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SHOW NOTES FOR EPISODE 118: 10 REAL ESTATE INVESTING RULES OF THUMB EVERY INVESTOR SHOULD KNOW
When it comes to investing in commercial real estate, it’s not as complicated as some people make it out to be. There are some simple short-cuts and methods that help make some of the more complicated stuff of real estate investing a little easier. When, analyzing deals, for example, in the interest of time, there are certain established “rules of thumb” that help us quickly and easily determine whether the property or asset we are assessing is a good deal or not. In this episode, Bill examines some of the top rules of thumb being used today by successful investors.
The term “rule of thumb” is said to have originated with carpenters who used the width of their thumb to measure things. The term has also been associated with farmers who used their thumbs as a measurement to plant seeds the proper depth. In either case, you can see that the rule of thumb is an approximation, or a quick way to estimate a value. This technique can be translated into real estate in a way that you can shorten the amount of time you take to analyze a deal while still not rushing into a decision that isn’t right for you.
Investopedia defines a rule of thumb as “a guideline that provides simplified advice regarding a particular subject,” and I’m here to show you that by adhering to several rules of thumb, you can be on your way to easy property analysis and a successful career in real estate.
The “3 minute Rental Property Analyzer” that I give away free at olddawgsreinetwork.com website uses many of these rules of thumb for a quick property analysis. You can quickly see some of these numbers and ratios at a glance.
Here are 10 of some of the most common real estate investing rules of thumb.
1. 20% rule
Simply stated, I ALWAYS try to buy a property at least at 20% below market prices. That way, you have “instant equity,” and it allows for things like market correction or economic factors that can reduce property values. If you have to get out of a property sooner than planned, you won’t lose money on the sell. The old adage, “The money is made at the buy” is a smart general rule.
2. Vacancy
Let’s begin with a simple one. What percentage of the property’s total potential gross income is being lost to vacancy? A high property vacancy can be an indicator of many things:
- down units in need of rehab or repair
- poor management
- rents are too high
- bad area
- low demand
In either case, it’s a red flag to investigate further. Start off by collecting some market data, so you will know what is typical for that type of property in that particular location. Does the property you own or may buy differ very much from the norm? Obviously, much higher vacancy is not good news and you want to find out why. But if vacancy is far less than the market, that may mean the rents are too low and/or the demand is strong in an area. If you’re the owner, this is an issue you need to deal with. If you’re a potential buyer, this may signal an opportunity to acquire the property and then create value through higher rents.
What is a good rate? Some conservative lenders won’t lend on anything higher than 20%. But as an owner, our goal should be no more than 5%.
3. Loan-to-Value (LTV)
One of those standards is the Loan-to-Value Ratio. The typical lender is generally willing to finance between 60% – 80% of the lesser of the property’s purchase price or its appraised value. Conventional wisdom has always held that leverage is a good thing — that it is smart to use “Other People’s Money.”
The caution here is to beware of too much of a good thing. The higher the LTV on a particular deal, the riskier the loan is. It doesn’t take much imagination to recognize that in the post-meltdown era, the cost of a loan in terms of interest rate, points, fees, etc. may rise exponentially as the risk increases. Having more equity in the deal may be the best or perhaps the only way to secure reasonable financing. If you don’t have sufficient cash to make a substantial down payment, then consider assembling a group of partners so you can acquire the property with a low LTV and therefore with optimal terms.
4. Debt Coverage Ratio (DCR)
DCR or DSCR (Debt Service Coverage Ration) is the ratio of a property’s Net Operating Income (NOI) to its Annual Debt Service. NOI, as you will recall is your total potential income less vacancy and credit loss and less operating expenses.
It’s calculated as follows: DSCR= NOI/Annual Debt
If your NOI is just enough to pay your mortgage, then your NOI and debt service are equal and so their ratio is 1.00. In real life, no responsible lender is likely to provide financing if it looks like the property will have just barely enough net income to cover its mortgage payments. You should assume that the property you want to finance must show a DCR of at least 1.20, but prefer 1.6+, which means your Net Operating Income must be at least 20% more than your debt service. For certain property types or in certain locations, the requirement may be even higher, but it is unlikely ever to be lower.
Most smart investors will look for a DCR of 1.3 or 1.4. At that point, the property is producing 30% more revenue than the cost of the mortgage, practically guaranteeing that you’ll meet all of your obligations and have cash flow left over.
5. Capitalization Rate (Cap Rate)
The Capitalization Rate expresses the ratio between a property’s Net Operating Income and its value.
The Cap rate is calculated as follows: Cap Rate =NOI / value
Typically it is a market-driven percentage that represents what investors in a given market are achieving on their investment dollar for a particular type of property. In other words, it is the prevailing rate of return in that market. Appraisers use Cap Rates to estimate the value of an income property. If other investors are getting a 10% return, then at what value would a subject property yield a 10% return today?
Remember first that the Cap Rate is a market-driven rate so you need to interrogate some appraisers and commercial brokers to discover what rate is common today in your market for the type of property you’re dealing with. But you also need to recognize that Cap Rates can change with market conditions. Rates can go as low as 3-5% (corresponding to very high valuations) and as high as the mid-teens (very low valuations), with historical averages probably bunched closer to 8-10%. If you are investing for the long term, and if the cap rate in your market is presently pushing the top or the bottom of the range, then you need to consider the possibility that the rate won’t stay there forever. Look at some historical data for your market and take that into account when you estimate the cap rate rate that a new buyer may expect ten years down the road
My rule of thumb is that I target 8-10% minimum cap rate. There is too much work involved if it is less than that. You need to be compensated properly for the additional risk and work involved.
6. Cash Flow
“Cash Flow is King,” is our motto here at the Old Dawg’s Network. If you can first project that your property will have a strong positive cash flow, then you can exhale and start to look at the other metrics to see if they suggest satisfactory long-term results.
Negative cash flow means reaching into your own pocket to make up the shortfall. There is no joy in finding that your income property fails to support you, but rather you have to support your property. On the other hand, if you do a have a strong positive cash flow, then you can usually ride out the ups and downs that may occur in any market. An unexpected vacancy or repair is far less likely to push you to the edge of default, and you can sit on the sideline during a market decline, waiting until the time is right to sell.
Overambitious financing tends to be a common cause of weak cash flow. Too much leverage, resulting in greater loan costs and higher debt service can mark the tipping point from a good cash flow to none at all. Revisit LTV and DCR referenced earlier.
For me, I will not buy a property that yields less than $200 per door or unit, although I obviously prefer $200-300, if possible.
Again, with my “3 minute Rental Property Analyzer” that I give away free at olddawgsreinetwork.com I can go right to the cash flow column to see what my cash flow is and to the “cash flow per unit” column as well for an immediate assessment.
7. Cash-on-Cash Return
A cash-on-cash return is simply the return an investor receives on the amount of “cash” that is invested in the deal. To calculate this figure, take the annual cash flow from the property and divide by the TOTAL cash invested. For example, if you receive $10,000 in cash flow and you invested $100,000 in cash, then your return would be $10,000/$100,000 = 10%. We strive to put in as little of our capital as possible in order to obtain the highest return of capital back as quickly as possible. The goal of any real estate investor is to control as many properties with as little money invested in each deal as possible. This strategy will explode your wealth because each property “should” be cash flowing, and each property will be appreciating in value. Our number one rule is to buy properties that cash flow every month. We will never purchase a property that has a negative cash flow.
Our rule of thumb for cash on cash return is that we strive for a 10% minimum, but try to get at least a 12% targeted return or greater, based on actual performance. ALWAYS analyze properties based on actual numbers, not some seller’s rosy pro forma figures. If the property has the potential to generate substantially higher returns once it is repositioned, then we are willing to drop that figure to 7-8%. Just make sure that you can raise the income or lower expenses to raise the return.
8. The 50% Rule for Expenses
One of the most valuable “tools” to a real estate investor is known as the 50% rule. This rule of thumb states that for a real estate investment – the non-mortgage expenses will usually average out to about 50% of the rent.
Let me explain. If you own a fourplex that brings in $2,000 per month – you can probably assume that over the long run, this property is going to cost $1000 per month in vacancies, maintenance, and other charges (not counting the mortgage.)
Now, it’s easy to estimate your monthly cash flow by simply taking the amount of money you have left (known as the Net Operating Income) and subtracting out the monthly mortgage payment – which you can find using any online mortgage calculator.
9. THE 1% RULE
Another rule of thumb, I should mention, and the fastest way to quickly decide if a property is worth pursuing, is known as the 1% rule (or sometimes, the 2% rule) The 1% rule states that an investment property should rent for at least 1% of the purchase price. So, the fourplex we discussed earlier – which was bought for $140,000 – should bring in at least $1400 per month in total income (which, according to our example, it does meet.)
Some investors choose other ratios, such as the 1.5% rule or the 2% rule to achieve greater returns and greater cash flow. I typically won’t buy anything below 1.5% and try to aim for 2%, though your percentage may depend on your location and risk tolerance.
10. Unit Mix
Unit mix is simply the different number of bedroom apartments in a property. Apartments range in sizes from efficiency (or studio apartments) to 5 bedrooms.
An efficiency apartment is usually occupied by a single person and combines the sleeping, living, and kitchen areas. Studio apartments are larger versions of the same footprint, but tend to have a larger kitchen. Many investors shy away from these types of apartments because the tenant base tends to be transient, which means that the tenants move in and out and can create a high tenant turnover. I however, have been fortunate to have acquired and targeted longer-term tenants, some who have rented their studio apartments for 5 plus years, helping me maintain a 90-95% occupancy, but it isn’t easy.
The next size is a one-bedroom unit, which can also have a higher turnover rate, but not as high as efficiency or studio apartments. Typically, municipalities allow two tenants to occupy an apartment for each bedroom, and in turn, it shrinks the tenant pool.
However, it all depends where the units are located. One-bedroom units are favorable for college students, senior citizens, and couples.
My preferred unit size to work with is the two-bedroom apartment.
They’re ideal for most demographics yet larger families can’t occupy them. Larger families tend to cause more deferred maintenance on a unit, another costly expense for landlords. Two-bedroom units are usually the most cost effective for tenants and are the easiest to rent out.
There are also three-, four-, and five-bedroom apartments, but it’s pretty rare for apartment buildings to contain four- and five-bedroom units. These sizes are found more often in single-family homes.
The key to unit mix is to acquire an asset that has a favorable number of two-bedroom units in relation to one-bedroom units. The ideal ratio is 2 two-bedroom units to 1 one-bedroom unit. For example, on a 100-unit property, I like to see 66 two-bedrooms and 34 one-bedrooms.
This type of unit mix makes the asset more valuable, and will make it easier for the landlord to rent out the units as well as choose from a larger tenant base. Tenants also have the option of moving up or down a size without having to leave the property, which also benefits the landlord in that it reduces vacancies.
We wouldn’t discount a property solely on the tenant mix. It’s only one piece of the puzzle, but a rather important one.
Well, there you have it – 10 real estate investing rules of thumb that will help you quickly evaluate properties as you look for those “diamonds in the rough” that will generate consistent and significant cash flow for years to come.
Again, a “rule of thumb” is just that – a “quick” means to analyze and assess properties. Digging deeper, with thorough due diligence and underwriting looking at every number and critical factors, is critical to your long-term real estate investing success.
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