I recommend anyone investing in real estate to do a thorough job of due diligence before and after getting a property under contract. And this involves doing a very detailed financial analysis too. If you are flipping a property, you should line out all the expenses to rehab, sell and close and make sure the profit is still sufficient. On the other hand, if you are buying an apartment, you should calculate the ROI (return on investment) and IRR (internal rate of return).
But you don’t have enough time to do a detailed analysis of every property on the market. This is where “rule of thumb” or “back-of-the-envelope” calculations can come in handy. In real estate, there are three famous ones: The 70 Percent Rule, the 50 Percent Rule and the 2 Percent Rule.
The 70 Percent Rule
(After Repair Value X 0.7) – Rehab Cost = Maximum Allowable Offer
This is the best rule of thumb there is in real estate investment. It accounts for the rehab costs and leaves 30 percent to spare for closing costs, real estate commissions and, of course, the profit. So it works very well for flipping. And since you should be buying and holding with built-in equity too, it works well for holding.
You may want to adjust the percentage you multiply the After Repair Value by up or down though depending on the overall market (it’s really hot now so maybe use 75 percent) and submarket (if you’re buying luxury properties for example, you will need to increase that percentage). And, you should always do a detailed, item-by-item analysis before buying a property regardless.
But as a “back-of-the-envelope” calculation, the 70 Percent Rule is pretty good.
The 50 Percent Rule
Gross Revenue x 0.5 = Approximate Operating Expenses
The 50 Percent Rule is predominantly for apartments. It assumes the operating expenses will be about half of the gross (not net) income. This, broadly speaking, will be in the ballpark. It’s a good place to start, but ONLY a good place to start.
Some apartments are all bills paid, for others the tenants pay all the utilities. Older buildings need more maintenance than newer ones. Buildings with large common areas also need more maintenance. The general condition will also affect the maintenance. Some states are high tax, others low tax, etc. etc.
Namely, there are a lot of things that effect the expenses of a property and you need to line those out before even making an offer. The 50 Percent Rule is only good for quickly testing whether something is even worth looking at or not.
The 2 Percent Rule
If the Monthly Rent / Total Cost of the Property = 0.02 (or 2 percent),
it is a good investment
Spoilers: The 2 Percent Rule is trash. A property’s expenses do not go up equivalent to its price. A roof costs the same per square foot on a luxury home as it does on a turd. And old properties in bad areas usually have higher operating expenses even though they cost less.
Therefore, the two percent rule doesn’t give you a good idea of whether a property will cash flow or not. Rent-to-cost ratios can be useful when comparing properties in similar neighborhoods, but not between neighborhoods.
Furthermore, it’s almost impossible to get 2 Percent these days other than in the worst of the worst neighborhoods. And that’s not where new investors (or anyone but specialists) should be investing.
So stay away from this rule at all costs.