How do I do a real estate rule of thumb relating to adjustment?

 Real Estate Investing Rules You MUST Know (The 2%, 50% & 70% Rules)

What is the 2% rule in real estate?

The great Recession in 2007, and subsequent housing crash, left people understandably leery of property investment. However, home prices have been increasing steadily since then, and many are now wondering: should I be investing in real estate?

Investment properties can be a sound strategy for wealth accumulation - especially today - and there are several basic strategies that you can follow. 

Buying & Renting

Buying a property and renting it out can allow you to effectively pay for your mortgage - and possibly make additional money through rental income. Renting out your property can also give you passive income, allowing you to spend your time elsewhere while still accruing capital. Buying and renting is an easy way to get into real estate investing. What’s important to know?

The Two Percent Rule: Is it True? 

The two percent rule in real estate refers to what percentage of your home’s total cost you should be asking for in rent. In other words, for a property worth $300,000, you should be asking for at least $6,000 per month to make it worth your while.

 The reality, though, is that the 2% rule is often impossible to achieve in metro real estate markets. It can be a good rule of thumb for understanding what you would need to charge in order to be cash-flow positive very quickly: however, the average rental cost in a city like Philadelphia is $1,660 - while the average home costs $203,000. Charging $4,000 for the average home rental, in other words, will be out of line with the local rental market.

In most markets, anywhere from .8% to 1.3% is more realistic. To figure out how much you can charge in rent, it’s a good idea to use Facebook, Craigslist, Apartment.com, etc. to see what other landlords in the area are charging. If your listing isn’t competitive, you’ll have trouble finding stable tenants. Pay attention to: 

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• Lot size
• Number of bedrooms
• Number of bathrooms
• Included amenities
• Year built

When comparing other rental properties to your own. 

Capital Gains Tax

If you’re not going to be living in your investment property, Capital gains tax on real estate investment property will apply (If you live there for at least 2 years, you can minimize - or even eliminate - your capital gains tax responsibility). 

If you hold onto property for less than a year, you’ll essentially pay the same in taxes as your ordinary income is taxed. If you hold the property for at least a year, it’s considered a long-term capital gain. These gains are taxed at a lower rate: 0%, 15%, or 20% depending on your income and filing status. 

Price Appreciation

Price appreciation is another way you can build wealth through real estate. In many cities across the U.S., home prices have been appreciating quickly over the past five years. Philadelphia, for example, has seen a 14.2% increase in average home value year-over-year - a home worth $150,000 in 2015 is now worth about $245,000. Because the U.S. housing stock has dropped to historic lows - maintaining intense competition among buyers - it’s likely that this trend will continue for the foreseeable future.

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Price appreciation, though, must be balanced against the rate of inflation (about 1.4% per year), and of course, homeowners lose money every year through taxes, upkeep and other expenses. This is why homeowners typically opt to either use their investment property as a residence, rent out a room, or rent out the entire property. 

How to Find Investment Property for Sale

Working with an experienced Realtor is the best way to find investment properties. They can direct you away from homes that are likely to have expensive problems in the future - and direct you towards homes that are likely to see quick appreciation in upcoming years, based on their experience and knowledge of the local area. 

Our guide to house flipping has more suggestions for how you can find properties, especially properties that might need a bit of work before they can be occupied. 

What to Look Out For

What factors are important for an area (and therefore property) experiencing price appreciation?

• Growth: if the neighborhood is experiencing influx of new, young families and lots of building, the price of housing in the area will typically increase.
• Local schools: access to schools, and school quality, remain a driving force of real estate appreciation
• Walkability: areas with easy access to local shops, restaurants, and amenities are increasingly popular. This can lead to predictable price appreciation.
• Nature:University of Washington research indicates that homes adjacent to nature parks and open spaces hold a 8%-20% higher value than comparable properties.
• Commercial properties: A Starbucks on every corner may work for your investment. According to Homelight, “Research shows homes close to Whole Foods, Trader Joes, and Starbucks appreciate faster than other homes.”

3 Rules of Thumb for Evaluating a Potential Rental Property - The 50%, 10% Rule, and The 1% Rule

And of course, many other factors go into price appreciation - or lack thereof- such as population trends, the economy, and mortgage rates, which can be more difficult to predict. 

REITs

REITs, or Real Estate Investment Trusts, are another way to get involved with real estate investment. Similarly to the stock market, you’re basically investing in a company’s portfolio of real estate investments. They are seen as a good investment category because they deliver high returns and long-term capital appreciation.

They also are distinct from other asset classes, and diversity of investment can help reduce overall risk in one’s financial portfolio. You can buy shares in a REIT through the public stock exchange; you can also invest in private REITs.

What to look for in a REIT:

• Growth industries. Residential real estate is a hot market, but malls - and their associated real estate - have been largely on the decline.
• A Growth in earnings. Higher occupancy rates and increasing rents means more revenue for investors.
• Good credit rating. A REIT that has been overextending itself with debt is more likely to have a poor credit rating.

1% Rule, 2% Rule, 3% Rule, 4% Rule, Rule of 72, Rule of 144, and many more… if you're interested in learning more about all the different real estate investing rules of thumb, then you've found the right place.

Below is a list of each rule of thumb along with a very brief description of what the rule is and how it is used.

3 Rules Every Real Estate Investor Knows (2% Rule, 50% Rule, 70% Rule)

1% Rule

The 1% Rule suggests that a rental property should have monthly rent that exceeds 1% of the purchase price.

1% of Purchase Price = Monthly Rent

For example, if you're buying a duplex for $280,000, you would need to have the total of the gross rents equal to at least $2,800 ($1,400 per side).

There are a number of real estate markets where it is possible to find a decent selection of properties that meet the 1% rule. In some other real estate markets, it is incredibly difficult to find properties that meet this 1% criteria.

The 1% rule tends to work better on lower priced properties.

Real Estate Investing Rule Of Thumbs (1%, 50%, 70% Rules)

In some cases you may be able to change the characteristics of the investment to take a property that wouldn't normally meet the 1% rule and force it. For example, you might be able to take a property where rent for a typical year long lease would not meet the 1% rule. However, if you use that property as a short-term rental instead of a year-long lease, you might be able to easily get a full 1% of the purchase price in monthly rent.

Property taxes tend to be higher (as a percentage of purchase price) in markets where you can more easily find properties that meet the 1% rule.

Buying properties at a discount will help you find properties that meet the 1% rule.

2% Rule

The 2% rule is similar to the 1% rule. Instead of the monthly rent exceeding 1% of the purchase price, the rent for the 2% rule must exceed 2% of the purchase price.

2% of Purchase Price = Monthly Rent

If you thought finding properties that meet the 1% rule was difficult, the 2% rule raises the bar even higher.

Using The 1% Rule for Real Estate Investments? Not So Fast

Previous comments about the 1% rule concerning property taxes, changing the characteristics or use of the investment and buying at a discount still apply for the 2% rule.

3% Rule for Estimating Rental Property Depreciation

If you take 3% of the purchase price of the property, it should approximately estimate the gross depreciation benefit of owning that property as a rental property.

3% of Purchase Price = Gross Annual Depreciation Benefit

Let's look at an example.

Property Purchase Information - Real Estate Investing Rules of Thumb - 3% Rule

Property Purchase Information – Real Estate Investing Rules of Thumb – 3% Rule

If we were to buy this example new construction property in Windsor, Colorado for $350,000… we might estimate our gross depreciation benefit to be 3% of the purchase price. That would be:

Why You Should NOT Use The 1% Rule

3% of Purchase Price = Gross Annual Depreciation Benefit

3% of $350,000 = $10,500

However, what happens if we do a more thorough calculation for the gross depreciation?

We can only depreciate the value of the building—not the value of the land. So, first we need to estimate what the value of the building is.

In our spreadsheet input you can see that we estimate that the land to be worth 15% of the purchase price or $52,500.

The remaining 85%, or $297,500, is the value of the building.

On residential rental properties, the value of the building can be depreciated over 27.5 years.

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Gross Depreciation - Real Estate Investing Rules of Thumb - 3% Rule

Gross Depreciation – Real Estate Investing Rules of Thumb – 3% Rule

So, take the $297,500 and divide by 27.5 years and you get a gross depreciation of $10,818. We can see this on the spreadsheet as well.

Estimating your gross depreciation benefit as $10,500 using the 3% rule when it really is $10,818 is close enough for what we're using it for.

Speaking of using it, how do you use this rule of thumb? When out looking at properties, you can use this rule to quickly estimate how much gross depreciation you will get by owning this property as a rental.

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Then, if you know your top tax bracket (or more conservatively… your effective income tax rate), you can multiply the gross depreciation amount by your tax rate to determine how much cash flow from depreciation you will receive.

Continuing with our example above, if you estimate you're paying an effective tax rate of 20% (across all your tax brackets), you can take 20% of $10,500 or about $2,100 and that's how much cash flow from depreciation you will receive.

This means you're property will appear to be cash flowing about $2,100 more per year when you take into account the tax benefits of owning the property. So, this property will give about $175 more in cash flow (from depreciation) than you think you're getting from your traditional cash flow calculation.

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The actual cash flow from depreciation calculation (when using the $10,818) in the spreadsheet is $2,163.64. That's pretty close to the $2,100 we'd get by estimating it with the 3% rule.

The cash flow from depreciation is the number in yellow, in the bottom right corner of the Return on Investment Quadrant™. In the image below it is shown as a percentage return on your initial investment in year 1.

Return on Investment Quadrant - Cash Flow from Depreciation Circled - Real Estate Investing Rules of Thumb - 3% Rule

Return on Investment Quadrant – Cash Flow from Depreciation Circled – Real Estate Investing Rules of Thumb – 3% Rule

4% Safe Withdrawal Rate Rule

If you have a million dollars invested for retirement, how much can you safely withdraw each year if you want to make reasonably sure you don't run out of money?

That's what the 4% Safe Withdrawal Rate Rule tells us.

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The 4% safe withdrawal rate is based on a study done by three Trinity University professors (commonly called the Trinity Study if you want to look up more info on it).

It basically states that:

We can safely withdraw 4% of our initial starting balance at retirement and adjust the withdrawal amount each year for inflation.

So, as an example, if you started with a million dollars invested in stocks and bonds, you can withdraw $40,000 per year in the first year. In the second year, you can safely withdraw $40,000 plus an adjustment for inflation. Each subsequent year the original $40,000 is adjusted for inflation so that you maintain the same “buying power”.

A few interesting points about this rule of thumb.

First, it does not apply to real estate investments. It was intended to be used when investing in stocks and bonds. For real estate, we typically look at a combination of cash on cash return on investment (when we have a mortgage on the property) and cap rate once the property is paid off.

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Second, it only looked at a 30 year retirement period. If you plan to retire early or live longer, this rule of thumb may no longer apply.

Third, in a large number of the test scenarios to evaluate the 4% rule, you end up with more money than you started with. In a small number of the test scenario cases, you do run out of money. If you continued to live beyond 30 years and needed to continue to withdraw money, you'd run out of money in a larger number of cases.

70% Rule of After Repair Value on Cash Offers

In many real estate markets, the formula for the Maximum Allowable Offer (MAO) you can make when buying a property for cash (or with a hard money loan) is defined by the 70% Rule:

Maximum Allowable Offer (MAO) =

(70% of After Repair Value (ARV)) – Cost of Repairs

For an example, let's assume the following:

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After Repair Value (ARV) is $200,000 – the property will be worth $200,000 once you're done fixing it up

The property needs $30,000 in repairs

So, the Maximum Allowable Offer you could make to purchase this property would be:

Maximum Allowable Offer = (70% of After Repair Value) – Cost of Repairs

Maximum Allowable Offer = (70% of $200,000) – $30,000

Maximum Allowable Offer = $140,000 – $30,000

Maximum Allowable Offer = $140,000 – $30,000

Maximum Allowable Offer = $110,000

It is important to realize that is the maximum offer you could make. You may want to start lower than this.

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This rule was originally designed for lower priced properties.

In more expensive markets—and especially competitive or hot markets—some investors will use alternative formulas for making offers.

For example, they might do something like this: Maximum Allowable Offer = After Repair Value – $30,000 Profit – Cost of Financing – Cost of Closing Costs – Cost of Repairs.

Rule of 72 for Compound Interest

If you have $100,00 invested in something earning 10% annual return, how long will it take for your $100,000 to double in value to be worth $200,000?

That's what the Rule of 72 can tell us. It states:

Number of Years Until Money Doubles = 72 ÷ Yearly Interest Rate

So, to continue with our opening question. Here's how the math would work for our example:

Number of Years Until Money Doubles = 72 ÷ 10%

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Number of Years Until Money Doubles = 7.2 Years

It will take 7.2 years for our initial $100,000 investment to be worth $200,000 if it is earning 10% per year.

Rule of 144 for Compound Interest with Regular Periodic Investments

The Rule of 72 works great if you have a lump sum amount of money you've started with and want to know how long it will take to double.

However, what if you're investing $1,000 per year and earning 10% per year on it? How long will it take for you to have twice as much as you invested?

That's what the Rule of 144 deals with: periodic investments at a fixed rate. It states:

Number of Years Until Total Amount Invested Doubles =

144 ÷ Yearly Interest Rate

To continue with our example, if you're investing $1,000 per year and earning 10% per year, how many years will it take for you to have twice as much as you've invested?

Flash Settings for Real Estate Photography

Number of Years Until Total Amount Invested Doubles =

144 ÷ Yearly Interest Rate

Number of Years Until Total Amount Invested Doubles = 144 ÷ 10%

Number of Years Until Total Amount Invested Doubles = 14.4 Years

So, it will take you 14.4 years before you have twice as much as you've invested in your account.

We then need to figure out how much you've invested to that point. If you're investing $1,000 per year for 14.4 years, then you've invested $14,400. So, at the 14.4 year point, you should have approximately $28,800 total in your account using the Rule of 144.

2:1 Rule of Creative Deal Structuring

The 2:1 Rule with creative deal structuring is best explained with an example.

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Let's say you've been sending out postcards to get motivated seller calls. A seller calls you in the following situation:

Property is worth $300,000

Seller owes $250,000

You can offer the seller $280,000 if you can buy the property subject to the existing financing

What are some offers you could make to the seller?

One offer is that you offer to buy the property subject to the existing financing (taking over the payments on their mortgage) and pay the seller their equity of $30,000 in payments of $100 per month until paid.

This would be a nothing down deal for you.

What if the seller wants to some money? How do you adjust your offer?

That's what the 2:1 Rule addresses.

If the seller insists on getting $10,000 from you up front, you expect to get a discount for having to come up with money up-front. For every dollar you need to give the seller up front you need to reduce the price by a dollar. So, you get $2 for every $1 you give the seller up-front.

The Full-Time Real Estate Photographer

Using the 2:1 Rule and the $10,000 the seller would like up front, the new offer might be: you will buy the property subject to the existing financing, pay the seller $10,000 up front and ask the seller to accept payments of $100 per month on the remaining $10,000.

The final offer price would be $270,000:

$250K on original loan

$10K in cash

$10K financed at $100 per month

This rule is helpful when negotiating with a seller face to face as a really quick way to adjust your offer numbers depending on how much cash they need when buying properties creatively.

$50 Rule of 30-Year Financing

When I was a teenager my father taught me that the payments on a house were about $7 per $1,000 borrowed on a 30 year amortizing loan. With this rule of thumb in mind, you can quickly estimate how much monthly payment principle and interest payment would be when buying a property with, let's say, $80,000 in debt (80 times $7 = $560 per month).

However, this rule changes with the current mortgage interest rate.

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In our current, lower-interest-rate environment, the rule is more like $5 per $1,000. I like to explain it to clients as $50 for every $10,000 borrowed.

When I taught a class on this, someone in the class suggested based on the chart below, that it really is the interest per $1,000 borrowed. That's a really rough approximation.

Monthly Payment of $10K Borrowed on 30 Year Amortization

Monthly Payment of $10K Borrowed on 30 Year Amortization

With interest rates in the low 4% range (which is where they are at the time of this writing), you can see that the payment for every $10,000 borrowed is $50 per month. That's $5 per $1,000.

It is important to note that this is just the principle and interest part of the payment. It does not include taxes or insurance or private mortgage insurance (PMI).

It also assumes you're getting a 30 year mortgage. Mortgages of different durations will have differing rules of thumb.

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Additional Real Estate Investing Rules of Thumb

$50 Rule of 30-Year Financing

8:1 Rule of Showings and Offers

1/3 of Rent and Expenses and 2/3 Rule of Free and Clear Properties

Rule of Future Dollars Today

Off-Market Deal Finding Rule of Thumb

Motivated Seller Calls To Deals Done Rule of Thumb

Motivated Seller Postcard Response Rates

80/20 Rule aka Pareto's Principle

1.25 Debt Service Coverage Ratio (DSCR)

$100 Per Door

Debt Paydown Return on Investment

Deal Analysis Rules of Thumb

Rules of Thumb for Estimating Repairs

Balanced Real Estate Market

Debt Paydown Return on Investment

Here's a sneak preview of the rules of thumb for debt paydown depending on down payment for your loan.

Real Estate Investing Rule of Thumb for Return on Investment from Debt Paydown

Real Estate Investing Rule of Thumb for Return on Investment from Debt Paydown

Real Estate Investing Rules of Thumb Class Recording

On September 4, 2019 I taught a special 2 hour class on these real estate investing rules of thumb for our local club that caters to people interested in investing in Fort Collins investment real estate. Check it out in the video below or on… what I consider to be… the best real estate investing podcast.

STOP USING THE 4% RULE

If you want to apply these rules to analyze your investment strategy, check out the best real estate investment analysis software available anywhere.

What is the rule of thumb in real estate?

Is the one percent rule a hard and fast guideline every investor must follow to be successful? It depends. While it's a useful tool for evaluating the cash flow of a property, it doesn’t necessarily tell the whole story of investment potential.

In this article, we pull the curtain back on what the one percent rule looks like in real estate investing, and when it may (or may not) make sense to follow it.

→View investment properties on our marketplace that meet the 1% rule

What is the one percent rule?

The one percent rule (aka "1% rule") is a guideline frequently referenced by real estate investors when evaluating potential property purchases. This rule of thumb states that the monthly rent should be equal to or greater than one percent of the total purchase price of an investment property.

Keep in mind, the one percent rule doesn’t account for other property expenses, such as loan and acquisition fees, closing costs, repairs, maintenance, insurance, property taxes, etc.

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Here’s how to calculate whether a property passes the one percent rule:

Rent / purchase price x 100

Here’s an example with an investment property that costs $100,000, and rents for $900 a month:

$900 / $100,000 x 100 = .9% (This property comes in just under the one percent rule)

While the one percent rule isn’t a make-or-break-it benchmark for all investors, it can be a useful screening tool to quickly estimate how a property will cash flow. It can also serve as a target for setting rental rates if the property is currently unoccupied.

What does the one percent rule look like in practice?

The one percent rule is more of a guideline than a rule, and not one you should follow blindly. Think of it as a screening tool or benchmark in a multi-step evaluation process that also takes property quality, location, and tenants into consideration.

For example: Let’s say you purchase an investment property for $50,000 in Detroit that rents for $500 per month. 

Does this satisfy the one percent rule? Yes. 

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Does that mean it’s a great investment opportunity? Not necessarily.

It depends on your personal goals and criteria as a real estate investor, and how many of those boxes the property checks (we dig into that more here).

Our point is, properties that come up short of the one percent threshold can still have upsides in investment potential. So if you’re eyeballing an investment home that doesn’t quite meet the one percent rule, don’t write it off without considering other fundamental factors that influence overall rate of return.

These include (but are not limited to):

The local market

Neighborhood quality and amenities

The current renters

Property condition

Forecasted home price appreciation

Projected rent growth

Demographic and socioeconomic trends

Foreclosure rates

Vacancy rates

Days on market

Below, we’ll dive in to just a few of these factors.

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Fundamental factors that influence overall rate of return

Population & employment growth

You know what they say about a rising tide. If a market is experiencing above-average population or employment growth, it may be a great time to get your foot in the door before housing demand spikes and the competition heats up.

Of course, it’s important to consider barrier to entry, or affordability, as well. Don’t bank your decision solely on the hope you’re buying in the next Denver or Seattle.

We explore this more, as well as how to identify population trends, in our blog post how to spot an up-and-coming real estate market.

Risk/return threshold

Consider how comfortable you are with the risk/return tradeoff of a certain investment property. Oftentimes, lower-priced homes will be a little bit riskier due to location, property condition or renter turnover, but typically generate higher current or cash-on-cash money returns.

Alternatively, if you’re focused on safety and security, “consider exploring low-risk investment homes that generate steady, reliable yield,” explains Roofstock CEO Gary Beasley. “An example of this may be a more expensive investment property (think $150-$250K) in a good school district. You’re going to get a lower yield, but on the flip side you may see better downside protection and less volatility.”

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Here is an example comparing two different investment properties from the Roofstock marketplace:

Property 1: An investment home in Douglasville, GA comes in slightly under the one percent rule. However, there are many other factors that make it appealing from an investment standpoint:

Strong 6.3% cap rate

Located in a 4-star neighborhood

Attractive commuting distance from a major metropolis (about 35 minutes from Atlanta, a very strong real estate market)

Above-average expected appreciation: Douglasville home values have gone up 12.4% over the past year, and Zillow predicts they will rise 6.9% within the next year (this is above Zillow’s forecasted national average of 6.4%)

Recently renovated/new fixtures and appliances

Property 2: An investment home in Chicago, IL comes in above the one percent rule, with a very high cap rate of 9% and gross yield of 16.1%. For some investors, strong cash flow is the top priority. They may be willing to assume a little more risk due to the following:

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The property is located in a two-star neighborhood

It’s an older home (built in 1910) and may have more maintenance/upkeep needs

There are significant expected capital expenditures that must be completed next time the property turns

In the case of these two properties, neither is necessarily better than the other. It all boils down to your investing style, goals, and risk tolerance. The point is, using a single metric like the one percent rule doesn’t paint the entire picture of investment potential.

Tip: See how the Roofstock Neighborhood Rating helps you measure real estate investment risk

Neighborhood

Neighborhood attributes such as local school quality, the “walkability” factor, commuting distance and proximity to amenities/services all play a role in the attractiveness of an investment property — and its potential for overall return. Take stock of nearby amenities like public parks and spaces, transportation hubs/systems, shopping plazas, restaurants and employment concentrations, for example.

“Look out for new retail developments and special economic zones, as their presence may help home price appreciation. It’s smart to buy within close proximity to these areas,” advises Jason Green, Roofstock Enterprise Account Executive. “For example, in Atlanta, they are expanding MARTA stations throughout the city. The neighborhoods near these future stations will become more desirable, and therefore may increase in value faster as the area sees an increase in demand. Get in ahead of the curve to participate in the most upside.”

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Forecasted appreciation

Understanding historic and projected home price appreciation rates is another piece of the puzzle when looking at the potential ROI on investment properties. Depending on the area you buy in, a property that doesn’t quite meet the one percent rule could still be a lucrative longer-term investment opportunity based on how it appreciates.

To see how different markets stack up against national averages, check out Zillow’s home value index.

For example, in Kansas City, MO — where you can still find affordable investment properties — home values are forecasted to appreciate by nearly 8% in October 2019. This is above Zillow’s forecasted national average of 6.4%.

Like the one percent rule, appreciation is a factor that should be considered when evaluating investment properties, “but it shouldn’t be the only factor driving your decision, depending of course on your investment goals and priorities,” notes Green. “If higher monthly cash flow isn't as critical and you care more about building up equity over time, you might focus on properties with higher appreciation potential.”

Rental demand and vacancy rates

Getting a sense of local rental demand and rental vacancy rates in a given market will help you better gauge the potential profitability of your investment.

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A few primary drivers of overall rental demand include proximity to employment, home prices/affordability, commuting patterns and homeowner/renter profiles.

Tenant turnover also impacts your bottom line. Costs can range anywhere from $1,000 to $5,000, with estimated averages landing in the ballpark of $2,500. For reference, national vacancy rates in the third quarter of 2018 were 7.1% for rental housing, according to the U.S. Census Bureau.

>>Related: Our first tenant turnover experience: How much it cost and what we learned

Adds Green, “When comparing different properties in different locales, it’s helpful to assume that turnover and vacancy rates will typically be greater for a higher-yielding home in a lower-rated neighborhood, versus a lower-yielding home in a higher-rated neighborhood. This may negatively impact your ROI.”

Sleuthing out this information may seem overwhelming for people who are out-of-town real estate investors, but don’t hesitate to call up a local property manager (or two) in the market you’re interested in. Ask about local rental vacancy rates, rental demand and turnover frequency.

Alternatively, you can also get market insight and perspective by speaking directly with a Roofstock advisor or one of our vetted property managers.

Advice for Perfectionists & Procrastinators: The 70% Rule

Other expenses

Like we mentioned earlier, the one percent rule doesn’t account for a number of other expenses. You might be looking at a listing that meets the one percent threshold, but has high taxes or needs a brand new roof next time the property turns.

Here is a list from our post on how to calculate investment property ROI, which outlines several of the costs owners typically assume when purchasing an investment property.

Repairs

City taxes

Property taxes

Property insurance

Mortgage/financing

Property management fees

HOA fees (if applicable)

Landscaping (if applicable)

Capital expenditures (bigger renovations, additions, etc.)

Vacancy costs (this is typically calculated as a percentage and factored into your projected expenses as a conservative oversight, in case the home sits empty between tenants)

At the end of the day, there is no one metric you should look at when evaluating investment properties. Know your investing criteria, and look at a blend of factors to help guide your purchasing decision.

In our Ultimate Guide to Finding Real Estate Investments, we talked about the importance of setting up a lead generation system so you have lots of investment properties coming across your desk to analyze and can choose from the best.

Since you’ll be screening 100’s of potential investment deals, you will need to learn the different rules of thumb that can be used as quick screening tools in order to reduce the amount of junk properties from your list of properties to do further due diligence on.

Disclaimer: never buy a property based entirely upon one of these methods and financial ratios. These methods are a way to filter out the 99% of properties that are not good deals and only focus on the best. Do further due diligence once a property passes initial screening using these rules of thumb.

Part 1: Rules of Thumb

First we will start with the general rules of thumb you can use when building your financial analysis spreadsheet to see if the deal will work out numbers wise.

Rule of Thumb #1: The 50% Rule

This rule states that for a real estate investment, the non-mortgage expenses will usually average out to about 50% of the rent long term.

For example: If you own an 8 unit building that brings in $5,000 per month in rent, you can probably expect that over the long run this property will cost $2,500 per month in vacancies, maintenance, and other non-mortgage charges.

Purpose – to ensure that you leave yourself 50% of the income to cover mortgage debt payments. If a loan is going to cost more than 50% of your gross income each year then the rule would advise not to purchase that property because you’ll risk being negative cash flow after paying all the non-mortgage expenses.

 

Rule of Thumb #2: The 2% Rule

This rule states that the real estate investment should rent for 2% of the purchase price.

For example: If you pay $50,000 for a property, it should rent for $1,000 per month as this would be 2% of the purchase price.

Purpose – This rule is to ensure you can get enough rent from the investment property to cover expenses and produce a cash flow.

It’s tough to find deals that will rent for 2% so you may have to settle for less than 2% such as 1.5% but you shouldn’t go below 1%.

Make 1% be the minimum price floor in order to avoid getting into negative cash flowing properties.

Here is a quick video on the 1% rule but you should ideally apply the same principles in finding a 2% property instead.

 

Rule of Thumb #3: The 70% Rule

This rule states that your purchase price plus repairs should be 70% of the ARV (after repair value).

The after repair value is what we discussed in the single family home section about what your property would sell for using comps of other homes that recently sold.

Once you know this ARV comp, you can multiply it by 0.70 and subtract out your estimated cost of repairs to come up with a purchase price.

The purchase price usually ends up around 45% to 55% of the ARV depending on how much repairs are needed.

For example: If similar homes have recently sold for $100,000 and you estimate repairs to cost $20,000 on your potential investment property, then multiply 0.70 by $100,000 to get $70,000 and subtract out your $20,000 in repairs to get a max purchase price of $50,000.

Purpose – to ensure you have room to profit from the flip after purchase price and rehab costs. Closing costs and realtor commissions will also eat into that 30% margin you are leaving yourself so your net profit might not be the whole 30%.

Click here to check out our real estate investing course that will give you all the tools and lessons you need to start buying investment property.

Part 2: Multiples & Ratios

Along with quick rules of thumb, there are also ratios and multiples you can use to compare investments and help in your decision making.

The Gross Rent Multiplier (GRM) – the gross rent multiplier, also known as the gross income multiple, compares the purchase price to the annual gross rent that the investment property can produce. For example, if you purchase a property for $50,000 that rents for $10,000 a year, then your GRM would be 5 as the purchase price is 5x the rents ($50,000 / $10,000 = 5).

The Operating Expense Ratio – compares the expenses to the overall income of the property. For example, if you had $10,000 in annual rents and had $6,000 in expenses, the operating expense ratio would be 0.60 or 60%. Ideally, we estimate the operating expenses to be 50% when analyzing a property but it can be higher such as 60% leaving us just 40% income to cover debt repayment.

The Break Even Ratio – the number of months the property needs to be rented to collect enough income to cover operating expenses. For example, you have a property renting for $1,000 per month and annual operating expenses are $6,000. You would need to have this example property rented for 6 months to break even.

The Debt Service Coverage Ratio – comparing the net operating income the property produces before debt to the debt payment total. You want this ratio to be greater than 1 in order for the property to have more net income than the debt service cost. Banks will typically require a property to yield a 1.25 DSCR or higher.

Example: You have an investment property that produces $10,000 in annual rents and has $5,000 in operating expenses.

The net operating income before debt would therefore be $5,000. Then you have debt payments that total $3,000 annually.

Take your net income of $5,000 and divide it by the $3,000 debt service cost to get a 1.6 DSCR. Had your net income been $3,000 you would have a 1.0 DSCR and a net income of $2,000 would yield a 0.67 DSCR.

When it goes below 1 it means you will be negative cash flow after paying your debt costs. Always find properties that yield above 1 to avoid over leveraging.

Resources:

• Real Estate Investing School: How to Retire on Passive Income
• Flipping Houses Made Simple
• Rental Properties Made Simple
• Personal Finance School: How to Maximize Money

Conclusion

These rules of thumb, financial ratios, and financial multiples are great places to start when analyzing an investment property so that you save time and prevent putting in wasted effort to analyze a deal further if it doesn’t pass initial screening.

On the other hand, these are just rules of thumb and can also hurt you if you stick to them too strictly.

Two issues are that you’ll pass up some good deals that may have worked out well had you done further analysis and secondly, these rules of thumb don’t always work as markets change.

In a hot market, for example, you’ll struggle to find a rental property that meets the 2% rule because prices have risen so much and rents haven’t kept up.

So it will appear that the rent to price ratio is 1% or less, nowhere near your goal of 2%.

Take these thoughts into consideration when analyzing your market! Best of luck to you.

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• Real Estate Investing School: How to Retire on Passive Income
• Flipping Houses Made Simple
• Rental Properties Made Simple
• Personal Finance School: How to Maximize Money