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The Fifty Percent Rule and the Two Percent Rule




If you spend any time on real estate blogs like biggperpockets.com, you'll run into mention of these two rules all over the place. There's a lot of debate over them-mostly because so many people misinterpret their use.

The fifty percent rule states that over time, all expenses (including vacancy, but not financing) will equal one-half of the gross income of the building. So if you have single family rental house, renting for $700 per month ($8,400 per year), your average annual expenses, over time, will be $4,200 per year. The fifty percent rule actually pans out very close to reality nationwide. The problem is how people interpret the rule. One Realtor, even after reading my definition, thought that I was saying that maintenance only was half of gross income. Other people think it means your costs will equal half your income every single year, period. Here's the deal: The fifty-percent rule includes every little expense on a property, even vacancy and large-scale capital improvements. It also includes a property management fee, (even if you manage the property yourself). Most important might be what it does NOT include: It does not include financing, because financing varies depending on the term, down payment, etc. and so including it would artificially enhance or diminishes investment returns. In other words, you wouldn't be able to "compare apples to apples". A deal where we need only put 5% down, and we have 30 years to pay is going to look radically different on paper than a deal where 25% is required with only 20 years to pay. So when we analyze an investment property, we first want to know what our return will be if we pay cash, so that we can compare the "unleveraged return" to other available investments like stocks or bonds (or another property).

People use the fifty-percent rule most often like this: Let's use a four unit as an example, grossing $2,400 per month or $28,800 yearly. Take your gross income and subtract fifty percent. You're left with $14,400. Now decide what you need for cash flow. For example, if it's a four unit, and you've decided you want the fairly common minimum of "$100 per door" (per unit), you would subtract another $400 per month, or $4,800 per year, from your $14,400. Now what's left is what you have available for debt servicing, which is $9,600. Take this amount, divide it by twelve, and plug it into the proper calculator (linked below), to find out the maximum amount you can borrow. Calculate this as if you're borrowing 100%. This will tell you the maximum amount to pay for the building if you want your numbers to work. Put "0" in the down payment and insurance fields, and use your expected terms for financing. I used 5% and twenty years because this is similar to the terms I usually get. You can use thirty years if you are able to get thirty-year investment property financing. The calculator I use says I can pay up to $121,200 for this four unit. This includes the purchase price plus up-front improvements, or "cost plus repairs." I also did a second analysis using thirty-year vs twenty-year financing. I found it intriguing that the calculator told me I can afford to pay $149,000 if I were able to get a thirty-year loan. This is why it's crucial to do a full and proper analysis on a property and not just blindly follow a simple rule of thumb.

Use this rule as a general ballpark to check against your own analysis, but don't use it exclusively to judge the merits of a deal.
Link to calculator: http://www.escapesomewhere.com/cgi-bin/real_estate_calculator_html.pl?view=house_payment

The two-percent rule: The two percent rule is a bit cruder, and if too much emphasis is put on it, can lead to some bad decisions. The two percent rule states that the price you pay for a building should result in the monthly rent equaling two percent of the purchase price. In other words, if a house rents for $700 per month, you should pay no more than $35,000 for it. Now show me a $35,000 house and chances are you'll be showing me an old rundown house in the worst neighborhood in the city. So this rule isn't always a great one to use if you're looking for decent middle-class homes in nice neighborhoods. Using this rule alone may mislead you into thinking that everything you look at is overpriced. On the other hand, depending on where you live, you may indeed be able to find nice, middle-class homes in desirable neighborhoods for under 40k. That's something you need to discover.

Now for SFHs a lot of investors use a variation called the one-percent rule, which is just what it sounds like: The price you pay for a building should result in the monthly rent equaling one percent of the purchase price. This results in an acceptable price of $70,000 for that $700 per month rent, which is more typical of a livable blue-collar type house situation. You won't make a ton of cash flow in these situations, but you'll still have a decent shot at building wealth faster than the average investment.



The two percent rule starts to become more useful when you start applying it to four-unit buildings and up. Using our earlier four-unit example, each apartment rents for $600 per month for a total of $2,400. The two percent rule would allow you to pay $120,000. This is only $1,200 off from using the fifty percent rule, so now we know we're onto something. Keep in mind, again, this is the "cost plus improvements price" not the purchase price (unless the building is in perfect condition).

The two percent rule isn't perfect, and many real estate investors will tell you it's only useful in low-income situations. And that may be true in some markets. Here in Central Maine, I'm finding it's useful even for class B properties. There are four-unit properties here that can be picked up for $100,000 that need some work, and $120,000-$150,000 that are very desirable "turnkey" properties. That being said, our one foreclosure experiment (two unit property, class C neighborhood) has turned out to be a "four percenter." Our nicest buildings, full of white-collar residents, just cross into two-percenter territory. Keep in mind that this is Central Maine, which is slightly less affluent than average. For example, you can buy a decent quality three-bedroom, two-bathroom starter home in this area for around $120,000.

Like the fifty-percent rule, the two-percent rule is not the end all/be all. Run it up against your own numbers. What I find useful is doing my own analysis first, coming up with an offer price, and then testing that price against both these rules. If one of them is way off, then I know I might need to double check my numbers, but because these rules are so quick and easy to check, I recommend you toy with them on each property you consider, even ones you already own. The more ways to look at something, the better.

What I would recommend you not do with these rules is use them to blindly eliminate a property from consideration. Don't take a property off your radar just because rent would be 1.5% vs 2% of the purchase price. Check your own analysis. Some buildings will make you enough cash flow even if they don't adhere to the 2% rule. If it's close, make a lower purchase offer. Use these rules, but don't let them control you.

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