Common investing rules help to quickly analyze deals. When looking at these rules remember that all rules are meant to be broken and these are no different. These rules can help you decide if the deal deserves further analysis, how well a property should cash-flow, or if the deal would be a good flip. Again, these are “Rule” of thumbs and not set in stone. Every deal is different and should not analyzed separately.
The 2% Rule refers to getting 2% of the purchase price a month in rent. If you purchased a property for $100,000 and were able to rent it for $2,000 a month you would be in line with the 2% rule. Here’s how the math would work out;
$2,000/$100,000 = .02 or 2%
The 2% rule of thumb is hard to come by and usually means a property is going to cash flow well. When you come across a 2% deal you need to make sure the asking price isn’t too far below market value. If it is, you’ll want to dig into it and figure out why that is. You’ll also want to make sure the rent is comparable to market demand. If the rents being advertised seem higher than current market demand request to see the rent rolls and make sure the tenants are consistently paying on time.
The 1% Rule refers to getting 1% of the purchase price a month in rent. If you purchase a property for $100,000 and were able to rent it for $1,000 a month you would be in line with the 1% rule. Here’s how the math would work out;
$1,000/$100,000 = .01 or 1%
The 1% rule of thumb is easier to find than the 2% rule and generally means you’ll still be cash flow positive. Some common pitfalls that could throw the 1% rule off is higher insurance or debt services. If the property is in a flood zone or other hazardous area requiring higher insurance, you could be cutting into your profits. Debt services refers to the principle and interest you pay each month. Higher interest rates would increase your debt services and cut into your profits.
The 50% rule refers to how well a property will cash-flow. It’s the belief that 50% of the income generated from a property will go towards operating expenses over the life of the deal. Operating expenses include everything but the debt services of the property. If a property generates $12,000 a year in rental income the 50% rule would imply that it costs $6,000 a year to operate the property. Here’s how the math would work out;
$12,000/2 = $6,000
The 50% rule of thumb is a great way to see how well a property will cash-flow and if it’s worth the time. It’s also a good reminder to make sure you’re putting money into reserves each month. Some properties may go months or years without a problem but eventually repairs will be required.
The 70% rule is most commonly used to flip properties. The rule of thumb is that the purchase price of a potential flip property should not be higher than 70% of the After-Repair-Value, (ARV) and subtract the renovation costs. If the potential property will be worth $100,000 AFTER all the renovations are complete and it’s going to cost $20,000 to renovate the property than the purchase price for the home should not be higher than $50,000. Here’s how the math would work out;
$100,000 X .7 or 70% = $70,000
$70,000 - $20,000 = $50,000
The 70% rule of thumb makes a bad deal stand out quickly but it’s not perfect. The 70% rule of thumb will rarely apply to properties in an expensive market because properties will rarely sell that low. As with all rules of thumb it’s never perfect and every deal needs to be analyzed individually.
The DSCR rule of thumb applies more to the likelihood of a commercial deal getting approved for financing. Lenders will want to see how well the cash flow will cover the debt services of the property. Debt services is the principal and interest owed each month for a property. Lenders will calculate the DSCR by dividing the NOI of a property against the debt services. When lenders run this calculation they generally want to see it above 1.2, and here is how the math would work out with an NOI of $7,500 and Debt Services of $5,000 a month;
$7,500/$5,000 = 1.5
Every lender is different and just like every “Rule of Thumb” you want to do your due diligence. Check with your lender to see if they require a higher or lower ratio but by knowing how they calculate deals you can quickly run your numbers before presenting the deal to your lender and moving towards the offer stage.