Why do I suggest my clients the 50%, the 2% and other rules for real estate investments
Recently I’ve been asked by my clients whether some rental income calculators are reliable. My answer is that they are quite reliable but not that realistic. I mean, if you do follow the calculators entirely, you’ll end up not investing. First, some expenses such as vacancies are very hard to calculate (and factoring them in while investing can be quite harsh on the numbers). Second, it is hard to grab all expenses upfront and then calculate the investment return.
For these reasons (and more), I usually tell my clients to follow some rules that make it easy to assess real estate investments. Let us have a look at them:
The 50% rule: a practical overview
I’ve got tons of questions about the 50% rule. “What the heck is that?” Even my clients, when I tell them to follow the 50% rule go like “the what?”.
The 50% rule is a simple rule that enables you to calculate on the fly how profitable a given rental income will be. Essentially, you assume that half of your income will cover costs. So you cut the rental income in half, which you assume will go towards tax, vacancies, maintenance, mortgage, etc. You consider that 50% of the rental income will be net and therefore you consider the YNROI (yearly net return on investment) to be 12*0.5*income / investment.
In my opinion, anything above 9% following this calculation is awesome. The reason why anything yielding 9% on this model is great is because the 50% rule is usually considered relatively conservative. Note, however, that each market is one specific market and not all rules fit equally well in every market.
Let me give you a practical example of the 50% rule. I looked at the rental income of the property (about $600) and I divided it by 2. As the property cost €68,000, I figured that 300*12 / 68,000 = 5% was not a good investment, so I offered €34,000 (which would make it 10%), which was obviously rejected. I did my best though.
The 2% rule: a practical overview
This rule is equally simple: you should get 2% of your investment back, every month. For example, if a home costs $100,000, the rent should be 0.02*100,000 = $2,000 per month.
In this rule, you don’t need to account for taxes. This amount should be enough to pay for all expenses and generate a nice net yield at the end of the month.
At the same time, this rule is bi-directional because it allows you to determine how much you should pay for each property, based on how much it is already rented out for. For instance, let us assume that you find a property that rents for $400 per month. The question is, how much should you pay for it, given that it rents for $400 and you want to apply the 2% rule. The answer is $400 / 0.02 = $20,000.
The 7-year rule and other rules you can use in real estate investing
I have written a blog post on the 7-year rule before. Essentially, the property must be paid off in 7 years (or less). This is my favorite rule: as a cash flow guy, I look forward to getting my capital back as soon as possible, and that is what I think of when investing. Therefore, I ask myself the question “how much time will it take for me to get my capital back?”
The math beyond this rule is very simple as well. The hardest part is estimating the income that each property will bring. I personally shoot for properties that return my capital within 4-5 years, and I account 2-3 years for taxes and maintenance. Of course that these numbers are not that easy to achieve.
This rule works whether you go all cash or you borrow money from the bank. However, if you borrow money to buy your property, 7 years won’t probably do the trick as you need to factor interest in.
Let us now have a look at my real estate properties:
- RP#1: I bought this property all cash from a very motivated seller. This was a very different investment. One that is quite liquid and one that offered me the possibility of becoming my primary home (which eventually did). I knew from the beginning I would never be able to get my investment back in 7 years with this property. Initially, my idea was to flip the property (and eventually I did list it for sale) but I am living there for now and I like it. A very peculiar investment, which I won’t analyze in light of these rules because of that.
- RP#2: I used leverage on this one. I paid a total of €41,000 to buy it – this includes closing costs. As this property brings in €6,145 per year, it does meet the 7-year rule. As I borrowed money to acquire this property, we should take interest into account, which brings up the time to pay it off, but like I said we shouldn’t take interest into account when checking the 7-year rule. As for the 50% rule, this property generates a “net” yield of 7.5%, which is quite good. This property fails in the 2% rule, as it should bring in €820/mo. However, I think that the higher the investment, the easier it is to meet the 2% rule. This goes to show you that deals don’t necessarily have to meet all rules to be considered a good investment.
- RP#3: Another leveraged property. Closing costs in, I paid €36,500. I spent about €60,000 renovating it (this includes the second renovation phase). You guys are going to beat the crap out of me, but I don’t have a really accurate figure for renovation. I know, shame on me. In December, when the property is fully renovated, the gross rental income will be €1,430 per month (or €17,160 per year). For a total investment of €96,500, this property will surpass the 7-year rule by a mile, almost hit the 2% rule and yield 9% “net” according to the 50% rule, which is pretty decent.
Don’t get too strict on these rules though. You don’t really have to meet all rules to make it a good investment! They are simply a guideline, not more than that!
What defines a good real estate investment – practical examples
Let me teach you my method to look for properties… If I am to buy a property, the first thing I do is filtering out a few properties according to the rules above
Then, I ask myself the following questions, for the deals I was able to identify:
Is the owner of the property a motivated seller? Although you won’t know this all the time, you can be friends with real estate agents and try to get as much info as possible. I can often know how badly the owners want to sell.
How much money would this property cost if I were to build it today? Is that lower or higher compared to the listing price? Are you getting enough value for that purchase?
How does the final price compare to the market price, under different criteria, such as the price per square feet (or meters for my fellow Europeans), location, etc? Are you getting enough equity? (This is also a key rule in flipping with no money down).
If there are already tenants in, would they continue on the property if you raised the rent by 10%? Is there any particular negotiation with the owner of the property that makes it a special deal?
If there are no tenants in, how long would it take to rent out the property? How cheap did you have to go to rent out the property “right away”? Would that be a good deal, still?
There are hidden costs and the renovation budget goes crazy, ramping as much as 50%! Is that property still a good deal?
What should we do to filter out the properties, looking for those that:
Are sold by motivated sellers.
Are listed for more than 6 months.
Would cost me 5-10 more if I were to build them today. Hint: we only get these numbers if we look at multi-units.
Pass the check tests on the liens of the house, the neighborhood, the current tenants, etc. Ask yourself: does anything fail to add up?
Would rent and sell for a higher price than you’re getting on the property. You can check this by asking many real estate companies in the area how much that property should sell/rent for.
Are susceptible to good (aka low) renovation budgets.
Also, consider reading these free books on real estate investing to learn more about real estate investing.
First, I should say that none of the rules you read on the Internet are flawless or universal enough to be applied to every market with success. These rules are great to provide you with a general rule and a quick filter to filter out deals. That is personally what I do when assessing deals: I grab as many deals as possible, in Excel and I calculate the 50%, the 2%, and the 7-year rule. Then, I select the deals that met these rules and I submit offers. Where there is none (which is often the case), I submit many offers that, if accepted, would render the deals interesting (aka meeting these rules).