH leverage: 18%

    In this case, we have forced an 18% ROI out of this property, which is excellent. However, our breakeven occupancy jumps to almost 80%.
    Neither approach is right or wrong, I just wanted to share some of our underwriting methods and add to the excellent points the two of you have bought up already. Real estate is constantly evolving and there’s ALWAYS something to be learned from guys who are out there in the trenches. Do what works for you…..just don’t stop!

    – Eben

  18. Sarah July 16, 2012 at 4:59 pm #

    I’m way late to the party, but this is just such a timely post. It turns out my house does fit the 50% and 1.5% rule, which likely explains why we recently got a note in the mail from the company that just bought three of the 10 houses on my tiny cul-de-sac offering to make a cash offer on the house. Of course they are planning to charge almost 40% more than my current mortgage payment for rent. Actually, the Mr. and I briefly discussed trying to rent it and moving to a lower rental place ourselves. Only trouble is that I’d have to move much further out (so no more biking) and there’s no guarantee we could rent it. Three of the houses on our block have been vacant the entire year we have lived here.

    Of course using Alex’s 0.6% rule my house is undervalued by $150,000 (that’s 150%!) But I think the reason that doesn’t work is the rent is elevated due to the proximity to the university (walking distance to the stadium!) rather than the quality or size of the house.

  19. david November 4, 2012 at 10:02 am #

    Great post, and good comments from Joe—very thought provoking and also its a good sign from MMM that you would be willing to share such a critical response with everyone else…I think the comments discussing how your local market operates are spot on…in my own area, coastal Carolinas, I think it would be rather easy to reach a 1% rule=buy a 100k dollar house, and rent it out for close to 1k, but anything over that, and you are pushing the rent cap here, IMO. Anyone with good credit can BUY the same damn house here with a 30yr mortgage at 3.5% and with the low taxes and insurance costs here, total mortgage comes to just about 600 a month, give or take. Actually, I think a rental bubble is building up, since many people are going to start to realize these facts, and hopefully, other people are recovering from losing their homes and jobs in 2008-9 and will get back in the home buying market, and out of dead end rentals.

  20. Bruno August 11, 2013 at 10:25 am #

    Very interesting discussion. And everyone seems to be a bit right.
    In my town it is possible to get the 50% rule, but very hard to hit 2% or even 1.5%. (The 0.6% seems blatantly wrong for the US.)

    And an important typo: “Annual rent: 1320″ should be 13,200 in Joe’s part of the text.

  21. 2tall February 5, 2014 at 1:53 am #

    I like the post. Had to respond (first time) for this one. Having been in the rental prop biz for 11 years, being a licensed real estate agent and stockbroker, and having a day job as one of 40 or so CFOs in a Fortune 500 I have a decent background to assess the merits of both sides above (caveat: I am always learning something new so I don’t claim to know everything).

    Stay away from Joe and Joe’s advice on 50%/2%.

    50% rule is pretty crude; I line item estimate each expense (which includes management fees, vacancy, etc…) when I do my analyses. I tend to get 60% to 80% net unless I have natural disasters (which rarely occur, certainly not to the 50% level). If you have absolutely nothing better, then use 50%. If you’re serious about investing, do the line items.

    2% rule is complete garbage. I’ve lived in 4 countries (US, 1 European and 2 Asian) and owned or rented in ~20 unique real estate markets around the world, and I’ve NEVER been in a market where this is possible. The only market I have familiarity with (but not first hand knowledge of renting / owning) where you could get 2% is downtown Detroit. NO – F’ING – WAY am I investing there. Personally, my properties run around 0.7% to 1.0% (though I never use that, I use that number times 12 so it’s comparable to other investments grown ups work with).

    I did have a property running 1.3% once. Surprise, surprise, it was an inner city property (2% territory is slum lord. no question). That property sat vacant longer, had so many headaches from tenants, and such high operating costs compared to my other units that it became the only rental I’ve ever sold.

    I do low-maintenance properties ONLY. The longest I’ve ever had a vacancy in recent times is 1 week. I have no property managers, yet I live overseas. My workload is about 2 emails per rental property per year. No headaches. I don’t want to give away my secrets, but lets just say my investment targets are the exact opposite of slumlording.

    Finally, keep this in mind (Oprah would call this an “ah-ha” moment): any investment can be reduced to a set of cash flows and asset behaviors. Investment property is an inflation protected bond with equity features.

    What does that mean? Three key things:

    1) That means your target for annual total return of investment property is ~5% (the US stock market 7.5% net of inflation 2.5%). Anything beyond this means you’re beating the market and pretty much anybody on wall street (the only consistently higher return is buying, then improving and holding/flipping businesses, but good luck getting into that game without years of white collar work under your belt and tens of millions in the bank). That’s why I exited the stock market years ago and dumped all my non-401k money into rentals – nobody gets a better return than 7.5% without huge volatility. Real estate, when done right, has 7.5% and no volatility.

    2) If you have a low maintenance rental with a mortgage it’s literally no different than buying stocks and bonds on margin. Most experts think it’s crazy to buy stocks and bonds on margin. Draw your own conclusion.

    3) Investments are all about risk and reward. If you get a high return you are investing in a very risky asset (ie you have to buy inner city for 2% and you’ll spend all your time managing it). If you don’t see the risk, you’re being naive. It’s there. If you’re ok getting market returns, you’ll only have to invest minimal time, like me.

    —–

    Separately, great blog. I read a lot of them, many say the same thing and I lose interest after a while. Not so here.

    I’m focused on maximizing savings and investment (I’m at 72% savings at the moment when counting my salary + my investment income) and real estate, and I also used to be a computer guy, who worked with his hands on home improvement, so that probably helps.

    It may be a little heretical for you, but I don’t do this for early retirement (I reached that level a while ago), I keep working and saving because I love my job (I’m lucky) and so I can increase my spend level without affecting my savings. The great news is that the tools you provide to your readers can support either lifestyle approach!

    I spent 20 years in a tiny house on a farm in a rural area, with almost no material possessions other than the clothes on my back and a bicycle. That’s long enough for me. ;)

    Personally, I really enjoy my job and I love not having to feel concerned about how much I’m spending on experiences in life such as touring the world, living abroad, throwing formal parties, etc. I wouldn’t say I’m materialistic (i’ve given up nearly all of my possessions and live in furnished rental apartments allowing me to move at a moments notice), but when something is on my “keep” list, such as laptops or automobiles (I’ve been a car nut since age 12) I buy the best that money can buy — because I’ve saved up first.

    • bwall February 11, 2014 at 6:03 pm #

      2tall: Thank you for the informative analysis.

      As an aside: Were those 20 years spent in the rural area from age 0-20?

  22. CTY April 14, 2014 at 7:12 pm #

    What a great discussion. I have learned so much. For sure want to collect a few rental properties–this article has given me a lot to consider.
    Thank you.

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