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Author Topic: Property rental investment - is it matching the 2% rule?  (Read 4082 times)

Babymoustache

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Property rental investment - is it matching the 2% rule?
« on: September 07, 2013, 07:31:52 AM »
Hi, I am a newbie mustachian and have been learning a great deal from this website and the forums.

I would like to ask the advice of more experienced mustachians on a property investment that seems to meet the 2% rule. But, may be more than meets the eye based on the fact that I would only be buying a house and not the land it sits on (the land is leased).

House: $20,000 (only bricks and mortar house, not the land it sits on, I can pay cash for house, but I read what Joe said about not forcing cash flow, so...)
Finance: $1,344 per year ($112 per month)
Land lease: $2,900 per year (this is a fixed rate for 5years)
Gross Rent: $7,272 per year ($606 per month)
Rent (minus land lease): $4,680 per year ($390 per month)
50% rule = $2,340 per year
Minus finance = $996 per year
2% rule $390x50 = $19,500 (did I calculate this right, or do I use the 50% rule first?)

It seems to pan out, however its such small amounts of money, I'm wondering if economies of scale kicks in here and its not worth the investment?

I've never rented property, but was thinking this might be a way to dip my toes in the water and learn the ropes. If I make a mistake its not worth huge sums of money and I could use it to learn from. I would initially get someone to property manage it because I live a town away and don't drive (its a $60 bus ticket return). There aren't any deals like this in my hometown of wellington, New Zealand. NZ has high house prices like Australia, with only a minor dip in value during the recession, after which prices all bounced back to match those from 2004.

Thank you so much in advance, I really appreciate your advice and knowledge sharing on this!
« Last Edit: September 07, 2013, 07:50:33 AM by Babymoustache »

arebelspy

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Re: Property rental investment - is it matching the 2% rule?
« Reply #1 on: September 07, 2013, 09:18:05 AM »
House: $20,000 (only bricks and mortar house, not the land it sits on, I can pay cash for house, but I read what Joe said about not forcing cash flow, so...)

Assuming I'm the Joe, I stand by that statement (and if I'm not, I still agree, sounds like a very smart fellow) - however - that doesn't mean you should do all financing.  It should stand by on its own if you did finance the whole thing, it should still make sense as an investment, but how much you put down should depend on your situation (other cash flows in your life, amount you have to invest, asset allocation, risk tolerance, interest rates and terms, etc.).

What is the total purchase price of the property?  What are you looking to put down, and what are the terms of the mortgage?

Can you actually get a mortgage on a property that small?  Most lenders here in the U.S. won't do loans under 50k.

As far as the 2% rule: take the purchase price of the property + any rehab.   Multiply it by .02.  That should be the gross monthly rent.  Or, flipping it around, take the gross monthly rent and multiply it by 50.  That should be the max you pay.  So gross rent of 606/mo, most you'd pay if you want to stick to 2% rule is $30k purchase price.  (Actually less, because the land lease needs to be taken out.)

Lastly, I know (almost) nothing about owning the structures and leasing the land.  What happens in 5 years with that land lease?  Interest rate goes up?  Or you renegotiate the whole thing completely?  Elaborate with any details you have on that, please.

If I look just at the numbers like this (and assume the land lease is like an HOA type expense, though it may be worse depending on what happens 5 years out):
Gross monthly rent: 606
50% expenses: 303
Land lease: 241
Cash flow: 62.

That's about a 3.7% cap if cash was paid for 20k. Meh?

(And if you're spending 112/mo financing, you're losing money monthly.)

My numbers may be off though if I'm misunderstanding something.
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honobob

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Re: Property rental investment - is it matching the 2% rule?
« Reply #2 on: September 07, 2013, 09:51:29 AM »

Gross monthly rent: 606
50% expenses: 303
Land lease: 241
Cash flow: 62.

That's about a 3.7% cap if cash was paid for 20k. Meh?


First, I don't understand your 3.7% cap.  I'll have to assume you mean a cap rate. But you are using made up numbers so why bother?  Even if you went to the time and trouble to compute an actual cap rate, what would good is it by itself?  Is it a fee simple cap rate or a leased fee cap rate?  Curious, what would it be if the property was financed?

babymoustache,  Your gross rent multiplier is 4.6.  How does that compare to similar properties?  Do you really think you'll learn anything on a cheap leasehold property that you will be able to use on a normal property?  Unless this is the type of real estate investing you plan to continue I would say very little.  There is a reason that properties in Wellington have maintained their value.  Cheap does not mean a "deal".  Also forget the 2% rule.  Find out what the percentage is for your area AND the type of property you will invest in.

arebelspy

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Re: Property rental investment - is it matching the 2% rule?
« Reply #3 on: September 07, 2013, 10:04:39 AM »
First, I don't understand your 3.7% cap.  I'll have to assume you mean a cap rate. But you are using made up numbers so why bother?  Even if you went to the time and trouble to compute an actual cap rate, what would good is it by itself?  Is it a fee simple cap rate or a leased fee cap rate?  Curious, what would it be if the property was financed?

Yes, naturally cap is cap rate.  It would be the same if financed, cap has nothing to do with financing.  (The redundant "if cash was paid" was added for those who may not know what cap is, to try and be a little more newbie friendly.  As I typed it I thought that you would nitpick on it, but I decided to include it anyways.)  Why bother to try and project your return as close as you can, even if the numbers are made up?  I'll let other people decide that for themselves.

Cheap does not mean a "deal".  Also forget the 2% rule.  Find out what the percentage is for your area AND the type of property you will invest in.

I agree with this (especially the first sentence), however, I would add that once you find out about your area, that often means you want to start looking elsewhere.

In almost every case identifying a market before a property is the way to go.

Since you seem to be looking close to home, definitely get familiar with what is the norm for that market, then decide if that norm is worth investing in to you.
We are two former teachers who accumulated a bunch of real estate, retired at 29, and now travel the world full time with two kids.
If you want to know more about me, or how we did that, or see lots of pictures, this Business Insider profile tells our story pretty well.
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honobob

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Re: Property rental investment - is it matching the 2% rule?
« Reply #4 on: September 07, 2013, 11:34:51 AM »


   Why bother to try and project your return as close as you can, even if the numbers are made up?  I'll let other people decide that for themselves.
 
Well as the self appointed internet cap rate cop I have trouble with people thinking they've computed a useful cap rate based on made up numbers for areas AND property types that have not been identified.  arebelspy, I would gladly give you  a pass on these crap rates if you would AT LEAST identify all v/c and expense categories you are using and their dollar amounts and percentages.  At least then people could compare each category for their expected costs.  Flat 50% doesn't help.  And if you are using flat 50% then WHY NOT JUST USE A GRM? Market value divided by annual rents!  No guesstimates needed.   Can you compare it to a CD rate?  Is a 5.5% cap rate on a Victorian in Cincinnati, Ohio better than a 7.5% cap rate on a stucco ranch in Las Cruces, NM? 

What is the definition of your "return"?  Seriously, what does your computed cap rate mean?

Babymoustache

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Re: Property rental investment - is it matching the 2% rule?
« Reply #5 on: September 07, 2013, 06:33:19 PM »
Arebelspy
Quote
Assuming I'm the Joe, I stand by that statement (and if I'm not, I still agree, sounds like a very smart fellow

...certainly is a very smart fellow. Very chuffed to have his feedback. Thanks so much!

Arebelspy
Quote
In almost every case identifying a market before a property is the way to go.

This piece of advice really struck home with me, I realised I'd been it approaching it the other way around. So, I've done some digging and found out:

Market: shrinking population since 1990s, increased number of rentals on market and less privately owned, population 2,000, found 2 rentals in my range that haven't rented since jan and 5 since may. Then did further research and found out it tends to have gang members renting in the nearby area which was a bit of a shock as it came across as a family style area. So, I'm extremely glad you gave me this advice! It really puts a completely different perspective on things.

Honobob
Quote
Cheap does not mean a "deal"...  Find out what the percentage is for your area AND the type of property you will invest in.

Arebelspy
Quote
Since you seem to be looking close to home, definitely get familiar with what is the norm for that market, then decide if that norm is worth investing in to you.

Thank you honobob and arebelspy, you both hit the nail on the head!  I have a piece of land in my area (value 200k, 138k left on the mortgage). It won't sell, but I have just received permission from council to build a duplex (4 bedroom and 2 bedroom). I was planning to live in one with flat mates and rent out the other. But I was worried about the 2% rule as it definitely doesn't match it. I would also have to get finance for $488,000 at 5.95% (fixed 3 years). The length of mortgage term would depend on the projected cash flow, for instance if there was no cash flow, I could cover it on my income alone over a 25 year term.

House: $530,000 (2 units = 2 bedroom and a 4 bedroom)
Total valuation $570,000 = land 200k, house 370k)
Finance: $36,000 annually ($3,000 monthly)
Gross Rent: $39,260 annually ($3,271 monthly)
50% rule = 19,630 annually ($1,635 monthly)
Minus finance = negative -$16,370 annually
2% rule $3,271x50 = $163,550
Market: slowly growing population, same proportion of rentals to privately owned as in 1990s, population 6,000, all rentals in my range are currently rented within a month.
Gross rent multiplier: 13.4? (Honobob is this correct?)
Cap rate: 3.7? (Arebelspy is this correct? Honobob I know its only an estimate for now and will look into all the research you mentioned next.)

What are your thoughts on the 2% rule in a case like this?  I have looked at similar houses in the area and they come in at 500k-650k for comparable rents.

honobob

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Re: Property rental investment - is it matching the 2% rule?
« Reply #6 on: September 07, 2013, 07:35:24 PM »
Arebelspy
Quote
Assuming I'm the Joe, I stand by that statement (and if I'm not, I still agree, sounds like a very smart fellow

...certainly is a very smart fellow. Very chuffed to have his feedback. Thanks so much!

Arebelspy
Quote
In almost every case identifying a market before a property is the way to go.

This piece of advice really struck home with me, I realised I'd been it approaching it the other way around. So, I've done some digging and found out:

Market: shrinking population since 1990s, increased number of rentals on market and less privately owned, population 2,000, found 2 rentals in my range that haven't rented since jan and 5 since may. Then did further research and found out it tends to have gang members renting in the nearby area which was a bit of a shock as it came across as a family style area. So, I'm extremely glad you gave me this advice! It really puts a completely different perspective on things.

Honobob
Quote
Cheap does not mean a "deal"...  Find out what the percentage is for your area AND the type of property you will invest in.

Arebelspy
Quote
Since you seem to be looking close to home, definitely get familiar with what is the norm for that market, then decide if that norm is worth investing in to you.

Thank you honobob and arebelspy, you both hit the nail on the head!  I have a piece of land in my area (value 200k, 138k left on the mortgage). It won't sell, but I have just received permission from council to build a duplex (4 bedroom and 2 bedroom). I was planning to live in one with flat mates and rent out the other. But I was worried about the 2% rule as it definitely doesn't match it. I would also have to get finance for $488,000 at 5.95% (fixed 3 years). The length of mortgage term would depend on the projected cash flow, for instance if there was no cash flow, I could cover it on my income alone over a 25 year term.

House: $530,000 (2 units = 2 bedroom and a 4 bedroom)
Total valuation $570,000 = land 200k, house 370k)
Finance: $36,000 annually ($3,000 monthly)
Gross Rent: $39,260 annually ($3,271 monthly)
50% rule = 19,630 annually ($1,635 monthly)
Minus finance = negative -$16,370 annually
2% rule $3,271x50 = $163,550
Market: slowly growing population, same proportion of rentals to privately owned as in 1990s, population 6,000, all rentals in my range are currently rented within a month.
Gross rent multiplier: 13.4? (Honobob is this correct?)
Cap rate: 3.7? (Arebelspy is this correct? Honobob I know its only an estimate for now and will look into all the research you mentioned next.)

What are your thoughts on the 2% rule in a case like this?  I have looked at similar houses in the area and they come in at 500k-650k for comparable rents.

Babymoustache,  what is the market value of the property?  first you state $530,000 then $200,000 land and $370,000=$570,000.

So your GRM is either 13.5 or 14.5.  But that tells you pretty much nothing, not return or profitability.  What if a similar property next door sells for a GRM or 11.5  or 16.5.  You as an investor need to be able to justify the difference to your property. 

The guesstimation of the crap rate is only the start of my problems with its use for SFH's or  less than 5 unit residential properties.  It means ABSOLUTELY nothing unless you have crap rates from similar located and types of properties.  That is information that is not available.  Commercial properties have publications that have the cap rates for specific types of properties in specific locations and for certain time periods.  If you are purchasing you have to analyze the range of reported cap rates comparing them to your intended purchase.  Saying you're buying at a 10% cap rate doesn't mean anything by its self. 

Same thing with the two percent rule or any other rule.  It does not mean anything unless you can compare it to similar properties in similar locations at similar times.  Sometimes a 5% cap is a good deal and sometimes a 10% cap rate is a good deal.  Just like GRM's the market determines these rates.  You need to know the historic figures and have some business sense to figure what the reasons are for up or down swings.

Knowing the historic rent and appreciation growth is WAY more important than coming up with some guesstimated crap rate. 

All real estate is local and so are their "rules".

arebelspy

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Re: Property rental investment - is it matching the 2% rule?
« Reply #7 on: September 07, 2013, 10:06:09 PM »
Cap rate: 3.7? Arebelspy is this correct?

Yes.  If that 50% expenses is true.  It very well may not be.  But under the (large) assumption that your expenses are approximately half of the gross rents, that would be your cap rate.

I choose not to engage honobob due to past experience, but take of his posts what will help you, and I'll happily answer any questions you have for me, or that you have in general.

I would not personally make an investment like either of the ones described.  From what I understand of the NZ real estate market, I would not be investing in it.  I would be investing in other asset classes, or if I wanted to do real estate investing, it would be international (possibly U.S., not necessarily though).

Glad you hit the realization of market being a key factor.  Many never even look into that, because they lock into a market without research (usually due to the fact of circumstance - it's the market they reside in) and thus end up with subpar investments (and then complain about real estate as an investment).

Good luck!
We are two former teachers who accumulated a bunch of real estate, retired at 29, and now travel the world full time with two kids.
If you want to know more about me, or how we did that, or see lots of pictures, this Business Insider profile tells our story pretty well.
We (rarely) blog at AdventuringAlong.com. Check out our Now page to see what we're up to currently.

honobob

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Re: Property rental investment - is it matching the 2% rule?
« Reply #8 on: September 07, 2013, 11:15:17 PM »


I choose not to engage honobob due to past experience, but take of his posts what will help you, and I'll happily answer any questions you have for me, or that you have in general.

 
What past experience are you talking?  Did I date you on a Vegas trip and not call you back? ;-)  This is a discussion forum.  A silent voice is as powerless as a silenced voice.  I think everyone could learn something if you would explain your views on the importance of a guesstimated cap rate for SFH's.  Or why you would bother to use a cap rate where all expenses and v/c is exactly 50% when a GRM would be easier and WAY more accurate in showing the relationship of rents to market value?  Com'on and put on your big girl pants and join the discussion. 

Putting something out there as fact and then taking snipes at me when I make a valid challenge seems kinda bitchy.  If I did something to hurt your feelings I apologize and if you point it out to me I'll make every effort not to repeat but I honestly can't think of anything but then my ex-wife always seemed able to drag up something from the past that I'd long forgotten. 

nz

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Re: Property rental investment - is it matching the 2% rule?
« Reply #9 on: September 07, 2013, 11:44:58 PM »
Can I ask what  part of NZ you are looking at?There are of course many  regional differences and some towns  appear to be doomed.......
Think about the quality of tenants you might attract  ...... and consider how stable/ reliable they may be. The human factor in rentals should not be under stated!

mpbaker22

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Re: Property rental investment - is it matching the 2% rule?
« Reply #10 on: September 09, 2013, 08:34:11 AM »
I have to agree with Honobob here, at least as far as ARebelSpy not make it clear that the 50% rule is an assumption, and not necessarily accurate.  Now, I would expect the OP to have understood that assumption, but perhaps he did not.

It seems that no one has mentioned this being a good investment property, and ARebelSpy did say that it was a 3.7% CAP rate (not very good).  Also, his CAP rate assumes 50% expenses, but I would plan on expenses being higher than that.  You're talking about the rents being fairly low (though high compared to purchase cost), but a water heater is still a water heater, furnace still a furnace, etc.  And having to replace something like that will eat up much more of your rent than when rent is $1200/month. 

I think that is what honobob and ARebelSpy are both getting at, without actually stating it clearly.