In real estate, there are some rules of thumb that investors can use to quickly screen through deals to make guesses on whether to pursue them or not.
It’s important to notice that I did NOT say, “There are some rules of thumb that can help investors make purchase decisions.”
Why? Because rules of thumb are not meant to be hard and fast rules. They simply help an investor get a quick and dirty opinion on some valuable metrics. Always do a thorough, proper analysis.
But regardless, these rules of thumb can come in really handy in saving you from analyzing every deal that you come across.
In the video below, I’ve outlined several of the most common real estate math “rules of thumb” so you can begin practicing them in your own analysis of properties.
The 2% Rule (aka the 1% Rule or the 2% Test)
Perhaps one of the most common rules of thumb used by rental property investors is commonly known as the 2% rule. But because it’s not truly a “rule,” I like the 2% “test” better.
Essentially, this rule of thumb looks at the monthly rent divided by the value in a percentage form. For those who just got confused, let’s make this super simple by considering an example.
If a property rents for $2,000 per month, and the value is $200,000, then:
$2,000 / $200,000 = 1%
In this example, the property does not pass the 2% test, but it does meet the 1% test exactly.
Or what if it’s a property that rents for $1,500 per month and costs $180,000 to buy?
$1,500 / $180,000 = .8%
This definitely falls short of the 1% test.
Or what if the property rents for $1,500 per month but is worth $120,000?
$1,500 / $120,000 = 1.25%
OK, so you get how the math works. But what does it mean?
Essentially, the 1% or 2% test gives us a quick and dirty view on whether or not the property will produce positive cash flow. Of course, as it’s just a rule of thumb, it isn’t always precise. But generally speaking, the higher the percentage, the better the cash flow.
This also depends greatly on location, price, and how much the expenses truly are on the property. But either way, the rule of thumb can help an investor make some decisions on whether or not to pursue a property.
For instance, I know that most properties that fall short of 1% will likely never produce positive cash flow. If it’s between 1% and 2%, it probably will. And if it is above 2% (which is incredibly difficult to find in today’s market), I’m almost positive it will.
So if my real estate agent tells me that they have a perfect rental house for me to buy, I see that the purchase price is $125,000, and I find that it will rent for $1,000 per month, I can make a very quick decision and know that—most likely—the deal won’t provide cash flow because it falls short of 1%.
$1,000 / $125,000 = .8%
In a case like this, I probably won’t spend much more time looking at the deal if I was only interested in cash flow.
The 50% Rule
While the 2% and 1% rules of thumb we just mentioned can help give you a go or no-go decision on looking further into a rental property, it doesn’t really tell us how much cash flow we might expect. For that, investors often rely on the 50% rule of thumb.
The 50% rule states that, on average and over time, half of the income a property generates is spent on operating expenses.
“But what are operating expenses!?” you ask.
Good question! Operating expenses are all of the expenses involved with running a rental property, except the loan payment. It includes taxes, insurance, utilities, repairs, vacancy, and other metrics that leave the landlord’s checking account each month or year.
The 50% rule can help an investor quickly estimate the cash flow of a rental property because it combines all of the expenses, except the loan payment, into one easy number—half.
So imagine a property that rents for $2,000 per month. The 50% rule says that half of this ($1,000) will be spent on expenses. This means we’re left with $1,000. But then we need to make a mortgage payment (unless you paid cash for the property).
With the $1,000 remaining, let’s say the mortgage payment was $600. How much do you have left? $400.
$2,000 x 50% = $1,000
$1,000 – $600 = $400
The remaining value, or $400, is your estimated cash flow.
Of course, that 50% estimate on operating expenses can vary wildly depending on the property. In some areas, taxes and insurance might be incredibly high, but in other areas, it might be much lower.
Some properties require that the landlord pay all of the utilities, where other properties allow the tenant to pay their own. These (and other) property-specific details demonstrate the weakness in the 50% rule.
But although inherent weaknesses do exist, the 50% rule does have value!
When you are looking at a property that rents for $1,200 per month, and you know the mortgage payment would be around $1,000, you can almost guarantee that the property WON’T produce a positive cash flow. Why? Because $200 is not a lot of room for all those expenses.
$1,200 x 50% = $600
$600 – $1,000 = -$400
The 50% rule helps keep real estate investors in check and reminds us that there are numerous expenses that add up over time! Yes, a new roof is only needed every 20 years, but if you divide a $10,000 roof into 240 months, that roof is actually costing you $42 every single month!
These operating expenses add up, and as most investors have seen, they tend to settle around 50% given a long enough time frame.
The 70% Rule
The previous couple rules of thumb were designed to help rental property owners. But what about house flippers or wholesalers? For them, the 70% rule can be helpful in determining just how much to pay for a property.
The 70% rule states that the most you should pay for a potential flip is 70% of the after repair value, or ARV, which is what it would sell for when it’s all fixed up, minus the repair costs.
Here’s an example.
If a home would sell for $300,000 all fixed up, and the property needed $50,000 worth of work to get it there, then:
$300,000 x 70% = $210,000
$210,000 – $50,000 = $160,000
According to the 70% rule, the most someone should pay for this property would be $160,000.
But there are problems with the 70% rule. This rule of thumb assumes that 30% of the ARV will be spent on holding costs, closing costs (on both the buyer’s and seller’s side, such as commissions, taxes, attorney fees, title company fees, and more), the flipper’s profit, and any other charges that come up during the deal. This works well in many markets, but it has some severe limitations.
For example, the 70% rule doesn’t work as well for a property where the ARV is low, such as $50,000. As mentioned earlier, the 30% deducted from the ARV includes the holding costs and closing costs, as well as the profit the investor or flipper wants to make.
However, 30% of $50,000 is $15,000. So following the 70% rule, all the fees, costs, and profit add up to only $15,000.
If the fees and holding costs were to total $10,000, that would leave just $5,000 in profit for the house flipper—and I don’t know any house flipper who will take on the risk of flipping for just $5,000.
So following the 70% rule, a flipper or wholesaler would pay far too much for the property in this case. An investor flipping houses at this level might require far less than 70%—perhaps 50% or even lower.
A similar problem with the 70% rule exists for more expensive properties.
The 70% rule would dictate that a home with an ARV of $700,000 that needs $50,000 worth of work should produce a maximum allowable offer of $440,000.
However, in most markets, finding a $700,000 property for $440,000 is simply not feasible. A person who sticks exclusively to the 70% rule will likely never find a good enough deal to ever wholesale or flip a single property. In this case, 80% or even 85% might be good enough.
Furthermore, some investors may spend more or less on fees and costs because of their particular life situation or location. For example, in some states, purchasing a home may require $3,000 in closing costs, while in other states, it might be $6,000. Some investors may have a real estate license, which saves them tens of thousands of dollars in commissions, whereas other investors may need to pay commissions when they sell.
So, how should the 70% rule be valued? Very carefully.
It’s a quick and dirty way to guesstimate the approximate amount you should pay for a property. But as with all rules of thumb, no concrete decisions should be made unless you’ve run a real analysis on a property.
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Do these calculations make sense? Do you have follow-up questions about any of the rules?
Ask me in the comment section below!