The 50% Rule – A Shortcut to Save You Time & to Avoid Negative Cash Flow
Finding good real estate deals is like a treasure hunt. You have to turn over a lot of stones before you find a true gem.
So, in the acquisitions part of my business I have found it helpful to develop some shortcuts that allow me to quickly evaluate the merit of potential deals.
One of the most helpful shortcuts is the 50% Rule.
I need to give a warning up front.
A shortcut is not the final analysis. I use shortcuts to save time early on, but I always follow-up with a more in-depth analysis before I buy the property. You should too.
As long as you understand that, then please keep reading:).
The 50% Rule is just a shortcut to estimate the Net Operating Income or NOI of a rental property. If NOI is a new concept or if you need a refresher, watch my 11-minute YouTube video.
The 50% Rule says that you will only keep 50% of the rent you collect on an average rental after paying for vacancy, management, taxes, insurance, and maintenance.
The 50% Rule and NOI exclude mortgage costs. I’ll tell you why later.
So if a house rents for $800 per month, after paying all of your operating expenses you will probably net $400 per month.
How does this help quickly screen potential deals? Let me give you an example.
Monday morning my real estate agent emails me a lead. She says it’s a bank owned 3 bedroom, 2 bath single family house in my target market. It needs work, but the list price was recently dropped from $100,000 to $80,000.
I quickly visit Zillow.com, look at some pictures, and I see that the rent zestimate is $900-$1,100 per month. I have also studied the market, and I know that this neighborhood could support a rent of at least $1,000 per month.
Here is where I use the 50% Rule.
Step 1) 50% of $1,000 is $500/month.
Step 2) 12 x $500 = $6,000 per year
I estimate that the property needs a minimum of $15,000 in repairs, and I’ll spend $5,000 in closing and holding costs until it’s rented.
So my total estimated cost would be $100,000.
Step 3) $6,000 ÷ $100,000 = 6%
This final percentage is called a capitalization rate or cap rate (Need a refresher on cap rate? See my 10-minute YouTube video).
The 50% Rule allows us to quickly determine a cap rate so that we can decide to pursue the deal or not.
A cap rate is a tool experienced investors use to compare the performance of one property to another. I also use a cap rate as a goal when analyzing my potential deals.
In some neighborhoods, a 6% cap rate will be a great deal. In other neighborhoods (usually lower-priced ones) I might need a 12% cap rate or more to make it worthwhile.
You can also use the 50% Rule to determine how much you can safely and profitably borrow on a property.
Using our prior example, I know I will net about $500 per month.
Using an amortization calculator I can estimate the maximum amount of money I can borrow while still breaking even on cash flow. My favorite amortization calculator is this one. I have used it almost daily for years.
For example, at 5% interest for 30 years, a $500 payment could support a debt just over $93,000. That means my rental would earn $500/month and I’d use all of the earnings to pay my $500/month mortgage payment.
But, what if you wanted a minimum of $100/month positive cash flow? You would instead only want to pay $400/month.
In that case at 5% for 30 years you could borrow around $74,500.
So with a 20% down payment, you could invest a total of $93,125 and still meet your cash flow goal ($74,500 ÷ 80% = $93,125).
Using my example of $15,000 in repairs and $5,000 in closing/holding costs, I could pay a maximum of $93,125 – $20,000 = $73,125. That would be my maximum offer on the property.
So if the list price were $80,000, I know I’m close to a deal. I personally would look at it right now, drop everything else, and make a quick offer.
That speed is the power of the 50% rule.
Do you use this shortcut? What about others? I’d love to hear from you in the comments at my blog.
Enthusiastically your coach,
Image Credit: Giro Katsimbrakis