Rules of thumb have been around forever. Common ones you may have heard of include “save 10% of your income”, “eat fewer than 2,000 calories a day” or my personal favorite “get 8 hours of sleep every night” (good luck with this if you have kids ages 5 and under). But what is a rule of thumb? Take it away Merriam-Webster:
Definition of rule of thumb
- A method of procedure based on experience or common sense
- A general principle regarded as roughly correct but not intended to be scientifically accurate
Basically, rules of thumb are ways to simplify a complex subject matter or problem. While they are not 100% accurate they can be a way to surmise a directionally correct analysis quickly. Analyzing a real estate deal can be very complex as there are a lot of factors to consider, so it is no surprise that rules of thumb have been created.
Here are five rules of thumb commonly used by real estate investors during the analysis of a property.
Hands down this is the most common rule of thumb for house flippers. The 70% rule is a quick way for an investor to determine the maximum allowable offer (MAO) on a house. The formula is:
Maximum Allowable Offer (MAO) = After Repair Value (ARV) X 70% – Estimated Repair Costs
The remaining 30% lump sum includes selling costs, holding costs, and most importantly the flipper’s profit. Wholesalers also utilize the 70% rule when calculating their offer price, however, they need to be sure they subtract their desired wholesale fee off of the house flipper MAO.
The 70% rule is a fantastic rule of thumb for house flippers and wholesalers. However, house flippers may adjust the 70% higher or lower depending on various other factors such as the housing market, competition, deal risk, experience, and other factors. For example, I’ve met contractors who are willing to pay 75-80% of ARV minus repair costs because maximum profit may not as important as keeping their crew busy. When housing supply is high and demand is low, some house flippers may adjust to 65% or lower.
We utilize the 70% rule in our business for the quick back of the envelope estimates to make an offer fast. However, we typically like to be more thoughtful in our cash offer calculation. Our offer formula is:
Maximum Allowable Offer (MAO) =
After Repair Value – Repair Costs – Selling Costs – Holding Costs – Minimum Profit
The reason we are more detailed in our offer calculation is that every deal is unique. Some deals have lower risk and therefore we may be able to take a lower profit than usual if that’s what it takes to make the deal work for the seller. Other times if a deal has a long timeframe or higher risk we may want more of a buffer.
The 50% rule is utilized to quickly estimate operating expenses to determine the net operating income (NOI) of an investment property. This rule of thumb assumes that operating expenses, such as property taxes, insurance, utilities, management, homeowners association (HOA) dues, maintenance, vacancy, etc. will be 50% of gross rents. The other 50% is a property’s NOI. Cash flow is then calculated by subtracting debt service (aka the mortgage payment) from NOI.
$1,000 Gross Rents X 50% = $500 operating expenses
Like many variables in real estate operating expenses for an investment property can vary greatly based on its location. Not just what state or city, but the neighborhood, block, and specific building! A property in an HOA has additional costs compared to those not in an HOA. Property taxes can be very different from one town to the next. Additional insurance policies or riders may be required if the property is in a floodplain, hurricane hotspot, etc. One duplex may have all utilities separately metered while the duplex next door does not.
The age and class of the property also impact maintenance, and vacancy. All these variables greatly impact the accuracy of the 50% rule.
When speed is necessary the 50% rule is useful to quickly estimate the operating expenses of a property. However, conducting proper due diligence to understand expected values for each type of operating expense is a must to properly ascertain if the profitability and return of an investment property will meet the investor’s expectations.
Before we walk a property we already have a very good idea of the value of the operating expenses. On the first call with the seller, we always ask what utilities are the responsibility of the tenant and how much the landlord pays per month for those they are responsible for (or we call the utility company). We check property taxes on the county land records site. Our insurance agent provides quotes on property (and flood, if necessary) insurance. Property management is 10% of rents. We calculate expected maintenance, and vacancy based on data for our current rentals and also from our property manager. While reserves for capital expenditure are typically not included in operating expenses, we include them. The properties we buy usually have operating expenses of around 45%.
This rule of thumb is a favorite for many buy-and-hold real estate investors to quickly determine if an investment property will have positive cash flow. The 1% rule states that gross rents from the rental property should be at least 1% of the purchase price plus estimated repairs. An example is below:
Purchase Price = $85,000
Estimated Repairs = $15,000
Estimated Gross Rents After Repairs = $1,000
$1,000 / ($85,000 + $15,000) = 1%
An investment property that satisfies the 1% is not necessarily a good investment. As we stated above much of real estate is location-dependent. There are areas where investors would drool over 1% rule properties while others it would be a negative cash flow deal. Operating expenses have a huge impact on whether or not the 1% rule leads to positive or negative cash flow.
In my personal opinion, a 1% rule property would not be a worthwhile deal for a long-term hold. We strive for 2% rule properties, but those are very hard to find. Currently, all of our rentals have gross rents that equate to 1.5%-2% of the purchase price plus repairs. However, our investment criteria are very conservative and we no doubt pass on properties that other investors may snatch up.
10% Cash-on-Cash Return
Like any investment, rental properties contain risk. Whether or not real estate is more or less risky than stocks or other alternatives is in the eye of the beholder. Some individuals have suggested a worthwhile rental property should at least achieve a return that is greater than the stock market, which historically has been around 10% for the S&P 500 since its inception in 1926. Given this logic, a real estate investor should strive for a cash-on-cash return of 10% or greater to make an investment property worthwhile.
To level-set, cash-on-cash return is the annual pre-tax cash flow divided by the amount of cash invested into the property (not including any loan amounts).
Annual Pre-tax Cash Flow = $2,400
Cash Invested (Down Payment + Initial Repairs) = $30,000
$2,400 / $30,000 = 8% Cash-on-Cash Return
Risk tolerance and return expectations are different for everyone. I have met real estate investors who buy everything with cash and are okay with high single-digit cash-on-cash returns. Others utilize leverage and expect a 20% cash-on-cash return or higher.
I side with the latter group of individuals who utilizes leverage to obtain very high cash-on-cash returns. In fact, my goal is to achieve a cash-on-cash return of infinity! For most of our rental properties, we utilized the BRRRR method (Buy, Rehab, Rent, Refinance, Repeat). The properties are purchased at a steep discount, rehabbed tastefully, rented at the market or above market rates, then refinanced to pull out all (or almost all) of our initial cash investment. The whole process takes about six months, but after the refinance all the cash flow is divided by zero to achieve infinite returns. This strategy gives us the ability to recycle the invested cash in another property and start the cycle again. We have had one property where four thousand dollars remained in the property after refinancing but the cash-on-cash return is 153%.
$200 Cash Flow per Door
If you ask a seasoned investor what their minimum cash flow per door is they will most likely provide a specific number. $200 cash flow per door is a common response I see on real estate investor forums and blogs, however, your market could have different expectations. I’ve heard responses anywhere from $100 to $400 per door for those who use leverage.
Cash flow per door is a simple calculation that is achieved by dividing the annual pre-tax cash flow by 12, to arrive at your monthly pre-tax cash flow. Then divide that number by the number of units in the building.
Annual Pre-tax Cash Flow = $2,400
Number of Units = 2
$2,400 / 12 = $200
$200 / 2 = $100 cash flow per door
Achieving a high dollar cash flow per door is obviously desirable. However, it does not tell the whole story. What do I mean? Look at the description of the two properties below.
Cash Flow per Door = $300
Cash Invested = $30,000
Cash-on-Cash Return = 12%
Equity = 25%
Cash Flow per Door = $150
Cash Invested = $0
Cash-on-Cash Return = Infinity
Equity = 25%
Without knowing anything else about the properties, I would rather have Property B. Sure the cash flow per door is half of Property A, but with zero cash invested and the same amount of equity, the investor in Property B can buy another property with the $30,000.
We choose invest in properties like Property B. Most of our properties achieve cash flow per door of $150 to $250. Using the BRRRR method we improve the velocity of our money to acquire more properties, achieve higher returns and build more wealth. The most difficult part is finding Property B. When we do find them we celebrate because we are one step closer to financial freedom.
Real estate rules of thumb like the ones discussed above are efficient ways to determine if additional due diligence is warranted. However, they are not hard and fast rules. Feel free to adjust, enhance or create brand new rules of thumb that fit your investment criteria. Since much of real estate is market-specific a great tip is to talk to numerous experienced real estate investors and property managers in your area. Ask them what rules of thumb they use in their business and how they came up with them. If nothing else the topic is a great icebreaker to use at real estate meetups.
What rules of thumb do you use in your real estate investing business? We’d love to hear from you in the comment section below.