% of cashflow formula question

[hthompson001]

I'm going to first off say that I'm a newbie to real estate investing and a bit of a numbers nerd.  I've learned a great deal by reading through these forums and will be joining my local REI club very soon.  My investing strategy is to buy and hold so I'll be renting the houses that I purchase.  I'm a very stable wage earner with extra money to float the mortgage if/when needed.
My question is what % of net income do you like to see from a rental?  ie if you find a deal and everything makes sense (it cashflows) how much more than the debt service do you consider a good deal?  I'm currently looking at a deal that where the house is $80k and just needs some paint and carpet to be rental ready.  I figure my monthly expenses will be $700 (I've already been approved for a mortgage and this number includes taxes and insurance) and comparable properties are renting for $950 to $1,000 in the area.  Does this sound like enough cashflow to make it work?  What do you experienced investors require of your deals?  Thanks in advance!!!

Heather

[TXRehabber]

Hi Heather,

Search the rehab and landlord forum for the 50% rule or 2% rule, Mike (Propertymanager) has written a lot of good stuff on this subject.

In short, the monthly rent divided by two should cover your debtservice and profit. The other half goes to expenses such as vacancies, evictions, repairs, taxes and insurance (Also known as Operating expenses).

So if your rental income is $1000 per month, the detbservice and your profit (preferred concensus seems to be $100 per unit) can not exceed $500 which would be your operating expenses.

[TXRehabber]

Sorry I need to clarify 

$500 is operating expenses, the other $500 is your debtservice and profit..... to fast with the keyboard.

[hthompson001]

Thanks TX I appreciate your help.

[jbaldwin]

Let me clarify this a little more for you.  TXRehabber is right in that 50% of gross rents should go towards operating expenses and the other half is debt service and profit, but I think he/she is confused about the 2% rule, or just simply left out that in his/her comments. 

The 2% rule is another screening tool to see if the asking price is at all in line with the monthly rent.  To use your $1000/mth number:

$1000/.02 = $50,000 ----->>> This is what you want to try to get the property for.  It's real general and doesn't involve any sort of sophisticated investing projections but it will give you a starting point.  Good luck.

Let's look at your deal given your numbers:

Monthly Rent:  $950-$1000
Expenses:      -$700
                         $250-$300
Less Debt:
$80K @ 7% / 20 yrs = $620/mth

Monthly LOSS:  $270-$320---->>>Increase Rent, Cut Price, Cut Expenses to get this number in the black.

[dd564]

Depending on your location, you may not find any rental close to working with those formulas EVER.  The thing with formulas are other factors in a given market can influence demand for the rentals.

Example would be NYC.  I don't think you'll find any rental in NYC that rents for $1000 per month that you can buy for $50,000.

In my market, my first rental is as follows, and I'm not sure longterm how it will shake out yet.

Monthly Rent Income = $1675. 
Debt Service = $1185
That leaves me with $490 per month.
My taxes and insurance = $300, so that's leaving me with $190 in expenses (repairs) for the remainder of the month.

So I'm nowhere close to the ratio, but part of the reason I'm renting it is to hold for a market turnaround.  From talking with other investors in the area, if you are breaking even on rental over debt and taxes here, you're doing well.

Instead of 50% for expenses, this rental is 29.2%.

[TXRehabber]

Jbaldwin,

Thanks, I did forget to mention the 2% rule, like you said I am confused 

I usually go more by the 50% rule but the 2% rule seems good as an initial checkpoint of where the price should be.

And o by the way  I am a man (At least last time I looked)

[j1dias]

Depending on your location, you may not find any rental close to working with those formulas EVER.  The thing with formulas are other factors in a given market can influence demand for the rentals.

I have mixed feelings about this. One part of me feels that you are right in your statement that formulas are only a good indicative but other market conditions should also be taken into consideration (at least this is what I understood from your statement above). But another part of me feels that good formulas should not be disregarded because we can find reasons to make a deal look good. I believe the risk is that we may end up finding excuses to make a deal even though the formulas don't recommend it.

I guess what I am trying to say is that even though it is true that formulas are only good indicatives, we should be aware that when we disregard them we may be including more risk into our portfolio than it would be wise.

Just my 2cents...

[hthompson001]

Hey guys....well I put in a bid at $50k for the house (really lowballing them) but we'll see what happens.  Thanks again for the advice, I have more "direction" now.
Heather

[dd564]

Depending on your location, you may not find any rental close to working with those formulas EVER.  The thing with formulas are other factors in a given market can influence demand for the rentals.

I have mixed feelings about this. One part of me feels that you are right in your statement that formulas are only a good indicative but other market conditions should also be taken into consideration (at least this is what I understood from your statement above). But another part of me feels that good formulas should not be disregarded because we can find reasons to make a deal look good. I believe the risk is that we may end up finding excuses to make a deal even though the formulas don't recommend it.

I guess what I am trying to say is that even though it is true that formulas are only good indicatives, we should be aware that when we disregard them we may be including more risk into our portfolio than it would be wise.

Just my 2cents...

I agree formulas can be very good rules of thumb, but PropertyManager's is basically this:

Monthly rent / 2 = debt service.

So if monthly rents = $500, that's $250 for debt service.  That leaves $250 per unit for income, expenses, and repairs.  Say taxes and insurance takes up $100 of that, that leaves $150 for repairs or profit.

I guess my formula that I'm starting with is that I need enough in rent to cover debt service, insurance, and taxes, plus and additional $150 per unit for repairs per month.

If you look at the amount he and I each have for repairs, it's probably about even, but as a percentage of rents, mine is much lower.  Where I'm exposed however is if my more expensive properties cost more to repair, etc.  I have more risk on that side, but for the market I'm in and the neighborhoods I invest in, the appreciation  (which should never be the reason to invest, but it will be the one that ads the most net worth) could be more.

[jbaldwin]

I agree formulas can be very good rules of thumb, but PropertyManager's is basically this:

Monthly rent / 2 = debt service.

Sorry, but you're wrong in your analysis.  You guys/girls are confusing and interchanging the 50% rule and the 2% rule when you shouldn't be.  It's real simple:  The 50% rule is just stating that on a national average 50% of gross rents are used up in operating expenses.  That's the national average according to organizations such as the National Apartment Assoc.  Mine happens to be much lower than that, but it is an average to go by.  The 2% rule states that your acquisition price (purchase + repairs) should be 2% of your monthly gross rent, therefore is monthly gross rent is 1k, then 1,000/.02 =  $50,000--->>>That is what you want to try to get the property for.  It seems as if the previous posts are confusing their math when it comes to dividing by 2 or .02, clearly it makes a huge difference.

So if monthly rents = $500, that's $250 for debt service.  That leaves $250 per unit for income, expenses, and repairs.  Say taxes and insurance takes up $100 of that, that leaves $150 for repairs or profit.

Here's a perfect example of not understanding the formula.  If montly rents = $500, that's $250 for operating expenses, not debt service.  The leftover $250 is for debt service AND profit!!!  Taxes and insurance are included in the operating expense $250, because they are by definition, operating expenses.  It's real simple I feel like you guys are over analyzing this.  Good luck.

[j1dias]

The 50% rule is just stating that on a national average 50% of gross rents are used up in operating expenses.

Is the 50% really an average? I thought it was more like a conservative estimate. My thinking...

If it is an average, it means that approximately half of the time the expenses are higher and half they are lower than 50%. If you have multiple properties, than it is probably ok because you may hit the 50% on average. But if you have only one property, you would have 50% chance of having more than 50% in expenses...

However, my belief is that the majority of the properties will not require 50% in operating expenses. The 50% is only a conservative number. Am I right?

With this in mind, is it really true that the 50% is an average? Or it is more like a conservative estimate? I believe it is the second.

Hey - over analyzing is fun... :O)

Now let's see if I can over work and apply it... :O)

have a good day!

[BrianA06]

How do the formulas change when you get to more expensive properties?  If the price tag is $500k or even $1mil, and the mortgages are larger, do the formulas compensate for that?

I am working on a deal that is $550k, but that .02 theory comes back with around $340k as the price.

[jbaldwin]

Is the 50% really an average?

YES!  How many times do I have to say it.  Check with the National Apartment Association.  This number applies to the average for all residential rental properties.  It's just an average, that's it, my properties are something like 25-35%, others are probably 55-65%, that's what an average means.

How do the formulas change when you get to more expensive properties?  If the price tag is $500k or even $1mil, and the mortgages are larger, do the formulas compensate for that?

Mortgages have nothing to do with the 50% formula.  50% of gross rents are eaten up by operating expenses i.e. taxes, insurance, utilities, management, etc...not debt.  I've done 100k deals and I've done 1mil deals and I always keep the 50% in my head but I know for my market and my properties it's more like 30%.  The bigger the deal goes the more sophisticated investment formulas you should use, is my opinion.  This is where cap rates, IRR, and these other formulas come into play.

I am working on a deal that is $550k, but that .02 theory comes back with around $340k as the price.

My personal opinion is that the 2% rule is a little too good of a target to reach.  Most everything I buy isn't going to fall within that rule, but it's a rule of thumb, use it as a screening tool of sorts.  I don't base anything I buy off of it, I use cap rates but I'm just letting you guys know what the rule is.  Good luck.

[phlemboy]

If you want to see just how close the 50% rule is, just apply it to your local market conditions. You'll soon see the difference between what the agents say is positive cashflow and reality. The 50% rule also takes into account items like evictions,maint, etc. These are also items that are hard pinpoint from year to year. I'm finding the 50% rule to be more of an absolute than a rule of thumb in my area. Finding deals that cashflow using the 50% rule is very difficult in my area. But sometimes the best deal is the one you DON'T do. Happy Investing!!