Question

what are the shortcomings of using only rules of thumb in making RE investment decisions?

Answer 1

A rule of thumb is a guideline that provides simplified advice regarding a particular subject. It is a general principle that gives practical instructions for accomplishing or approaching a certain task. Typically, rules of thumb develop as a result of practice and experience rather than from scientific research or theory.

Although a rule of thumb may be appropriate for a wide audience, it may not apply universally to every individual and unique set of circumstances.

There are a number of financial rules of thumb that provide guidance for investors, including the following guidelines:

Rule of Thumb #1: The 50% Rule: This rule states that for a real estate investment, the non-mortgage expenses will usually average out to about 50% of the rent long term.

For example: If you own an 8 unit building that brings in $5,000 per month in rent, you can probably expect that over the long run this property will cost $2,500 per month in vacancies, maintenance, and other non-mortgage charges.

Purpose – to ensure that you leave yourself 50% of the income to cover mortgage debt payments. If a loan is going to cost more than 50% of your gross income each year then the rule would advise not to purchase that property because you’ll risk being negative cash flow after paying all the non-mortgage expenses.

Rule of Thumb #2: The 2% Rule: This rule states that the real estate investment should rent for 2% of the purchase price.

For example: If you pay $50,000 for a property, it should rent for $1,000 per month as this would be 2% of the purchase price.

Purpose – This rule is to ensure you can get enough rent from the investment property to cover expenses and produce a cash flow.

It’s tough to find deals that will rent for 2% so you may have to settle for less than 2% such as 1.5% but you shouldn’t go below 1%. Make 1% be the minimum price floor in order to avoid getting into negative cash flowing properties. Here is a quick video on the 1% rule but you should ideally apply the same principles in finding a 2% property instead.

Rule of Thumb #3: The 70% Rule: This rule states that your purchase price plus repairs should be 70% of the ARV (after repair value). The after repair value is what we discussed in the single family home section about what your property would sell for using comps of other homes that recently sold. Once you know this ARV comp, you can multiply it by 0.70 and subtract out your estimated cost of repairs to come up with a purchase price. The purchase price usually ends up around 45% to 55% of the ARV depending on how much repairs are needed.

For example: If similar homes have recently sold for $100,000 and you estimate repairs to cost $20,000 on your potential investment property, then multiply 0.70 by $100,000 to get $70,000 and subtract out your $20,000 in repairs to get a max purchase price of $50,000.

Purpose – to ensure you have room to profit from the flip after purchase price and rehab costs. Closing costs and realtor commissions will also eat into that 30% margin you are leaving yourself so your net profit might not be the whole 30%.

Shortcomings for Thumb Rules in Real Estate Investment Decisions.

These rules of thumb are great places to start when analyzing an investment property so that you save time and prevent putting in wasted effort to analyze a deal further if it doesn’t pass initial screening. On the other hand, these are just rules of thumb and can also hurt you if you stick to them too strictly. Two issues for example are that you’ll pass up some good deals that may have worked out well had you done further analysis and secondly, these rules of thumb don’t always work as markets change. In a hot market, for example, you’ll struggle to find a rental property that meets the 2% rule because prices have risen so much and rents haven’t kept up so it will appear that the rent to price ratio is 1% or less, nowhere near your goal of 2%.