50 % Rule

[monnchew]

I'm still trying to figure out this 50% rule and could use some help.  I have done a few flips and have been successful, but want to understand the equation to get into the rental market.

In my area, a $50,000 home has property taxes around $2,900.  If I buy it at $35,000 - what is the minimum rent I need to get to be within the 50% rule?  Also, do these taxes seem unreasonable? 

Thanks for all your help and knowledge,

[Dave T]

The 50% rule says that if you collect the market rent for a property, then half of the rent will be needed to cover your overhead costs.  Out of the other half, you pay your debt service.  Whatever is left over is your cash flow.

The 50% rule is simply a screening tool when you don't have accurate expense data.  If a potential property will generate an acceptable  positive cash flow under the 50% rule, then you do a detailed cash flow analysis to see whether the cash flow is really there when you have good working numbers.

Each investor has his own criteria for an "acceptable" cash flow.  Many use $100 per unit per month as their threshhold.

[WeSellHomes2Fix]

50% of the rent - P&I = (whats ever left over is + monthly cashflow)

rule of thumb, but a good one

[monnchew]

So for this example, if I can pull in $500 monthly rent.  My monthly cashflow will be $29 ($221 monthly P&I - $250).  However, my taxes alone will take up the remaining $250 and the $29 cashflow will only cover a small portion of other expenses.  It seems that I only have a few ways to make this deal better.

1.  Get a better price on the house
2.  Increase rent - but this could lead to a higher vacancy rate
3.  Lower the property taxes - Does this ever happen?

Are there other solutions?  Do you believe in cash deals and if so, how do you evaluate the deal? 

[redhawk]

Rents are low. Taxes are high and you are squeezed in the middle.
Welcome to land lording. Yes those taxes seem high In some areas of the country the property taxes are the main problem with finding a good deal for the buy,fix and rent strategy. But good deals are still out there.
redhawk

[alex79]

monnchew,

You must be an engineer or something as you really like those formulas! I am new to REI, so take my advice lightly.

You can reduce your taxes by trying to fight them with or without professional help. There are tax consultants that will do it for you on percent of savings basis, so it's risk free for you. Or if you have the time, you can appeal them yourself, search for a post that I priviously posted on this subject.

Additional food for thought: mortgage interest and terms are big part of this formula. Going from 15 year to 30 year mortgage will help obtaining desired formula outcome. Is 40 year mortgage an option?

Alex79

[monnchew]

Alex,  You're funny.  I'm a financial advisor and just want to see how everything calculates out.  I try to reduce my risk by knowing the variables and what I have control over. 

[justin0419]

In my area, $2900 of taxes would be on a 200k house, not a 35k or 50k house.  The numbers in your example are not good for you financially.  This property would be a loser for 30 yrs.  Deals don't get better by throwing more of your cash at them.  They get better by negotiating lower purchase prices and by making cost effective improvements which allow you to raise rents. 
And there is no way that I would recommend going out to 40 yrs on a mortgage.  You're not going to find a financial institution to consider that anyway for such a low value property. 
You briefly mentioned taxes ate up most of your $250 used for operating expenses (and didn't leave much for other expenses).  Those other expenses are going to tear you up on a deal like this.  Do you have any idea why property taxes are so high there for a 50k property?

[monnchew]

Not totally sure why it's that much.  I guess it is worth more than I'm stating.  The SEV is $44,500, but the market value is about $68,000 (still a $68,000 home requiring $3,000 in taxes is insane...I believe).   And I'm claiming non-homestead.  So these taxes just kill me and the deal quickly.

The information I'm basing this on is a home I currently own and renting.  I've rented this house for the past five months and selling,  it to them on Wednesday.  So before I do a long-term rental, I need to make sure I am doing this correctly. 

Any advice?  Buy a cheaper house?  Work on the tax issue?  Increase the rent????

[justin0419]

Rents can only be at what the market will tolerate.  Otherwise you can ask well above market rent, but will have your property sit vacant.  Personally I would rather get just below market rent and keep my units filled.  Just one month of vacancy will kill any advantage someone gets by asking an extra $40-50/month.  The tax amount seems insane.  Even in some parts of TX (where property taxes can be really high) your tax amount would be for a $125k house or something in that range.  Even if your house is 68k, the 2.9k in taxes is very high and limits what you can do.  If your market rent really is $500/mo, there's not much that can be done to overcome the taxes.  Your proposed mortgage payment was only $221/mo.  Even if you drop that by $100/mo, you still don't have a whole lot of room because of the taxes. 
I wonder what other people's numbers look like in your area.  I moved last year from an area where the price to buy houses was so high that the only people who had rentals there were either people who had lived in the area and owned property for many years before the run-up or people who speculated and bought at the peak (and were stuck with their overpriced homes that the rent didn't even come close to paying the mortgage payment).

[Dave T]

Are there other solutions?  Do you believe in cash deals and if so, how do you evaluate the deal?
 

Since the 50% rule eliminates this property as an acquisition candidate, most seasoned investors won't waste time trying to make a deal work.  They will move on to another property

I evaluate cash deals a little differently.  For a cash deal, divide your annual cash flow by the purchase price and see what your return on investment is.  Compare the yield against other investment vehicles (not just other properties) to see if your money will work harder for you in another investment.

Actually, I use this same rule for a deal where I use financing.  I want to see if the return on my invested capital competes favorably with other investment vehicles for the risk.  For example, if you can get a 6% return on invested capital with a rental property, and a 6% after tax  return on investment with insured municipal bonds, the investment property does not seem to make sense when I can get the same return with much less risk with municpal bonds.

[monnchew]

Dave,

That is very true and great insight.  I have been struggling with this notion for awhile, however, I have been wondering how others in my community can make a rental work.  Like you said, these figures  don't work in my favor...why/how could they work for others?  Just trying to understand and apply what I've learned here.

[christopher w]

Monchew,

In regards to you wondering how others do it in your community the answer is...most don't. People get in and out of real estate all of the time. Unless you have huge reserves it is very easy to get caught up in future profits and forget about what is in store for them right now. Losing money now in the hopes of making money when you sell is a recipe for disaster.

[monnchew]

Let me run these numbers past you:  Cash Purchase - $15,000 (closing, repairs, etc), Monthly Rent- $500 (staying about $50 below market), Annual taxes and insurance - $3200.  How would you guys analyze this?

[justin0419]

My wife was working on an insurance policy today for some "investors" from NM who have 10 rental houses.  All but two of them have between 3 and 5 mortgages EACH.  Mortgages range from 121-237k.  The highest rent on any of these properties is $630/mo.  Yes, some people screw this stuff up pretty badly...