% of cashflow formula question

I’m going to first off say that I’m a newbie to real estate investing and a bit of a numbers nerd. I’ve learned a great deal by reading through these forums and will be joining my local REI club very soon. My investing strategy is to buy and hold so I’ll be renting the houses that I purchase. I’m a very stable wage earner with extra money to float the mortgage if/when needed.
My question is what % of net income do you like to see from a rental? ie if you find a deal and everything makes sense (it cashflows) how much more than the debt service do you consider a good deal? I’m currently looking at a deal that where the house is $80k and just needs some paint and carpet to be rental ready. I figure my monthly expenses will be $700 (I’ve already been approved for a mortgage and this number includes taxes and insurance) and comparable properties are renting for $950 to $1,000 in the area. Does this sound like enough cashflow to make it work? What do you experienced investors require of your deals? Thanks in advance!!!

Heather

Hi Heather,

Search the rehab and landlord forum for the 50% rule or 2% rule, Mike (Propertymanager) has written a lot of good stuff on this subject.

In short, the monthly rent divided by two should cover your debtservice and profit. The other half goes to expenses such as vacancies, evictions, repairs, taxes and insurance (Also known as Operating expenses).

So if your rental income is $1000 per month, the detbservice and your profit (preferred concensus seems to be $100 per unit) can not exceed $500 which would be your operating expenses.

Sorry I need to clarify :bash

$500 is operating expenses, the other $500 is your debtservice and profit… to fast with the keyboard.

Thanks TX I appreciate your help.

Let me clarify this a little more for you. TXRehabber is right in that 50% of gross rents should go towards operating expenses and the other half is debt service and profit, but I think he/she is confused about the 2% rule, or just simply left out that in his/her comments.

The 2% rule is another screening tool to see if the asking price is at all in line with the monthly rent. To use your $1000/mth number:

$1000/.02 = $50,000 ----->>> This is what you want to try to get the property for. It’s real general and doesn’t involve any sort of sophisticated investing projections but it will give you a starting point. Good luck.

Let’s look at your deal given your numbers:

Monthly Rent: $950-$1000
Expenses: -$700
$250-$300
Less Debt:
$80K @ 7% / 20 yrs = $620/mth

Monthly LOSS: $270-$320---->>>Increase Rent, Cut Price, Cut Expenses to get this number in the black.

Depending on your location, you may not find any rental close to working with those formulas EVER. The thing with formulas are other factors in a given market can influence demand for the rentals.

Example would be NYC. I don’t think you’ll find any rental in NYC that rents for $1000 per month that you can buy for $50,000.

In my market, my first rental is as follows, and I’m not sure longterm how it will shake out yet.

Monthly Rent Income = $1675.
Debt Service = $1185
That leaves me with $490 per month.
My taxes and insurance = $300, so that’s leaving me with $190 in expenses (repairs) for the remainder of the month.

So I’m nowhere close to the ratio, but part of the reason I’m renting it is to hold for a market turnaround. From talking with other investors in the area, if you are breaking even on rental over debt and taxes here, you’re doing well.

Instead of 50% for expenses, this rental is 29.2%.

Jbaldwin,

Thanks, I did forget to mention the 2% rule, like you said I am confused :flush

I usually go more by the 50% rule but the 2% rule seems good as an initial checkpoint of where the price should be.

And o by the way :beer I am a man :slight_smile: (At least last time I looked)

I have mixed feelings about this. One part of me feels that you are right in your statement that formulas are only a good indicative but other market conditions should also be taken into consideration (at least this is what I understood from your statement above). But another part of me feels that good formulas should not be disregarded because we can find reasons to make a deal look good. I believe the risk is that we may end up finding excuses to make a deal even though the formulas don’t recommend it.

I guess what I am trying to say is that even though it is true that formulas are only good indicatives, we should be aware that when we disregard them we may be including more risk into our portfolio than it would be wise.

Just my 2cents…

Hey guys…well I put in a bid at $50k for the house (really lowballing them) but we’ll see what happens. Thanks again for the advice, I have more “direction” now.
Heather

I agree formulas can be very good rules of thumb, but PropertyManager’s is basically this:

Monthly rent / 2 = debt service.

So if monthly rents = $500, that’s $250 for debt service. That leaves $250 per unit for income, expenses, and repairs. Say taxes and insurance takes up $100 of that, that leaves $150 for repairs or profit.

I guess my formula that I’m starting with is that I need enough in rent to cover debt service, insurance, and taxes, plus and additional $150 per unit for repairs per month.

If you look at the amount he and I each have for repairs, it’s probably about even, but as a percentage of rents, mine is much lower. Where I’m exposed however is if my more expensive properties cost more to repair, etc. I have more risk on that side, but for the market I’m in and the neighborhoods I invest in, the appreciation (which should never be the reason to invest, but it will be the one that ads the most net worth) could be more.

I agree formulas can be very good rules of thumb, but PropertyManager's is basically this:

Monthly rent / 2 = debt service.

Sorry, but you’re wrong in your analysis. You guys/girls are confusing and interchanging the 50% rule and the 2% rule when you shouldn’t be. It’s real simple: The 50% rule is just stating that on a national average 50% of gross rents are used up in operating expenses. That’s the national average according to organizations such as the National Apartment Assoc. Mine happens to be much lower than that, but it is an average to go by. The 2% rule states that your acquisition price (purchase + repairs) should be 2% of your monthly gross rent, therefore is monthly gross rent is 1k, then 1,000/.02 = $50,000—>>>That is what you want to try to get the property for. It seems as if the previous posts are confusing their math when it comes to dividing by 2 or .02, clearly it makes a huge difference.

So if monthly rents = $500, that's $250 for debt service. That leaves $250 per unit for income, expenses, and repairs. Say taxes and insurance takes up $100 of that, that leaves $150 for repairs or profit.

Here’s a perfect example of not understanding the formula. If montly rents = $500, that’s $250 for operating expenses, not debt service. The leftover $250 is for debt service AND profit!!! Taxes and insurance are included in the operating expense $250, because they are by definition, operating expenses. It’s real simple I feel like you guys are over analyzing this. Good luck.

Is the 50% really an average? I thought it was more like a conservative estimate. My thinking…

If it is an average, it means that approximately half of the time the expenses are higher and half they are lower than 50%. If you have multiple properties, than it is probably ok because you may hit the 50% on average. But if you have only one property, you would have 50% chance of having more than 50% in expenses…

However, my belief is that the majority of the properties will not require 50% in operating expenses. The 50% is only a conservative number. Am I right?

With this in mind, is it really true that the 50% is an average? Or it is more like a conservative estimate? I believe it is the second.

Hey - over analyzing is fun… :O)

Now let’s see if I can over work and apply it… :O)

have a good day!

How do the formulas change when you get to more expensive properties? If the price tag is $500k or even $1mil, and the mortgages are larger, do the formulas compensate for that?

I am working on a deal that is $550k, but that .02 theory comes back with around $340k as the price.

Is the 50% really an average?

YES! How many times do I have to say it. Check with the National Apartment Association. This number applies to the average for all residential rental properties. It’s just an average, that’s it, my properties are something like 25-35%, others are probably 55-65%, that’s what an average means.

How do the formulas change when you get to more expensive properties? If the price tag is $500k or even $1mil, and the mortgages are larger, do the formulas compensate for that?

Mortgages have nothing to do with the 50% formula. 50% of gross rents are eaten up by operating expenses i.e. taxes, insurance, utilities, management, etc…not debt. I’ve done 100k deals and I’ve done 1mil deals and I always keep the 50% in my head but I know for my market and my properties it’s more like 30%. The bigger the deal goes the more sophisticated investment formulas you should use, is my opinion. This is where cap rates, IRR, and these other formulas come into play.

I am working on a deal that is $550k, but that .02 theory comes back with around $340k as the price.

My personal opinion is that the 2% rule is a little too good of a target to reach. Most everything I buy isn’t going to fall within that rule, but it’s a rule of thumb, use it as a screening tool of sorts. I don’t base anything I buy off of it, I use cap rates but I’m just letting you guys know what the rule is. Good luck.

If you want to see just how close the 50% rule is, just apply it to your local market conditions. You’ll soon see the difference between what the agents say is positive cashflow and reality. The 50% rule also takes into account items like evictions,maint, etc. These are also items that are hard pinpoint from year to year. I’m finding the 50% rule to be more of an absolute than a rule of thumb in my area. Finding deals that cashflow using the 50% rule is very difficult in my area. But sometimes the best deal is the one you DON’T do. Happy Investing!!

Well, you can easily determine what is the truth with the property when you do your due diligence. The realtor can be right or wrong, but the rent rolls and expenses tell the truth.

What are the cap rates in the areas you guys are investing in?

The 50% rule (of thumb) is only an estimating tool which you might use to screen potential candidate properties that you would consider adding to your rental portfolio. It is an average based on the actual performance of a large number of rental properties across the nation over time.

The problem with a forecasting rule derived from a very large data sample is that it breaks down when you try use the rule to predict the actual operating expense for a specific property. Only the actual numbers for that property will determine that property’s operating expense.

I do find that the 50% rule holds up fairly well both for a large number of properties averaged for a single year and for a small number of properties averaged over several years.

Some properties in a single year will have an operating expense less than 50% while others may be somewhat greater. The more properties you have in your rental portfolio and the more geographically diversified your portfolio becomes, the closer you will get to hitting the 50% number every year.

For a single, or even a small number of properties, you will have some years when your operating expenses are greater than others. Some years your rental market will be strong with a low vacancy rate, while other years will have a softer rental market that may require you to endure longer vacancies and even lower rents. Some years nothing will break so your repair cost will be minimal, other years the cost will be much higher. I have found that over several years, my total operating cost for a single property has still averaged about 50% of rental income.

So, to answer your question, I would say, “YES”, 50% is really an average expectation that you should use when doing your cash flow analysis for a property you may consider buying for your rental portfolio.

The 50% rule and the 2% rule are really complementary. You shouldn’t really use one and ignore the other.

If you accept that half of the market rent for a property will be used to pay your operating expenses (the 50% rule), then you must conclude that only half of your rental income is available to pay your debt service and give you cash flow.

For example, consider a property that you want to purchase for your rental portfolio. The purchase price and rehab cost will total $50K. The property will rent for $750 per month. If half of your income is allocated to operating expenses, then you only have $375 each month available to pay your debt service and give you your desired cash flow. Let’s assume that you use a commercial loan to finance all $50K at 7% amortized over 15 years. Your debt service will be $449.41 each month, giving you a negative cash flow.

Obviously, if the rent were $1000 per month, then there would be $500 left over after operating expenses to pay the debt service and have a little left over for a positive cash flow. It is not a surprise that $1000 monthly rental income is about 2% of the (after repaired) cost of the property in this example.

Of course you can manipulate the cash flow by simply financing less of your purchase price. If you routinely use 80% financing with 30 year amortizations and pay your rehab cost out of pocket, then you might have a positive cash flow with rents at 1.5% of your purchase price.

Mike (propertymanager) has not given me a copy of his book, so I don’t know the complete analysis that he used to derive his 2% rule of thumb. However, I believe Mike’s acquisition strategy is based on 100% financing (including rehab cost) using commercial financing to purchase low-cost properties. If your eventual goal is 100% financing (no money down) and a large rental property portfolio, then you will probably need to gravitate to commercial financing at higher rates and shorter amortization periods. For these financing parameters, the 2% rule seems to be valid if you need a positive cash flow.

I don’t purchase anything more expensive than about $100K for my rental portfolio, so I don’t know how the 2% rule holds up with the more expensive properties. I can only say that in my experience with properties costing less than $100K, I need about 2% of the purchase price in monthly rental income to generate a positive cash flow if I use 100% commercial financing (including rehab cost).

Excellent analysis by Dave T. The point is that you should expect your operating expenses to average 45% to 50% over time. The number one mistake that the vast majority of newbies make is being overly optimistic (ignorant) about the real world operating expenses. As Dave said, the 50% rule doesn’t mean that a given property in a given year will have operating expenses of 50%, but failing to account for the reality of the operating expenses WILL ABSOLUTELY DOOM YOUR RENTAL BUSINESS TO FAILURE OVER TIME. You can get lucky and cheat the odds if you only have a few rentals for a short period of time, but you won’t cheat the odds with even a few rentals over the long term or with a large number of rentals over the short term.

As an example, I have one SFH in a nice neighborhood that has been occupied by the same tenant for more than 3 years. I have NEVER had a vacancy in that house; never had an eviction in that house; never done ANY maintenance to that house; never had any legal expenses associated with that house; never paid any utilities for that house.

So, should I generalize my experience with that house and say that rentals don’t have vacancies; don’t ever need maintenance; never have legal expenses; never have evictions; etc??? Of course not! In fact, over enough time, even that house will trend toward the average.

I have had very good luck with this house. However, I have another very nice SFH in a good neighborhood that has had three evictions in a single year; needed roof work; had a fire caused by the tenants; etc! Should I conclude from this that every house will have a fire every year; will have several evictions in a single year; etc? Of course not. This house isn’t jinxed, it’s just on the other side of the averages.

It's just an average, that's it, my properties are something like 25-35%,

Ridiculous! I think we’ve already proven that you don’t include all the expenses (by your own admission). So, claiming that your expenses are 25% to 35% is absolutely meaningless.

Mike

Thanks Mike and everyone else for the advice. I put in a much lower bid for the property in question, which subsequently was not accepted. Now I’m off looking for something that will work with the numbers.

Thanks again guys and I’m sure more questions will follow!

~Heather

Dave T - I agree with Property Manager on the quality of your analysis/explanation… Thank you for taking the time to explain the 50% rule of thumb in such detail. I am sold… :O)