Say a $100,000 property has a Cap of 10%($10,000), divided by 2 to get NOI which equals 5% ($5,000). To get a Debt Service ratio of 2 or greater, I can only handle a debt service of $2,500 per year or $208 per month. According to bankrate.com thats only $30,000 financed.
Even if you purchase at $30,000 discount ($70,000), which would change the Cap to 14% ($10,000) your NOI would be 7% ($5,000), you would still have to pout down 45% to get the Debt Coverage of 2.
I am a little frustrated
Hi Faceplant,
A Cap Rate is distinctly a commercial property term and a cap rate is used for commercial property.
A single family home that grosses $10k per year has expenses but not as many expenses as commercial property. Even a duplex, triplex or fourplex will have more expenses than a single family home.
Your single family property may look like this.
$1000 - Per Year.
$700 - Per Year.
$300 - Per Year.
$500 - Per Year.
$500 - Per Year. ($15,000 over 30 years.)
$3,000 - Per Year.
Debt service and cash flow:
$7,000 = $583.33 Per Month.
These numbers are set up without management as most of us manage our own single family properties.
This covers $100k @ 5.75% for 30 years! (Debt and cash on cash returns)
$20k down
$80k mortgage
GR
so instead of the 50% rule your figuring more around a 30% rule for single family?
Hi,
Every single property you buy will have expenses! If I buy a new property with builder warranty and figure to buy a home warranty when the builder warranty expires and I intend to sell the property in 5 years my expenses are almost nothing, $350 per year for a home warranty, taxes and insurance!
On the other hand if you buy a property built in 1950 which has never been remodeled, upgraded or had the gut’s replaced you could be at a 60 percent expense ratio to debt service and positive cash flow (Cash on cash returns).
You have to be the one to evaluate those numbers.
50 / 50 rule is a commercial property term and used in residential 2 to 4 unit properties to check to cover all expenses! But a 2 to 4 unit property may be running a 34 / 66 ratio or a 39 / 61 ratio or a 43 / 57 ratio!
GR
Faceplant,
Don’t confuse the 2% rule with the 50% rule with Debt Coverage Ratio. Each of these is different and have different uses.
The 2% rule is a screening tool suggested by Mike Rossi. Under the 2% rule, you only consider a rental property as a candidate for purchase IF the monthly gross rent is at least 2% of the total of your purchase price and any initial rehab needed to get the property ready to rent.
Once you have a candidate property, use the 50% rule to see if the gross rent is sufficient to support the property. The 50% rule allocates half of the gross market rent to overhead, and the remaining 50% to debt service. If 50% of your gross market rent is not high enough to cover the debt service and give you an acceptable cash flow, then this is not a good candidate property.
If the property passes the 50% rule test, then compute the debt coverage ratio. Divide the monthy NOI by the monthly principal and interest payment (debt service). If the ratio is 1.25 or higher, then you have a good candidate property that may be worth your time to examine more closely. If the ratio is less than 1.25, then the cash flow is probably insufficient to handle the unplanned repairs that always crop up, yet stilll produce a positive cash flow for the year.
Each of these “rules” are just quick and dirty screening tools and are not meant to replace a detailed cash flow analysis.
Hope this helps. Note that Cap Rate is meaningless when discusssing single family dwelling rental property.
Thanks for your replies, it helps and I literally save this page and hit refresh every 20 minutes to see if anyone replies. :biggrin.
Although, I am still flying blind here. If I drop the Debt Coverage Ratio down to 1.25 then the MAX Debt Service per year is $3800, which gives me a MAX financed amount of $50,000. (Obtained from Bankrate.com)
The 2% rule cant be practical or actually applied, correct? If I bought a house for only $60,000 it must rent for $1,200. If I only converted HALF of revenue to NOI i would have a 12% ROI, thats a 24% return yearly - gross anyway.
Faceplant,
It’s easier in some places than others to find deals that will cashflow as rentals. I’ll give you a couple quick examples of houses I bought that didn’t require much to get up and running.
One house was purchased from an online auction for $10,800. I put about 2k in it to get it ready to rent. It has been renting for the past couple years at $500/month.
Another house was purchased directly off the MLS for $19k. This one only needed about $500 to get ready. It has been renting for the past couple years at $550/month.
As you can see, using the 2% rule I could have had 25k in the first deal and 27.5k in the second dea, but was far below that on each of them. This is how we do it. We’ve done deals like these over and over again.
Thank you justin for your reply.
Would you say most of your properties are Section 8? I have watched online auctions before but I do not know if I could bring myself to purchase a house without walking through it - I guess it is still knew to me. I do understand how you are getting excellent Debt Coverage Ratios by purchasing properties under (I assume) $30,000. I also assume you do not factor in appreciation in your profit expectations, but you try to pull your original investment back out. Do you manage them or do you have a company do it?
Also, is it fair to say then that house in the 90k + range cannot cash flow positive?
I’d say about half of our properties are currently on section 8. Let me add something about that online auction… It was a property that was listed on the MLS with all the others. We didn’t even know it was on an auction site until we tried to put in an offer. We also got to walk thru it just like you would for any other listed property so I knew what we were getting with that property. You’re right about our numbers. I don’t think we’ve ever had more than 30k into a house to purchase it and get it ready. I also don’t care about appreciation. I keep track of each property’s value (it’s part of the financial statement we have to submit to the banks each year anyway), but I don’t worry about what the houses will be worth 10, 20, or 30 years from now. I just let the tenants pay for them one month at a time. We manage the properties ourselves. We’ve had good success with it overall and we’re pretty hands on with everything, so we don’t pay someone else to manage them for us.
Market rents aren’t going to go up linearly when compared to purchase price. The rent increases will start to settle out as prices increase. There are some houses being rented in my neighborhood that are worth about 300k. I know one house was renting for $1700. So you can see how that’s vastly different from me getting $600/mo out of a 25k house from a cash flow perspective. Generally the quality of tenants will increase as you get up out of the low income properties. That’s not to say all low income folks are bad. There’s just usually more drama in the low income properties so some people decide to stay away from them. We’ve got a pretty good bunch of people overall so we try to keep them happy.
So what do you think is the Debt Coverage Ratio of the average single family investor is?
Wrong question. Chances are that the “average” SFR investor is running a negative cash flow. The question you need to answer for yourself is what DCR makes the property support itself. For me, that number has consistently been 1.25 or higher. When I finish my detailed cash flow analysis, I don’t go forward with a purchase offer unless the DCR meets or exceeds my number using 80% LTV financing.
When there is no financing involved, such as the $20K property I pay cash for then rent for $600 per month, I look at the return on investment to make sure the yield is better than I could get on other investments available.
I was asking because i figured the average investor is cash flow negative, so I was going to reach higher than the responses I got back. :biggrin . I assume that by a 1.25 DCR your properties provide you with extra spending money and cash flow positive, correct?
Correct, but this is my number for my investment criteria. It fits my investment approach and property portfolio. If you have older properties that tend to become maintenance intensive, then you may need to reach for a higher number.