SS86: Real Estate Investing Rules of Thumb

What are the important rules and metrics that I am able to utilize when quickly underwriting rental properties? In this episode, Charles discusses these rules of thumb and which ones he follows and why.

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These real estate investing rules of thumb are broad guides and principles that mainly pertain to residential (1-4 unit) rentals but there are some principles that we use for investing in commercial multifamily (5+ units) as well.
The 1% rule – this is a pretty standard rule and it measures the price of the investment property against the gross income it will generate on a monthly basis. If you purchase a $100k property and it will rent for $1k or more; that property has passed the 1% rule. Make sure that you are including any deferred maintenance and repairs in the cost of the property. If you purchase a $100k property, it requires $25k worth of work and you can only rent it for $1,000; that property has not passed the 1% rule. It would need to bring in $1,250 or more. When you are reviewing properties; make sure you have an idea of the different rents at different levels of renovation. If you purchase a property for $95k, it really needs just $5k of basic work and at that finish level you are able to obtain $1,000 per month; that has passed the 1%. Maybe if you put $15k into it, you are able to get $1,250 per month; even better. However, if you put $50k into it; you are only going to get $1,400 per month. It would be suggested to put the $5k or the $15k into the property to maximize your returns. Even when purchasing 5+ multifamily I will run this rule in my head but if you are buying good B or above properties in growing markets; this is not always going to pass the 1% test. You are really focusing on increasing future rents after instilling new management and completing renovations.
The 2% rule – this rule is the same as the 1% rule but you need to be really stealing the property for it to work. You purchase a $100k property and it would need to generate $2,000 per month to pass the 2% test. Honestly, unless you are buying in D-class neighborhood war zones or you are buying in a 2009 or 2010 situation; this is very difficult to find. I remember only one time in my past when a property I purchased passed the 2% rule. Instead of requiring that property passed the 2% test; I would look for better properties and better areas in growing markets. You want a mix of cash flow AND appreciation when you are investing.
The 50% rule – this is a rule of thumb that is utilized by residential and commercial multifamily investors alike. This states that 50% of the gross income generated by a rental property should be allocated to operating expenses when determining profitability. If a property generates $20,000 per year in gross income; you should assume that about $10,000 of that goes toward expenses. Please note: operating expenses do not include your debt service. Operating expenses include; property insurance, property taxes, maintenance and repairs, property management, utilities, reserve funds for capital expenditures, etc. The 50% rule helps when analyzing deals. If you see an expense ratio over 50%; it should alert you to possible expenses that could be reduced (they are running other expenses or personal expenses through the property) or rents that are under the market; either way, there is most likely an issue that you can correct. If the operating expenses are under 50%; there are most likely expenses that have not been accounted for. This happens sometimes with property owners that own multiple properties; when they are planning on selling property A; they will pay partial expenses for property A from a different property or properties they own. Thus, increasing the net operating income at property A by lowering expenses and the lower expense ratio should be a reflag, or at least it will warrant a few more minutes of your time when underwriting.
The 20% or 25% rule is a rule that we use when looking at multifamily complexes. We want to see a path to growing rents by 20% or 25%. In a perfect situation, you will find a comparable property that has been renovated and is achieving rents of 20% – 30% more than the subject property’s current rents. This shows that there is a market and the ability to achieve a 20%-25% rent increase. If you cannot raise rents by 20%; it is going to be difficult to complete a successful value add a project.
The 36- or 48-month rule is another rule we use when looking at multifamily complexes. We want to see a return of any funds invested into renovations/upgrades within 36- or 48 months MAX. Anything less is great! Anything longer than 48 months might not be worth the investment. For example; if you add a washer and dryer to your rental units, it will cost you $1,000 including plumbing. You can however charge residents an extra $75 per month. That is great! You are getting your money back in just over 12 months. Or you are spending $5,000 per unit to upgrade the kitchens and bathrooms. You will achieve $250 more per month; another great investment. The goal is to make renovations and upgrades that will pay you back within 36 months. 48 months possibly but really 36 months is the goal.

Transcript:

Charles:
Welcome to Strategy Saturday; I’m Charles Carillo and today we’re going to be discussing real estate investing rules of thumb.
Charles:
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Charles:
These real estate investing rules of thumb are broad guys and principles that mainly pertain to residential one to 40 unit rentals, but there are some principles that we use for investing in commercial multifamily, five plus units as well.
Charles:
Now the 1% rule, this is a pretty standard rule that you’ve probably already heard, and it measures the price of the investment property against the gross income. It will generate on a monthly basis if you purchase a hundred thousand dollars property and it will rent for a thousand dollars or more per month, that property has passed. The 1% rule, make sure that you are including any deferred maintenance and repairs into the cost of the property. If you purchase a property for a hundred thousand dollars and it requires, uh, $25,000 worth of work, but you can only rent it for a thousand dollars per month, that property has not passed. The 1% rule it would need to bring in $1,250 per month or more when you are reviewing properties, make sure you have an idea of the different rents at different levels of renovation. If you purchase a property for 95,000 and it realistically needs just $5,000 of basic work at the finish level, you are able to obtain a thousand dollars per month in rent that has passed the 1%.
Charles:
Maybe if you put $15,000 into it, you’re gonna be able to get 1,250 per month, even better. However, if you put $50,000 into it, you are only gonna get $1,400 per month. It would be suggested to put the $5,000 or the $15,000 into the property to maximize your returns. Even when purchasing five plus multifamily, I will run this rule in my head, but if you’re buying good B or above properties and growing markets, this is not always gonna pass the 1% test. You’re really focusing on increasing future rents after instilling new management and completing renovations. The next is the 2% rule and this rule is the same as a 1% rule, but you really need to be stealing properties for it to work. You purchase a property for 2000, a hundred thousand dollars, and you need to generate $2,000 per month for it to pass the 2% test, honestly, unless you’re buying D class property, neighborhood war zones, or you’re buying in a, in 2009 or 2010 situation, uh, this is a very difficult to find.
Charles:
And I remember only one time in my past where a property I purchased passed the 2% test, but instead of requiring that a property pass, the 2% test, I would look for better properties in better areas. In growing markets. You want a mix of cash flow and appreciation when you are investing the 50% rule. This is a rule thumb that is utilized by residential and commercial multifamily investors alike. This states that 50% of the gross income generated by a rental property should be allocated to operating expenses when determining profitability, if a property generates, uh, $20,000 per year in gross income users should assume that about 10,000 of that goes towards operating expenses. Please note operating expenses do not include your debt. Service operating expenses include property insurance, property taxes, maintenance, and repairs, property management utilities, uh, reserve fund for capital expenditures. The 50% rule helps when analyzing deals.
Charles:
If you’re seeing, uh, an expense ratio over 50%, it should alert you to possible expenses that could be reduced. Uh, for instance, they are running other expenses or personal expenses through the property or rents that are under market either way. There is most likely an issue that you can correct if you, uh, you see operating expenses are under 50%, there are most likely expenses that have not been accounted for. And this happens sometimes when property owners that own multiple properties, um, are planning on selling, say property a and they will pay partial expenses for property a from a different property or properties they own thus increasing the net income at property, a by lowering expenses and the lower expense ratio should be a red flag, or at least it should warrant a few more minutes of your time when you’re doing underwriting. The 20% or 25% rule is a rule that we use when looking at multi-family complexes.
Charles:
And we wanna see a path to growing rents by 20% or 25% in the near future. After doing renovation in a perfect situation, you’ll find a comparable property that has been renovated and is achieving rents of 20% to 30% more than the subject properties, current rents. And this shows that there is a market and the ability to achieve 20% to 25% rent increases. If you cannot raise rents by 20%, it is going to be difficult to complete a successful value project. The next and the last rule is the 36 or 48 month rule. And this rule is really when you’re looking at multifamily complexes and we use it. Um, we wanna see a return, uh, on any funds invested into, uh, renovations and upgrades within 36 or 48 months, max, anything less is great. Anything longer than 48 months might not be worth the investment.
Charles:
For example, if you add a washer and dryer combo into your rental unit, it’ll cost you a thousand dollars, including the plumbing. You can, however, charge residents an extra $75 per month. That is great. You’re going to get your money back in just over 12 months, or you are spending $5,000 per unit to upgrade the kitchens and bathrooms you’ll achieve $250 more per month in rent. Another great investment. The goal here is to make renovations and upgrades that will pay you back within 36 months, 48 months possibly, but really 36 months is the goal when you’re trying to, uh, complete a value add project. So I hope you enjoyed, please remember to rate reviews, subscribe, submit comments, and potential show topics at global investors, podcast.com. Look forward to two more episodes next week. See you then
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