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.