Real estate deals require analysis. We explain 2 rules of thumb to size up deals quickly.
Analyzing real estate deals involves using formulas to find the best ones. In most cases, the criteria are best cash flow.
Our two rules of thumb to size up deals quickly will save you time and increase your profits.
The Three Stages for Real Estate Deals Analysis
Before we explain the two rules of thumb, you need to establish your priorities with real estate investing and how to determine your goals.
Don’t get hung up on fancy investment “analysis formulas” you read about in a real estate course. They don’t always work. Carefully choose which formula works best with your investment goals and objectives.
Check out our informative post to learn the basics: How to Make Millions with Rental Properties.
Let’s explore the three stages of real estate deals analysis.
Stage 1 – Instant Analysis
The basic test during stage 1 will help you to make quick decisions: the sniff test.
Sniff Test: Depending on your basic criteria for investing in a property, you need to sniff out the best ones to pursue. For instance, let’s say you want to avoid major renovation projects. Thus, you must spot one only requiring cosmetic fixes. If at first, a property looks like a major gut job, it fails your sniff test. It doesn’t warrant a second look. Move on. Time saved.
Stage 2 – Pre-Offer Initial Analysis
The Math Test: You mathematically determine if the property deserves an offer. Here are the steps:
Fix-Up Costs: Get an estimation of the repair costs from a general contractor you trust. If you don’t know one, ask your Realtor for a recommendation.
Rent: Your Realtor can help you gather comparable comps of nearby rental properties. They must be similar to the property under consideration. Likewise, your comps must be within close proximity with similar amenities and square footage as your subject property. If you are investing in San Diego County contact SoCal Lifestyle Realty for free comps.
Monthly Expenses: These include your mortgage (principal, interest, tax, and insurance (or PITI). Don’t forget to include your property management fees. Also, account for maintenance, repairs, and vacancies.
Other Expenses: Consider what’s included with the rent like cable/internet services, lawn care, trash removal, and utilities.
Add up these expenses and subtract them from the rent. The result is your monthly cash flow indicator.
Knowing your monthly cash flow helps determine the value of the property or how much you should pay for it. Compare your subject property with similar ones recently sold and currently for sale. Eliminate the ones exceeding your Maximum Allowable Offer (MOA).
Stage 3 – Deal Analysis with the 2 Rules of Thumb
Once you pass stage 2, you need to use one or more of the two rules of thumb deal analysis. Some investors only use one of them, others perform both.
Here are the two rules of thumb:
1. The 2 Percent Rule
The 2% rule is the most popular for rental property investors. The 2 Percent Rule divides the monthly rent by the purchase price. When the number hovers around two percent it indicates positive cash flow.
Simply multiply the purchase price by 0.02 (2%). For example:
A rental home’s purchase price of $200,000 x 2% = $4,000.
The monthly rent must equal $4,000 or greater.
Note: Depending on the market, some investors use a 1% rule instead of 2%.
Remember, this is only a rule of thumb. It’s not precise. Basically, the higher the percentage, the greater the cash flow.
2. The 50 Percent Rule
The 2% rule only provides a fast buy or don’t buy decision for a rental property. It does not predict cash flow. Thus, many investors prefer the 50 percent rule.
The 50% rule claims over time that half of the rental income is spent on operating expenses such as insurance, taxes, repairs, vacancies, and others. Yet, they do not include the loan payments.
The 50 percent rule helps investors to quickly estimate the cash flow by combining all expenses (except loan payments) into an easy number: half.
For instance, a property renting for $2,500 per month. The 50% rule claims that half ($1,250) is spent on operating expenses. This leaves you with $1,250. Unless you paid all cash, your mortgage payment is paid with the remaining $1,250 leaving you with your estimated cash flow.
Let’s look at the numbers assuming a mortgage of $600:
$2,500 x 50% = $1,250
$1,250 – $600 = $650
Your estimated monthly cash flow is $650.
Note: Each property has different operating expenses.
There is another rule called the “70 Percent Rule”, but it is mainly used by house flippers and wholesalers.
The Importance of Due Diligence
Remember, the two rules of thumb are just that, only indicators of the potential for positive cash flow.
You must perform compete “Due Diligence” on the subject property after getting your offer accepted by the seller. This includes:
Physical Due Diligence – Where you inspect the entire property with a qualified inspector to look at the interior and exterior physical conditions. Inspect the building structure and integrity and the electrical, plumbing, and heating systems.
Neighborhood Due Diligence – Check the crime stats with local police to see how safe it is. Look into zoning and development restrictions. Look for any upcoming developments and building plans affecting property values.
Seller’s Disclosures – California requires sellers to make certain disclosures to buyers including a complete Real Estate Transfer Disclosure Statement (TDS). It requires sellers to disclose property defects, easements and encroachments, legal claims against the property, and environmental issues like flooding.
Contingencies – Your purchase and sale agreement must list contingencies allowing you to walk away if any are not met before the closing. Learn all about contingencies by viewing the SoCal Lifestyle Realty blog post: “What are Real Estate Contingencies in California?”
2 Rules of Thumb to Size Up Deals Quickly – Conclusion
The 2 rules of thumb to size up deals quickly are mainly used by housing investors to estimate cash flow. They are performed after the preliminary stages to determine if an investor wants to do some number crunching.
Stage 1 is an Instant Analysis involving a “Sniff Test” determining if it meets your initial criteria. For instance, avoiding major repairs;
Stage 2, a pre-offer initial analysis using a “Math Test” estimating fix-up costs, monthly and other expenses compared to the monthly rent.
Stage 3 uses the two rules of thumb for quick deal analysis. They are the:
- 2 Percent Rule – Dividing the monthly rent by the purchase price. If the number is around two percent, it indicates positive cash flow. Yet, the 2% rule only gives a fast buy or don’t buy suggestion for a rental property. It does not predict cash flow; and
- 50 Percent Rule – The 50% rule helps investors to quickly estimate the cash flow by combining all expenses (except loan payments) into an easy number: 50%.
Note: These two rules of thumb are only indicators. They do not give you exact numbers.
Once your subject property passes one or both rules of thumb you must do “Due Diligence” to get at the real numbers.
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Contact us no matter how small or large your rental properties are in San Diego County.
Steven Rich, MBA – Guest Blogger
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