Grading the Most Common Real Estate Calculations
Putting the 70%, 50% and 2% Rules to the Test
The world of real estate investment is dominated by simple rules of thumbs and quick calculations to determine whether a particular property is worth purchasing or not. By far, the three most common rules are the 70% Rule, the 50% Rule and the dreaded 2% Rule. So, are these rules any good?
Well, I’m glad I asked this question on your behalf. As rules to definitively determine which properties to invest in, I would generally say no. As rules of thumb to determine which properties to spend time and energy evaluating… well, that depends.
So let’s go ahead and put these rules to the test.
The 70% Rule
The 70 percent rule is a rule predominantly for home flippers and BRRRR investors and goes like this:
This rule is generally pretty good. If you can get a property for 70 percent of its value, then you are almost certainly getting a good deal. That being said, before purchasing and deal, I would still recommend breaking out all the costs like this:
- Costs to Close
- Repair Costs
- Contingency (for overages, I put about 20 percent of the repair estimate)
- Holding Costs
- Realtor Commission (if selling, usually six percent)
- Closing Costs (if selling; if refinancing then use the loan costs)
Equals Anticipated Profit
Even aside by that qualifier, there are several issues with this rule. First, the two most important numbers are things the rule doesn’t help you with; namely the ARV (After Repair Value) and Repair Estimate. The repair estimate in particular is where I see the most mistakes made, especially by new investors. (It would be worth checking out my presentation on estimating repairs here.)
The other problem is that is assumes that a 30 percent discount is the right amount to ask for across the board. In this market, BRRRR and traditional flips are extremely difficult and its best to seek out opportunities to lock in ridiculously low fixed rate debt on performing assets. But furthermore, when analyzing a luxury house and D property, the percentage discounts you should seek after are not fixed.
For example, offering $70,000 on a property listed at $100,000 is a low ball. Offering $700,000 on a property listed at a million will usually be seen as a joke. And if it’s a turd on the market for $20,000 or something like that, a $14,000 offer may look good in percentages but that $6000 will cover little more than the roof. Remember, a roof costs the same on a $100,000 house and a million dollar house, more or less.
Still, this rule is very helpful for quickly figuring out which deals are worth pursuing and approximately what to offer. There’s more to be done after running this calculation, but it’s a good place to start.
I give the 70% Rule a B+
The 50% Rule
The 50 Percent Rule is all about evaluating apartments.
For houses, this rule is utterly useless and should be avoided. I would say the same for most commercial properties too, especially those with triple net leases.
For apartments however, it has some utility. The rule is for evaluating the operating expenses (or net operating income) which it assumes will be half of the gross income.
The problems with this are vast and deserve a bullet list:
It doesn’t account for the occupancy of the building nor if the area it is in tends to have high vacancy rates.
It doesn’t account for what the market rent of the apartment is or if the property is rented below market. That is something you would need to determine.
It assumes each building will have the same expense profile; but older buildings and buildings that have not been repositioned in a long time will almost always have higher operating expenses.
Other factors also play a role in the expense profile of the building that are not unaccounted for, such as the size of the units, whether there are common areas, the size of the grounds and the number of amenities to maintain (i.e. pool, playground, tennis court, etc.), whether there are flat roofs or not, etc.
In short, the operating expenses of an apartment may be correlated with the gross income, but the relationship is not directly causal.
Even still, it gives you a ballpark figure for expenses and thereby can help you decide whether a potential apartment deal is even worth looking at. But it should never be used for anything more than that.
The 2% Rule
The 2 Percent Rule is a catastrophe that should be banished from this world. As I have written before, it deserves to die a horrible, horrible death.
This is all based on a misreading of a useful calculation; rent to cost:
Monthly Rent / Total Price of Property = Rent to Cost
This calculation is useful, but it’s only useful when comparing like properties in similar areas. For example, a house that rents for $1000 and costs $100,000 (a 1 percent rent to cost) will cash flow better than a similar house that rents for $850 and costs $90,000 (0.94 percent rent to cost). Thereby, regarding its cash flow potential, the first house is a better deal despite costing more.
This rule cannot, however, be used to compare houses across classes. Just as the gross expenses of an apartment are only loosely related to the gross income, the monthly income is only loosely correlated to the net income (or cash flow without a loan).
The reason for this is because properties in rough neighborhoods typically cost more to operate than the income they produce. This is why there are so many empty, blighted and dilapidated houses in bad areas. They just don’t make financial sense to rehab nor operate.
Yes, you can make money in bad areas. Yes, there are good tenants in bad areas. But these are areas you need to be an expert in. Rough areas are not for new investors. In fact, they are not for most investors.
The 2 Percent Rule acts as if the only thing that matters is what the market rent is when compared to the value of the property. Unfortunately, as stated above, a roof costs the same—foot for foot—on a $100,000 house as a million dollar house. And while the material costs won’t be the same between good areas and bad areas, there will not be the same stark difference as there are in home values.
A home in a nice area might cost five to ten times as much as in a bad area. But stainless steel appliances cost only about 20 percent more than white or black. Tile flooring costs only about twice as much as vinyl and tile countertops only about twice as much a Formica and so on and so forth. The costs of materials do not go up one to one.
And labor should be about the same cost either way.
And on top of that, you need to worry much more about things like theft and non-paying tenants in bad areas.
All in all, the 2 Percent Rule just pushes investors into the worst areas of town where investments look good on paper… but only on paper.
I give this so-called “rule” an F- and that is being kind. It really should be graded visually as follows:
In summary, the 70 Percent Rule is useful, the 50 Percent Rule can be helpful a little bit sometimes and the 2 Percent Rule is a Dumpster Fire.
That being said, no quick calculation or rule should ever be relied up on completely. Real estate is an expensive investment and you should be much more thorough in your analysis than just a couple of quick calculations.