Just trying to get a compilation of all the “thumb-rules” that REI’s use. I’ll throw a few out to start off with, and update this post with any additions. (Pardon the rental slant)
2% Rule
Monthly rental revenue >= 2% of Purchase price
1% minimum, 1.5% recommended, 2% probably a good deal
1/2 Rule
All non-mortgage costs = 1/2 revenue
1/3 Rule
P & I <= 1/3 Monthly rental revenue
Some recognize it as profits >= 1/3 NOI
CAP Rate Rule
CAP >=14
100 Rule
Profit / Rent Unit >= 100 USD
$h!7 Happens Rule
Projected Profit > Actual Profit.
Projected Costs < Actual Costs.
*Please post any I missed and I’ll update as frequently as possible.
** I’m looking for the deals rule, something like 100/30/10/1. Also the 80/20, if someone could phrase it better than I can. There’s the 95% one also. If you know 'em, post 'em!
2% Rule
Monthly rental revenue >= 2% of Purchase price
* 1% minimum, 1.5% recommended, 2% probably a good deal
This is a screening tool based on the math associated with rentals. If you buy a rental with rents of 1% of the acquisition cost, it is a guaranteed loser, so 1% is not “minimum”. Likewise, 1.5% is NOT “recommended” if you want to make an acceptable cash flow. Rents of 2% of the acquisition cost will usually be a good deal for a SFH or small multi, but you still MUST do a cash flow analysis using real world numbers.
I'm looking for the deals rule, something like 100/30/10/1
In my opinion, this is just guru nonsense aimed at lazy newbies. I certainly do not go through 100 leads to find one deal. Maybe 3 or 4, but certainly not 100. The guru idea here seems to be that the newbie should just flail around making all kinds of lowball offers and finally one will be accepted. With any effort at all, anyone should be able to do better than that.
The only 95% rule of thumb that I know of is that the gurus claim that 95% of newbies will never do anything with the expensive courses, bootcamps, and mentoring they buy.
We should note that the Cap Rate calculation is appropriate for multi-plex (5 or more units) but not really valid for single family dwelling units or small-plex properties of 4 units or less. Setting the Cap Rate standard at 14 will eliminate many otherwise acceptable properties with a Cap Rate of 10 through 13. Maybe this standard is set too high for a rule of thumb.
… However, it’s going to be very hard to me to acquire rental properties in my area (Northern Virginia) according to these rules. Even with Cap Rate at 11%, it is still very hard to find SFH to meet these rules in my area.
Question: Are there any tips/methods to find properties that satisfy the above requirements (rules)?
I'm looking for the deals rule, something like 100/30/10/1. Also the 80/20, if someone could phrase it better than I can. There's the 95% one also. If you know 'em, post 'em!
100/30/10/1 = Look at 100 hundred properties, make offers on 30, arrange financing for 10, purchase 1. Who has the time to do this?
80/20 = never heard of it, unless you’re stating the addage of 80% of biz comes from 20% of customers or some variation.
95% = gurus offer at their seminars that if anyone can get a property under contract within 30 days they will refund your money because 95% of the attendees will do nothing with the “skills” they have equipped them with.
CAP Rate Rule
CAP >=14
I have to disagree here. Cap rates differ from market to market and property class to property class. Right now cap rates for large student rental properties are coming in at about 7%, for office it's like 10%. I try not to buy below a 12 cap, which is the same as the 2% rule. I'll go down to a 10 if I can add value to the building and raise rents to get it to a 12 or above but this 14 cap being a rule is not correct.
As we already noted in earlier responses, the cap rate rule does not apply to SFH. The cap rate rule is really meant to be used to determine the Value of an income property that does not have comparable sales to establish a fair market value.
I have read a statistic related to lease options, that you could probably use as a rule of thumb – 95% of tenant buyers never exercise their option to purchase. I don’t do lease options and have no first hand knowledge of the accuracy of this statement.
Let’s say Cap Rate is 10%, and Total Gross Income (Gross Rents) is $22,800.00 ($1,900.00 per month) annually. The project price/value for the property would be: $22,800.00 / 0.1 = $228,000.00.
In Northern Virginia, $228,000.00 wouldn’t be enough to purchase a town home that can be rented for $1900.00 / month.
Is this standard set too high, or is it because of the area that I am in doesn’t apply to these rules? Also, I have been reading this forum for awhile, another rule of thumb that I came aware of is: “Do not invest out of state”. So it sounds like a catch 22 to me.
Question: Can I lower the Capitalization Rate to 8% or is it too low to even consider investing?
#1 - REI in general is done in flyover country. If you’re doing REI in seaboard states, then you’re either from old money (no P&I) or you’re using the “There’s always a fooler fool than me.” principle. (Betting on appreciation. See Florida/SoCal/Las Vegas)
#2 - CAP rate is like the mean in statistics. It’s rather sensitve to outliers, in this case, newbies in REI. As REI once again hits the fad stage, CAP rates are beginning to fluctuate. Think variance is going up in case of statisical mean. Rather considered a standard measuring bar, esp in the 80s, it’s growing slightly out of favor. (What’s hot now seems to be the 45-50% rule instead. CFA’s back then used closer to a 35% rule.)
Disclaimer. I’m a newbie. I have only a years worth of REI ed (~100 books + few thousand posts read + ZERO deals) under my belt and if anyone else disagrees, I would believe him/her over me:D
Capitalization rates, which reached historic lows last year, have started to inch up for apartment buildings and office properties. The capitalization rate is a calculation of rental income in the first year of ownership, divided by the purchase price. In December, average cap rates for apartment buildings were 6.1%, up slightly from 6.09% in November. For central-business-district office properties, average cap rates rose to 5.87% in December, up from 5.76% in November.
Capitalization rates, which have fallen steadily since 2001, inched up last month for apartment buildings and office properties. The cap rate is a calculation of rental income in the first year of ownership, divided by the purchase price. In October, average cap rates for apartment buildings were 6.10%, up from 6.08% in September. For central-business-district office properties, average cap rates rose to 5.80% in October, after hitting a low of 5.54% in September.
So … It looks to me that the Cap Rate rule of thumb above doesn’t sound like a reasonable value.
I suggest none of you buy using cap rate as your screening/evaluation tool. You’re missing on some major points here.
Let's say Cap Rate is 10%, and Total Gross Income (Gross Rents) is $22,800.00 ($1,900.00 per month) annually. The project price/value for the property would be: $22,800.00 / 0.1 = $228,000.00.
Cap Rate = NOI/purchase price…NOT!–> Gross Rents/purchase price
So…let’s say that you are of the belief that 50% of rents are eaten up by expenses then,
22,800-11400(projected expenses)=11400/.10=$114,000 (max price you would pay), a far cry from the 228k.
Question: Can I lower the Capitalization Rate to 8% or is it too low to even consider investing?
Look what happens to the price you're willing to pay when you do that. 11400/.08=$142,500. When you are the buyer you want a higher cap rate, when you are the seller you want to sell at a low cap, or when you have an appraisal done you want a low cap because it increases the value of your buildings therefore making you net worth higher.
Capitalization rates, which reached historic lows last year, have started to inch up for apartment buildings and office properties. The capitalization rate is a calculation of rental income in the first year of ownership, divided by the purchase price.
Again, cap rates are calculated using NOI, not rental income. The reason they're inching up is because the price of properties is going down, finally!
This nonsense about cap rates in the 5-6% range boggles my mind. First, these are the rates that big time investors are getting right now, we’re talking multi-million dollar deals here, not your small town landlord. And really I’m not sure how they’re making money on a 5-6 cap. The only way I see this being possible is if they have interest rates at 4-5%, and I still think that makes profit margins real slim. My best guess is that companies buying at 5-6 caps are buying for value and appreciation not cash flow. If anyone can enlighten me on how to make money on a 5-6 cap I’d love to know.
Is this standard set too high, or is it because of the area that I am in doesn't apply to these rules? Also, I have been reading this forum for awhile, another rule of thumb that I came aware of is: "Do not invest out of state". So it sounds like a catch 22 to me.
Question: Can I lower the Capitalization Rate to 8% or is it too low to even consider investing?
Unless basic mathematics has been repealed, all these issues still apply in your area. You can lower the cap rate to anything you like. It’s just a matter of how much money you can afford to lose each month!
You might also want to search the forum for “cap rate”. Cap rate doesn’t really apply to small residential rentals, because accurate expense data is almost non-existent and is a market cap rate.
“The capitalization rate is calculated using a measure of cash flow called net operating income (NOI), not net income.” … “For example, in valuing the projected sale price of an apartment building that produces an annual net cash flow of $10,000, if we set a projected capitalization rate at 7%, then the asset value (or price we would pay to own it) is $142,857.”
JBaldwin: “22,800-11400(projected expenses)=11400/.10=$114,000 (max price you would pay), a far cry from the 228k.”
In Northern Virginia, even with $228,000.00, it wouldn’t be enough to purchase a town home that can be rented for $1900.00 / month. Therefore, it is IMPOSSIBLE to purchase any rental here that can generate cash flow here if the value dropped to $114,000.00.
Question: I would love to find out/learn how Northern Virginia Real Estate Investors that can purchase properties with cash flow!!!. Is there anyone here from Northern Virginia that can educate or shed me some light how to buy rental properties with cash flow in NVA? I’d greatly appreciated.
I hear that all the time “it is impossible to find properties that will cash flow in my area”. However, that is not usually true. Even here in Ohio, the vast majority of new landlords fail because they don’t understand the numbers and they pay too much for their property. The question I always ask is “what have YOU done to find GREAT deals?” You don’t make money in this business by paying retail for rental property!!!
I’ll tell you what I have done, I met a local probate attorney that has provided leads this month. Both have been total disasters that I’m not willing to take on, hope he still thinks i’m a real buyer though.
Yes, that is why I kept asking all these questions to make sure that once I start to invest, all these numbers have to come automatically to me as they would to you. I am still learning and absorbing everything that I can… either from you or other seasonal investors out there. In addition, I am trying to read as many books as I can about RE investing. I DO NOT want to make the same mistakes like others.
“Learn from the mistakes of others. You can’t live long enough to make them all yourself.” – Martin VanBee
I tried to join my local REI Club as suggested by a lot of people here, in order to learn more about real estate investing and networking. But guess what? When I looked at local REI club website, the information was outdated, mispresented and stale. Would you like to join a place/club when it can not even update its own website? This is the reason why I decided not to join and learn everything on my own, either from this website, books or seasonal investor like you.
Even though you may now understand the cap rate definition (formula), I don’t think you understand how it is used.
The investor sets the cap rate he desires, then uses that rate to determine the market value of a property he might be considering for purchase. Using cap rate to establish the value of a property (to that investor) is only meaningful for large multiplex or commercial properties where there are no comparable sales to estimate the value of the property.
If you want another way to look at cap rate, cap rate is really the return on investment that an income property generates. If your Northern VA SFR costs $225K and has a market rent of $1500 per month, then the expected NOI is $750 per month. At $225K, your return on investment (cap rate) for this property would only be 4%. Since there are better yielding investment vehicles out there for you right now, you might not consider this property to be a good investment at that price.
SFRs have plenty of comparable sales to establish market value. No one selling a SFR is marketing exclusively to an investor market, they are focusing on the owner-occupant buyer. SFR sellers are not marketing the income potential of their property and are not going to reduce their price to an income-oriented investor just because the cap rate is too low.
… Especially for the quotation: “only meaningful for large multiplex or commercial properties where there are no comparable sales to estimate the value of the property.”
PropertyManager
Thank you for your advise on…
“Cap rate doesn’t really apply to small residential rentals, because accurate expense data is almost non-existent and is a market cap rate.” … and I do enjoy reading your blog. Here is my question to you: Why are you willing to put up with all the headaches and troubles of dealing with tenants like that beside of being able to make good money on rentals? IMO, with the position that you are in, why wouldn’t you want to consolidate all your rentals and buy a commercial properties, where you can rent them out to the professionals so you don’t have to deal with the frustration on daily basis?