Author Topic: Challenging the 50% rule  (Read 24950 times)

eldub

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Challenging the 50% rule
« on: August 07, 2012, 06:41:54 PM »
Ok, I almost hijacked another thread with this so have started a new one.

Arebelspy and others have mentioned the 50% rule of landlording. I hadn't heard of it before and it has seriously challenged my own thoughts on owning a rental property. We live in a city where real estate is pricey, and I can't see the 50% rule ever working here. I'll use my current home, which has two units, as an example as my huband and I have considered keeping it as a rental in the future while we move into a new home for our growing family.

Current value of our home: $535,000 (conservative estimate - we will soon get an appraisal and I anticipate it could worth be a good deal more than this)
Mortgage: $410,000 at 3.29 over 25 years
Monthly P+I: $1940
Monthly property taxes: $210
Potential rental income: $1350 for the basement suite, $1550 for the main floor = $2900
Monthly surplus: $2900 - $1940 - $210 = $750
*We may pull the equity out of this house in order to contribute to our downpayment on a new house. I anticipate this would raise the mortgage payment by $200 per month maximum, at today's interest rates.

Our home has been renovated to within an inch of its life. $750 per month = $9000 per year profit. That would cover three months of vacancy of both units every year, which in our low-vacancy rate area I can't ever see happening. We don't expect to have much in the way of repairs in the forseeable future as everything has been done. There will be routine maintenance, but the cost should be minimal. Also, my husband is a journeyman tradesman so most things he can do himself, or knows someone who can do it, often for a trade of work.

"In Victoria, BC, which had the country's tightest vacancy rate 0.5% - for four years running until 2009, saw vacancies ease to 1.5% in October 2010 and 2.1% in October 2011. The long-term dearth of supply has come with a cost, though. The average two-bedroom apartment there now rents for $1,045 per month, fifth-highest in the country, and analysts are already calling for vacancies to drop back to 1.5% by the new year."

We're not looking at the rental property to provide income in the short term, but to be more of a long-term investment. The way I see it, the house should carry itself as a rental enough to cover vacancy and repair. I know a lot can change in 25 years, and in particular we should count on higher interest rates, but I'm assuming we'll have a paid-off house with minimal cost input from us in the end. We can decide to keep the house and reap the monthly rental income in retirement, or sell it and put hundreds of thousands of dollars in the bank.

I know I've made a lot of assumptions. Arebelspy and others, show me where I've gone wrong!

totoro

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Re: Challenging the 50% rule
« Reply #1 on: August 07, 2012, 07:05:21 PM »
I don't think you have accounted for insurance costs.  Another cost likely borne by you is the municipal water bill.  You have also not accounted for income tax on the net.  You have not assigned a dollar value to your time for management purposes. You will have some maintenance costs - even if it is for landscaping and touch ups.  I use a calculator located here that accounts for all these costs:

http://www.biggerpockets.com/forums/88/topics/25519-free-property-analysis-worksheet

A risk is that when renewal time comes on the current mortgage term rates may be higher.  Many would look at the equity you have in this place and account for lost opportunity costs on this amount (ie. if you would otherwise have invested your $100 000).  There is a local caculator and discussion on this (look for Roger's posts) on that here: http://househuntvictoria.blogspot.ca/

That said, you also have to factor in principal pay down each month.  Appreciation and depreciation factor into the analysis.  You sound like you might be keeping the rental for more than seven years.  This should be ok in our market to recover from the coming drop (likely imho).

I agree that this is a good investment in the Victoria area.  It is, in fact, better than most because of your sweat equity and relatively low purchase price for relatively high rent.  The fact that it is all reno'd (roof, perimeter drains ok, foundation, furnace.. all ok?) means that short-term your costs should be lower.  There are still life expectancies on big ticket items so long term costs might go up a bit.

As for the 50% rule, that is a starting point.  Having a handy husband with trades friends mitigates some of this, as does the condition of the home and your willingness to manage it yourself.  The 50% rule does not work in our market but it does not mean that real estate makes no sense - in fact, I believe that you buying and renovating and adding a suite is the strategy that works best in our market.


arebelspy

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Re: Challenging the 50% rule
« Reply #2 on: August 07, 2012, 07:55:15 PM »
50% is long term. 

You may be able to beat it short term, but probably not long term, where you will see capital repairs (like roof replacement, HVAC, appliances, etc.), maintenance as things break and tenants move out (paint, carpet), vacancy (which, even if low in your city, you will see, and moreso with a duplex, IMO) -- if you aren't seeing vacancy your rent is set too low.  Property management is another cost, even if you do it yourself, that's a side job you have as a property manager, it's not a return on your investment.

If you took that same money from the house and put it in stocks (or whatever), then got a job to manage someone else's property, that'd be the same as putting that money in the rental house and then getting a job to manage your property, so you should take out the management fees from the return.

There's TONS of discussions on biggepockets.com about the 50% rule. Here's a decent one that helps describe where the money goes in the 50% rule: http://www.biggerpockets.com/forums/52/topics/63789-5-rule-lowest-cost-efficient-producer

It cites this study here:
http://www.naahq.org/SiteCollectionDocuments/Industry%20Resources/2010%20Income%20and%20Expenses%20Survey.pdf

A search on their forums will help find lots more discussion.

Personally, my avg. 50% looks more like this:
Gross Potential Rent $1050 x 12 = 12600
8.3% Vacancy (1 mo/yr) = 1050
2% collection losses = 252
Total Revenue = 11298

Expenses :
10% Management = 1260
6% repair/maintenance (~1% on 80k purchase price) = 756
6.3% Taxes ($800/yr) = 800
6% Capital Expenditures = 756
2.4% Insurance ($300/yr) = 300
2.4% utilities = 300
6.25% marketing (housing helpers) = 787.5

Total % = 49.65 (39.65 without management).

I'm also paying an avg of 5% towards HOAs.

« Last Edit: August 07, 2012, 08:16:31 PM by arebelspy »
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arebelspy

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Re: Challenging the 50% rule
« Reply #3 on: August 07, 2012, 08:16:06 PM »
Now let's look at your numbers.

Quote
Current value of our home: $535,000 (conservative estimate - we will soon get an appraisal and I anticipate it could worth be a good deal more than this)
Mortgage: $410,000 at 3.29 over 25 years
Monthly P+I: $1940
Monthly property taxes: $210
Potential rental income: $1350 for the basement suite, $1550 for the main floor = $2900
Monthly surplus: $2900 - $1940 - $210 = $750
*We may pull the equity out of this house in order to contribute to our downpayment on a new house. I anticipate this would raise the mortgage payment by $200 per month maximum, at today's interest rates.

50% of 2900 rent is 1450.  Since your P&I is 1940, this is obviously huge cash flow negative under the 50% rule.

Even if you discount the 50% rule and try to run your own numbers, I think you can get it close to break even, but realistically it'll be at least slightly cash flow negative.

You in the above numbers, to get your surplus, you don't take into account many of the expenses.

For example, the general rule of thumb on maintenace is 1-3%/yr. of the purchase price: https://www.google.com/search?q=percent+per+year+house+maintenance  Some sites say all the way up to 5%, though I think that's high.  But keep in mind, yours will be higher than an owner occupied, because a tenant is less likely to take good care of a home than an owner is.

Management fees are 6-10%.  If you don't pay yourself for this, you're working for free and valuing your time at $0/hour. That is not the correct way to calculate your return.  If you end up cash flow negative by $100, but "pay" yourself $200 in management, you should view it as that: house is cash flow negative 100, and you have a $200/mo PM job.  Not as a cash that is cash flow positive by $100 (oh, but you manage it at $0/hour...)

2900 rent
-210 taxes
-? insurance (look this up to get an accurate number)
-446 maintenance (this is using the low end number, 1%, on 535k is 5,350/yr, or 446/mo)
-174 management (using the lowest 6% number)
-1940 mortgage
___
That already comes out to only 130. 

It is not counting:
- Insurance
- Vacancy (even if your town has very low vacancy, you'll still have some during tenant turnover when getting the place rent ready again.. even 2 weeks/unit per year, a pretty low amount of vacancy costs you a prorated amount of 111/mo.)
- Any utilities you have to pay (tenants often pay most, but I pay sewer, for example .. with a duplex you'll probably find yourself paying more than you might with a SFR, simply because the two units don't have separate meters for utilities)
- Collection losses (i.e. a tenant not paying you - which will happen at some point, hopefully very rarely).
- Long term capital expenses like roof replacement you should be putting money away for.
- Any marketing you have to do, or other misc. stuff.

Even if you think you can beat the 50% rule, which says you are cash flow negative almost $500 per month (!), I don't think you can get anywhere close to making that house cash flow positive.

Now the plus side? Tenants are paying off that mortgage for you.

Principal pay down (aka equity gain) along with tax benefits/deductions (not sure what's available to you Canadians) may make it turn out to put some money in your pocket.  It may or may not turn out to be an okay investment, and we can discuss that.

But cash flow positive?  By the $750 you claim?  Sorry.. no.  =/
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totoro

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Re: Challenging the 50% rule
« Reply #4 on: August 07, 2012, 08:29:21 PM »
The 50% rule appears to ignore a number of factors.  Our market has high prices but the cost of repairs ie. a new roof or furnace is the same for a high price home in our market  that garners higher rents vs. a lower priced home in another market which gets lower rents.  Our costs will be lower relative to a percentage of rents than most markets in the states.  A dollar value on these costs each year I could buy into but not a set percentage of rents.

In addition, when property values go up in our established market tax rates go down.  Higher tax jurisdictions will have higher costs for this - our rates are relatively low.  I do not believe that the 50% rule is anything more than a starting point for evaluating your property.  In our market you can still make money long-term with a rental.

I also disagree that if your vacancy rate is too low your prices are too low.  Our overall vacancy rate is very low but turnover is a killer.  Better to rent at market and enjoy our low turnover based on low vacancy rate than have tenants who feel they are overpaying and decide to more.

http://www.biggerpockets.com/blogs/1148/blog_posts/16950-the-perils-of-the-5-rule-myopia


arebelspy

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Re: Challenging the 50% rule
« Reply #5 on: August 07, 2012, 09:05:56 PM »
Absolutely the 50% rule is a starting point for a property, as is the 2% rule.

Every property should be evaluated on its own.  I have separate spreadsheets (multiple) for my different properties, and for ones I'm evaluating for purchases.

But did you even read my two lengthy posts above, where I delved into the actual numbers, and didn't use the 50% rule, and actually evaluated the OP's property?  Cause your post seems to imply that you missed that whole thing.
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eldub

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Re: Challenging the 50% rule
« Reply #6 on: August 07, 2012, 09:17:33 PM »
Brand new metal roof, 2011 with 50 year warranty. Pretty new furnace.  Yes, I'll admit I've discounted the amount of maintenance/repairs but honestly, when I say this place is renovated to within and inch of its life, I mean it. I just don't know that I can get behind $446 a month, every month.

Also it's a pretty nice place, if I do say so myself.  Can we factor in the type of tenant we are likely to attract? Stereotypes and assumptions here, but I would imagine that people who will pay to rent this place might treat it better than the average tenant. thoughts? Perhaps not enough to make a difference?

Our two units do have separate meters for hydro (electricity). Gas is only used by the upstairs unit. I suppose that leaves water/sewer, but could you not have the two units pay it based on percentage of square footage, or number of people living in each unit, or some other equitable way of splitting it?

Also, why do I have to pay myself?  I don't pay myself to make contributions to my retirement account. Yes, I realize that doesn't take the same amount of time, but what if I don't mind putting in my time in order to get ahead?  I don't pay myself for a lot of work I do to get our family ahead. Why so adamant on this point, Arebelspy?

Also, should clarify. I didn't mean to imply that it was cash-flow positive by $750 per month, but rather that the $750 would cover maintenance, vacancy etc. Using your estimations, it's not enough but I don't intend for it to put money in my pocket every month. I've been looking at it this way: if it "carries itself", then great. Even if we do need to put a bit of money into it every month, maybe that's ok too if the payoff in the end is worth it.

Thanks for your comments so far...

arebelspy

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Re: Challenging the 50% rule
« Reply #7 on: August 07, 2012, 09:54:54 PM »
Also, why do I have to pay myself?  I don't pay myself to make contributions to my retirement account. Yes, I realize that doesn't take the same amount of time, but what if I don't mind putting in my time in order to get ahead?  I don't pay myself for a lot of work I do to get our family ahead. Why so adamant on this point, Arebelspy?

To put it as simply as I can, because that's a return on labor, not on capital.

If I offered you an investment where you earn an  ROI of 10%, and you invest $12,000.  You are earning 10%, which equates to 1,200/year, or 100/month return on your money.

Then you learn you could also earn an extra $100/month for digging ditches for 10 hours that month, an opportunity only open to those who have put money in this investment.

You say hey, extra side income, why not.  You are now earning $200/month because of that investment.  Only 100 is a return on your capital invested, however, the othe 100 is a return on your labor.  By digging those ditches, you aren't suddenly earning 20% on your 12,000 invested!

You take out all your money and spend it.  Then you find out that you could earn that same $100 digging ditches without the investment.  You decide to do it.  That clearly isn't a return on capital, you don't have any invested.

Being your own property manager is like digging those ditches in the first example.  Sure, you could do it, but it's a separate labor job that optionally comes with the investment, and by counting it as a return on your money invested, you will be overcounting your return (just like saying you are now earning 20% on your 12k invested is wrong).

If you dig those ditches for someone else (i.e. become someone else's PM), you would count that as money earned for labor.  So why wouldn't you count it when you do the labor for yourself?

If you sold the investment, you could probably continue to manage it and still make that money.. but that's not a return on your capital, and shouldn't be counted as such.  The management and ROI are two separate metrics, and people conflate them because they get one rent check and don't understand what part of that is actually a real return on their money.

I manage my own properties, and I view it as a side gig that earns me a few thousand a year.  One day I plan to pay upwards of 20k/yr for others to manage 20+ properties for me.  If I do it myself though, that 20k extra I earn isn't return on the money I have invested in the houses, it's return on me being a property manager for 20+ houses.

..is that a more clear explanation?
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totoro

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Re: Challenging the 50% rule
« Reply #8 on: August 07, 2012, 10:23:11 PM »
Arebelspy I read your posts.  You may have read mine as well and noted that I set out the deficiencies (no insurance costs, no lost opportunity costs, no management fees, no income tax on net, no water payment).  I was responding to the 50% rule and not your post.

To respond to your post directly, your maintenance costs are way out of whack and show why a blanket percentage does not fit all scenarios.  I own two more expensive properties in the same town which are well maintained and pay nowhere near $456 a month for maintenance.  The median maintenance cost per month for an american in 2005 was 27 dollars : http://www.freeby50.com/2008/12/what-does-home-maintenance-really-cost.html  Even grossed up for inflation we hit nowhere near $456 a month.  The OP is starting with a fully reno'd property - even long-term she is not going to hit this figure.

As far as I am concerned the OP can choose to discount the property management fee as she may view this as a hobby and not work.  I know I view my properties as a fun project and am very happy to spend time improving them outside of my paid employment.  I would never work more to earn more during this time - I choose to do this.  I agree though that if you have a large number of rentals it gets to be a chore and it is probably better to account for this time.

As far as damage and vacancy rates, have a nice place and screen your tenants and put everything in writing.  Here we have a 50% damage deposit required and good landlord tenant regulations with almost free access to mediation and arbitration.  I have never had a problem in the nine years I have owned rentals, not to say that there could not be a problem.

I approach properties as a hobby I enjoy that must be cash flow positive to make sense.  I evaluate based on a number of variables and look for added value where I can find it through sweat equity, location, adding rooms...

eldub - I would set out everything on the spreadsheet I posted and look at the cash flow and CAP rate.  Here it is again: http://www.biggerpockets.com/forums/88/topics/25519-free-property-analysis-worksheet


totoro

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Re: Challenging the 50% rule
« Reply #9 on: August 07, 2012, 10:25:22 PM »
eldub - a professional real estate investor would be less likely to bank on principal paydown and appreciation but most long term gains are from appreciation.  will this always be the case? not sure.  likely in the long-term but you are vulnerable in the short term.  given your investment window I think you will be fine.

arebelspy

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Re: Challenging the 50% rule
« Reply #10 on: August 07, 2012, 10:33:08 PM »
As far as I am concerned the OP can choose to discount the property management fee as she may view this as a hobby and not work.  I know I view my properties as a fun project and am very happy to spend time improving them outside of my paid employment.  I would never work more to earn more during this time - I choose to do this.  I agree though that if you have a large number of rentals it gets to be a chore and it is probably better to account for this time.

Would you manage someone else's property for free as a hobby/fun project?

As far as damage and vacancy rates, have a nice place and screen your tenants and put everything in writing.  Here we have a 50% damage deposit required and good landlord tenant regulations with almost free access to mediation and arbitration.  I have never had a problem in the nine years I have owned rentals, not to say that there could not be a problem.

I don't know about there, but here you cannot charge for normal wear and tear.  So malicious damage, sure, security damage may cover it (unless they do more damage than you have on deposit, and then have fun bringing to court and collecting on it).  But things like new paint, carpet, etc. a landlord has to pay.  A house will run down over time.  Water heaters break.  Pipes burst.  Ovens stop working. I don't know about there, but here the landlord pays for those sort of things.  The nicer the house, the more  those things cost, in general.

I approach properties as a hobby I enjoy

That's fine, but that's different than evaluating it as an investment.  One should properly evaluate it NOT as a hobby, and see what returns it gets to compare apples to apples to other investments.
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eldub

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Re: Challenging the 50% rule
« Reply #11 on: August 07, 2012, 10:44:13 PM »
Perhaps we can look at it another way: it's not a matter of should we buy this property, but rather should we keep it?

It's pretty likely we will outgrow this house. I wrote about that a bit more here: http://4hutches.blogspot.ca/2012/08/will-this-be-our-forever-home.html

So our choices are these:
1. Stay in this house "forever" and continue to rent the basement. We'd be way better off financially, but it's probably not realistic given our twin boys
2. Sell this house, take the money and buy a new, more expensive, house for our family. Where we live, any house we could possibly afford will need a ton of work. The Mr. has done it all in this house, and I KNOW that he doesn't have it in him to do it all again somewhere else.
3. Try to hang on to this house as a two-unit rental and leverage it to buy our "forever home", as discussed above.

Considering we already own this place, and these are our three options, can we look at it as which is the most sound choice, financially and otherwise?


totoro

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Re: Challenging the 50% rule
« Reply #12 on: August 07, 2012, 10:50:32 PM »
1. Would I manage someone else's property - no.  I would also not tend someone else's garden for money but I love doing my own.  I would not fish for someone else for money, but I love to do it for myself.  The line between hobby and job is quite personal.  The truth is noone will look after your properties like you would.  I will look at everything from a hands-on perspective, look for additional value and savings and enjoy it.  It is intrinsically satisfying to save the $100 service call fee by tightening a washer myself.  The truth is that my properties don't require too much management anyway - but I suppose that is not the point.  What is my point is that pride of ownership is a good feeling that I enjoy maximizing by creating a nice place to live for tenants.

2.  Wear and tear do not cost $456 a month.  Water heaters have to be replaced every ten years and cost $700.  I have a schedule for everything.  Ovens cost $250 and last a long time and burners and elements can be replaced.  Burst water pipes could happen but are anomolies - never happened to my folks in thirty years of ownership and cross my finger has not happened to me.  Painting is required but not all the time.  We allow tenants to paint their own colours if they paint it back when they leave or pay for it to be done.  I paint my own places when necessary.

3.  I agree that when evaluating it as an investment you should compare apples to apples.  What about  the folks that spend hours analyzing investments and managing them?  This could be a job.  Is there an accounting for this in your comparisons?  I'm not saying that you should not account for this time, just that some smaller investors may choose not to and the 50% rule is a guideline and not the gospel - the percentages just don't work in all markets because of differences in valuations and rents.

3.

arebelspy

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Re: Challenging the 50% rule
« Reply #13 on: August 07, 2012, 11:00:45 PM »
Sigh.  You seem to not be listening to me.

the 50% rule is a guideline and not the gospel - the percentages just don't work in all markets because of differences in valuations and rents.

I agree.  I have agreed.  Multiple times.

I am not defending the 50% rule.  You seem to want to attack it, then place the onus on me to defend it.  I am talking about particulars of this property, not of the 50% rule.

The other things I mention (water heaters, etc.) are examples of the "other" costs and maintenance that hasn't yet been accounted for.

By all means, post what you think are realistic numbers for the property in the OP.  Stop attacking the 50% rule, as it's just a guideline, every property should be evaluated on its merits.  So evaluate this one, as I did.

You think it will have 0% vacancy?  0% maintenance?  Fine.  Post your numbers that you think are a realistic projection.
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totoro

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Re: Challenging the 50% rule
« Reply #14 on: August 07, 2012, 11:18:35 PM »
Must be a misunderstanding.  Sounds like I made a mistake in how I responded.  I was trying to respond to the OPs question about the 50% rule and got a bit sidetracked on your analysis which I read as based on the rule.  As far as the other factors - we probably agree on most of them except that one about the maintenance costs so I'll leave that then :). 

I did post a link to a spreadsheet and the OP can decide what are realistic numbers and post back.  That might be most helpful and I'm just out of time.  There are inputs for vacancy, income tax, maintenance and all the expenses.  I run these numbers for my places and find it helpful.


arebelspy

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Re: Challenging the 50% rule
« Reply #15 on: August 07, 2012, 11:26:28 PM »
Okay, no worries.  :)

I think in order to answer the OP's latest question (i.e. is this a property worth keeping) we need some hard numbers, even if some will be estimates.  I tried to trend on the low side in my estimates, but if you post your hard numbers, and if the OP adds in some details (such as insurance cost), we can figure out if that trapped equity would be better suited in another investment or not.

(For example, I calculate the OP is getting about a 7% return calculating JUST the equity paydown.. but it depends how much money they're feeding in each month if it's worth it.)

In any case, let's keep working the numbers.  First up, what we have been working on: NOI.

Gross rents - all expenses.  So let's keep working on narrowing down those expenses.  When you two, totoro and eldub, have time, try to work though my second post in the thread and comment on those specific numbers and add your own thoughts so we can get a working NOI to evaluate this investment.

Also eldub, did my latest explanation of why you should pay yourself as a PM make sense (i.e. return on capital versus return on labor)?
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Re: Challenging the 50% rule
« Reply #16 on: August 08, 2012, 06:00:30 AM »
Some good posts as always arebelspy. Thanks again!

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Re: Challenging the 50% rule
« Reply #17 on: August 08, 2012, 07:00:53 AM »
Having owned multiple rental properties of different ages for many years, I would say the 50 percent rule is not that out of whack in most markets.  If your holding period on a new property is ten years or less, you might drop that down into the high 30's, because you don't need much in the way of capital improvenents in the first 10 years.

I think it would be helpful to do a thorough analysis of the projected nymbers as suggested.  However, it would be equally helpful for the OP to talk to landlords and property managers in the area.  Find out what their experience has been for each of the expense categories with newly renovated properties.  What is the average turnover time and cost?  How much collection loss do they experience?  How often are they replacing paint and carpet?  Getting to know a few experienced landlords will be very valuable if you decide to pursue this.

Management is an expense that should accrue to the investment.  It may not be an expense you incur directly, but if you were to sell the property as an investment, buyers would incorporate management expense into their calculation of the worth of the income stream.

Almost every new investor goes into real estate thinking their property is different and they can juice their yield by doing one or more jobs themselves.  Sometimes the investor is successful, often they are not.   Talk to as many people in your market as you can before you run the final numbers and make the decision.

tooqk4u22

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Re: Challenging the 50% rule
« Reply #18 on: August 08, 2012, 07:51:12 AM »
Arebelspy's analysis and position is spot on overall - some of the figures may be more or less but the premise is correct. 

One thing that is being ignored is principal reduction, which should be about $10K in the first year of the mortgage.  Ignoring everything else and assume the OP's net is actually correct and add back $10k it results in a 3.6% cash on cash return - doesn't seem good enough to me but on a leveraged basis equals a 15.2% return - seems much better.  BUT that is the absolute best case scenario and only if you ignore everything else Arebelspy pointed out. 

As for repairs and maintenance, 1-3% is correct as well and the reason for the range is more to account for valuation differences and not so much newness.  It is based on long term average. 
Brand new metal roof, 2011 with 50 year warranty. Pretty new furnace.  Yes, I'll admit I've discounted the amount of maintenance/repairs but honestly, when I say this place is renovated to within and inch of its life, I mean it. I just don't know that I can get behind $446 a month, every month.

Also it's a pretty nice place, if I do say so myself.  Can we factor in the type of tenant we are likely to attract? Stereotypes and assumptions here, but I would imagine that people who will pay to rent this place might treat it better than the average tenant. thoughts? Perhaps not enough to make a difference?


Let's say you don't have to touch the roof for 50 years - even still you have to look at it this way, if spent $10k on that roof it would equal $17/month (undiscounted/uninflated) that you should be deducting from your cost.  This applies to everything - a water heater typically lasts for for 12 years and costs about $1500 installed - if you have 2 of them that is $3000 or $21/month.

Also Simply cleaning the place between tenants will be a cost in addition to fixing other wear and tear, sure your place may attract better quality tenants but maybe one of them will have a nut job child and they kick holes in everything - security deposit won't be enough. 

Vacancy and loss is a big one - one month down will hurt you.  It all adds up and you should be looking at it as Arebelspy suggest and not in the sense of a perfect scenario - and to be honest prices and trends in Canada look a lot like where the US was in 2007 - so appreciation may not be in the cards.

But on the other hand if it is really just asset accumulation and overall return is not important and you aren't comfortable with other investments then good - do what works for you but don't fool yourself that you are doing better than you are.

eldub

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Re: Challenging the 50% rule
« Reply #19 on: August 08, 2012, 09:13:49 AM »
Thanks everyone for your comments. Lots for me to look at and think about.

Let me see if I attempt a more realistic guess on our ongoing repair costs.

First, the roof. Our cost in 2011 was $4000, insurance paid the other $4000 as we hada leak from a windstorm. I don't know that it's correct to calculate a monthly cost going forward as it has essentially been rolled into our recent refinance, and that would be counting it twice. I'm going to leave it as $0.

Flooring: we have no carpet in either unit. Downstairs has laminate, upstairs mahogany hardwood. Cost of the laminate is $1200, husband lays it himself. Cost of the hardwood was $3600, brother in law installed it, on top of original 100-year old fir. I don't anticipate installing new harwood flooring ever, but perhaps a refinishing is realistic. Also, I don't anticipate installing new laminate (isn't the point of that stuff that it's indestructible?). Maybe someone can school me on this one. For now, I'm going to leave as $0

Paint: Obviously this will be an ongoing cost. Personally, I kind of like painting. Husband also has a childhood friend with a painting business who sprays our unit for the cost of product, some beer and maybe a meal or two. Let's say we paint each unit every 2 years for a total cost of $500, or $21 per month

Appliances: Brand new set for downstairs = $1300. Brand new set for upstairs = $2500. Say we replace each set every 10 years. In reality, I don't think we'd replace with new retail models every time, but rather snag some craigslist deals of pieces that are only a couple of years old. For sake of argument though, let's assign $32 per month

Water Tanks: We have two of them, one per suite. One is brand new today, one is essentially new. Husband is a plumber so no way does it cost us $1500 installed. A new tank runs around $600. BUT, husband changes the sacrifical annode every couple of years and claims that if you do this one bit of maintenance, tank should last indefinitely. According to him, almost no one does this. Let's account for weird one-offs like exploding tanks though and say we replace each one every 15 years. at $1200 for two, that's less than $7 per month.

Miscellaneous: kicked in doors, leaky faucets, drywall repairs, etc, etc. Would assigning $50 per month for this stuff be fair?

Outside: we'd likely need to spend time pulling weeds, mowing grass, keeping the outside looking good. I'm assuming a minimal cost for this, but it is our time.

Management: yes Arebelspy, totally take your point about paying yourself for this stuff. Everything I've calculated above is disregarding paying ourselves to do the work.

So far I'm at $110 per month for R&M before paying ourselves.

Insurance would run around $100 per month

Vacancy: If each unit sits empty one month per year, that's $2900 per year, or $242 per month - fellow Victorians, is one month per year realistic? We plan on being excellent landlords and hope it makes a difference in people deciding to stay long term. We also intend for tenants to sign 1-year leases.

So far I'm coming in at $452 per month. I guess the remaining $298 could go to paying ourselves.

Okay, let's see what holes you all can shoot through my estimates above and I'll find the time to work through the spreadsheets.


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Re: Challenging the 50% rule
« Reply #20 on: August 08, 2012, 09:31:36 AM »
Interesting: I thought your $446 per month was way off. I come in at $452. Hmmmmm.....

tooqk4u22

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Re: Challenging the 50% rule
« Reply #21 on: August 08, 2012, 10:14:26 AM »
I know you keep dismissing the labor aspect of the equation - whether it be for management, painting, landscaping, laying floors, etc. but think about it in the context of what happens if you have to move or become disabled then you would have to PAY someone to do these things.  As others have said this is the side job part of the equation not the ROI part and you should be separating the two. 

Another way to look at is if you or spouse could make $60/hr doing whatever and instead you are cutting the lawn at what you can pay someone $10/hr why wouldn't you pay somebody.


eldub

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Re: Challenging the 50% rule
« Reply #22 on: August 08, 2012, 10:23:58 AM »
Yes, that's true and husband certainly does make that and more doing plumbing jobs on the side. Putting it that way, it does make sense to pay some neighborhood kid to cut the lawn.

You'll see I've allocated the remaining "profit" after R&M expenses, or $298 per month to managment. That's $30 an hour for 10 hours per month. Do you think that's relaistic?

totoro

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Re: Challenging the 50% rule
« Reply #23 on: August 08, 2012, 10:26:01 AM »
eldub - if you plan on getting signed leases for a one-year term I believe your vacancy rate will be lower than this.  One-year leases are often required here in Victoria.

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Re: Challenging the 50% rule
« Reply #24 on: August 08, 2012, 10:28:55 AM »
Interesting: I thought your $446 per month was way off. I come in at $452. Hmmmmm.....

The $446 was the estimated maintenance.  I believe you are at $110 for this?

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Re: Challenging the 50% rule
« Reply #25 on: August 08, 2012, 10:31:05 AM »
Ah yes, true. Totoro, as a fellow Victorian, what do you think of my numbers? Vacancies?

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Re: Challenging the 50% rule
« Reply #26 on: August 08, 2012, 10:32:15 AM »
I'm not going to talk about the expense percentage calculation.  I'm going to talk about a couple of your assumptions that based on my experience appear incorrect.

I NEVER put laminate floors in a rental.  I inherited some in a house I bought last year and it will be replaced with tile on the slab sometime in the next year or two.  That stuff is extremely susceptible to water damage and scratching.  Cats will pee, babies will leak, drinks will be spilled, furniture will be moved in and out.  Tenants rarely take care of stuff the way you do.  It might last a little bit longer than carpet, say 7 years.  The mahogany hardwood is an even bigger waste in a rental property.  If the wood is engineered, it will suffer the same fate as the laminate.  These floors typically cannot be refinished and have to be replaced when they are damaged.  3/4 inch solid oak hardwood can be refinished several times and could last 50 years or longer.  That's if a cat does not soak the floor repeatedly with urine.  Count the cost of at least one refinish in over your likely holding period.

With regards to the roof, the new roof has entered its useful and depreciable life.  You need in theory to set aside a reserve for the NEXT roof.  As the roof should last at least 15 or 20 years, longer since it's a metal roof, it's a small amount each month for a big capital improvement then.  Same with the cost of the water heaters and furnaces.  It's small on a monthly basis.  Paint and carpet will probably be every 5 years, unless you get the tenant from hell.  Then you will be doing drywall repairs and a full paint and carpet at moveout.  I think $100 per unit per month for miscellaneous repairs is more realistic.  Appliances last 8 to 10 years, and Craigslist can help there.  Again, average in replacement cost, allowing for inflation.

In a two-family, the landlord will usually pay for landscaping maintenance.  That's another expense.  You may need to meter the water separately for that.  Insurance should be priced at the investment property rate for a duplex.  Call your broker to get a quote.  It may be more or less than an owner occupied property, depending on coverage.  You will also want to look into additional liability insurance if Canadians are anywhere near as litigious as Americans are.  Expense any utilities you pay, and remember you will have to put the unit utilities in your name when the tenant moves out, especially in winter.  Don't want those pipes to freeze.

In a very tight rental market with high quality tenants that stay a long time, your frictional vacancy plus your collection loss might be as low as 5 percent.  To be on the safe side, I would allow 8 percent.  The market might change, you may get a bad tenant and have difficulty removing them, etc.

Again, I think you are on the right track, but you need to talk to local landlords and property managers for the best information about your market.  We can offer our experience, but the experts are there.  Why not start by casing the neighborhood for the "For Rent" signs, call the numbers and talk to the landlord or property manager that answers?

arebelspy

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Re: Challenging the 50% rule
« Reply #27 on: August 08, 2012, 10:44:07 AM »
Some good posts as always arebelspy. Thanks again!

Arebelspy's analysis and position is spot on overall - some of the figures may be more or less but the premise is correct. 

Cheers guys.  I think this post will be good a good reference to new real estate investors, as it ended up being a little more detailed than most.

One thing that is being ignored is principal reduction

Yeah, on purpose.  We're just working on getting operating expenses so we can get Net Operating Income (NOI) and from there we'll work to total return.

Interesting: I thought your $446 per month was way off. I come in at $452. Hmmmmm.....

It sucks to get a little realistic, huh?

Trust me, I did the "OMG rent- piti = profit $$$$!!! :D :D :D " thing for my first rental.

Heh.

(Oh, and my oldest rental was built in 1998.. many are 2003 or newer.)

I know you keep dismissing the labor aspect of the equation - whether it be for management, painting, landscaping, laying floors, etc. but think about it in the context of what happens if you have to move or become disabled then you would have to PAY someone to do these things.  As others have said this is the side job part of the equation not the ROI part and you should be separating the two. 

Right.  Mr. eldub could make money laying laminate for someone else.  Yet he chooses not to, or if he did, he'd want to get paid.  He should get paid for doing the same with his own rental.  (Although how it actually works is you don't pay him, it stays in the real estate money account, but you take it out on paper when you calculate your ROI to get a realistic return on your money invested, rather than a number that is a mix of return on capital and return on labor.)

First, the roof. Our cost in 2011 was $4000, insurance paid the other $4000 as we hada leak from a windstorm. I don't know that it's correct to calculate a monthly cost going forward as it has essentially been rolled into our recent refinance, and that would be counting it twice. I'm going to leave it as $0.

The usual way to do this is count what it will cost you in the future and prorate it to today.  So say the roof will last 30 years, and cost 4k.  That's $11/month that you have to start saving now, for the next 30 years, to end up with 4k 30 years from now to pay for that new roof.  Ditto on other similar items (even laminate, which will fade, get outdated, etc. a remodel on a 20-30 year old building to update it is fairly common).  Plumbing issues alone can run more than you'd think.  Sucks when a plumber has to cut into the wall / jackhammer the outside of the house.. trust me. ;)

As far as vacancy, I always do one or two year minimum leases.  However there will be times that it takes a week just to get the place in shape again (due to new carpet, which has to be ordered, or a few days to paint the whole place, or whatever), and the next tenant isn't moving in until the beginning of the next month, or whatever.  Or the one tenant you have to evict and it takes two months (plus the month of them not paying first) means those three months ruin your average for the next 3+ years.. My "typical" (read: median) tenant ends up causing me very little vacancy.  But the outliers cause much more problems.  (No, I haven't had to evict a tenant yet.. but I have had one move out early without warning. Stuff happens.)

So going back to actual costs:
2900 rent
-210 taxes
-100 insurance
-110 maintenance (again, I think that's much, much too low. 0.2% on the house value? but we'll use your number..)
-242 vacancy (1 mo/yr)
-1940 mortgage
___
298 left over


So we are still not counting:
- Any utilities you have to pay (you have some separate meters, but what will you still have to pay?)
- Landscaping
- Collection losses (can probably lump in with the vacancy).
- Any marketing you have to do, or other misc. stuff (legal, accounting, etc.)
- Asset protection (protection for you from liability .. typically an extra insurance policy to cover that, like an umbrella policy, or an LLC)
- Management

Thoughts on those?

(We will eventually get to the principal pay down and appreciation and taxes and all that, I promise.)
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tooqk4u22

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Re: Challenging the 50% rule
« Reply #28 on: August 08, 2012, 10:52:41 AM »
Right.  Mr. eldub could make money laying laminate for someone else.  Yet he chooses not to, or if he did, he'd want to get paid.  He should get paid for doing the same with his own rental.  (Although how it actually works is you don't pay him, it stays in the real estate money account, but you take it out on paper when you calculate your ROI to get a realistic return on your money invested, rather than a number that is a mix of return on capital and return on labor.)

Actually, I would suggest that a separate entity be created as a management company, especially if the plan is to own more than one property, then bill your services to each property - for one it actually separates out the value and it without getting into specifics this will help with taxes, current and deferred, and can provide other benefits.

arebelspy

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Re: Challenging the 50% rule
« Reply #29 on: August 08, 2012, 10:58:13 AM »
You're right, that's the ideal way to do it.

Most investors who invest for a hobby don't do it that way, so the funds for labor and capital are all mixed together in one big payment called "rent received."  Then they don't actually pay themselves for the labor, they just leave it in the same bucket.  I'm just pointing out that if they do it that way, it's fine, just separate that out when you go to calculate ROI.

One big reason why it's important to separate that out: to compare to other investments.

If you find out that you're earning 8% on your investment, you're happy.  But if you find out that you're actually earning 2%, and the rest was labor, you may not be so happy.. you could instead sell, put the money in an investment making 5+%, and then still get that other 6% if you wanted to keep doing the labor (as a side gig for someone else).  Suddenly you're making 11% instead of 8, for the same amount of work. 
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totoro

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Re: Challenging the 50% rule
« Reply #30 on: August 08, 2012, 11:00:22 AM »
Ah yes, true. Totoro, as a fellow Victorian, what do you think of my numbers? Vacancies?

I think vacancy rate is extremely low here but you will have some times you need to repaint and repair between tenants.  Evictions are always a risk as arebelspy has pointed out.  I haven't had to do this, but make sure you screen tenants carefully.

I think arebelspy's new numbers are realistic and the vacancy rate may be estimated high but the maintenance may be low so that probably evens out.

Marketing costs me nothing as I use free online resources.  Liability issues are not big here as they are in the states and insurance should be adequate - you don't need to hold the rental in a corporation but you do need to check on the insurance levels.  You shouldn't have to pay utilities except water - I pay this fee for my rentals as it is hard to divide up and is not a monthly charge - build it into the rents.  Landscaping will cost you something annually.  Management - well leave it to you whether to account for this or not.

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Re: Challenging the 50% rule
« Reply #31 on: August 08, 2012, 11:04:22 AM »
Right.  Mr. eldub could make money laying laminate for someone else.  Yet he chooses not to, or if he did, he'd want to get paid.  He should get paid for doing the same with his own rental.  (Although how it actually works is you don't pay him, it stays in the real estate money account, but you take it out on paper when you calculate your ROI to get a realistic return on your money invested, rather than a number that is a mix of return on capital and return on labor.)

Actually, I would suggest that a separate entity be created as a management company, especially if the plan is to own more than one property, then bill your services to each property - for one it actually separates out the value and it without getting into specifics this will help with taxes, current and deferred, and can provide other benefits.

I would disagree.  In Canada for someone who owns a single rental the expense does not justify any expected savings at all.  Also, if you start charging for your labour this may create a tax deduction but it must also then be accounted for as taxable income for the work performed - definitely not in your favour here.  Better to set up a set of books for the property.

eldub

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Re: Challenging the 50% rule
« Reply #32 on: August 08, 2012, 11:09:11 AM »
Take your point on the laminate. It is rated for "water resistance", whatever that means. Scratching, you're absolutely right. Replacing every 7 years would be $15 per month. As an aside, it's not the cheapest laminate out there. Don't know if that makes any appreciable difference.

Upstairs was not originally intended as a rental, but our home. I agree that hardwood in a rental isn't the best idea. The mahogany is solid though, not engineered. As mentioned, our original fir floor was 100+ years old and certainly worn but I thought it was beautiful that way. A refinishing at some point though would be prudent. Would have to get a quote on the cost (about 900 square feet of it)

Again, the roof is metal, has a 50-year warranty and is one year old. Do I really need to factor in a replacement?

Liability insurance - hadn't considered. And no, I think everyone would agree that Canadians are nowhere near as litigious as Americans. Worth considering though.

While pipes freezing is not really an issue (Husband has run waterlines properly i.e. away from exterior walls, and believe it or not, Victoria does not get that cold) would still want to have utilities hooked up during any vacancies in winter.

Arebelspy:

So we are still not counting:
- Any utilities you have to pay (you have some separate meters, but what will you still have to pay?)
- Landscaping
- Collection losses (can probably lump in with the vacancy).
- Any marketing you have to do, or other misc. stuff (legal, accounting, etc.)
- Asset protection (protection for you from liability .. typically an extra insurance policy to cover that, like an umbrella policy, or an LLC)
- Management

Thoughts on those?

I wonder if it's safe to assume that our entire $750 left over after PIT is eaten up R&M plus the items you list above and there is nothing to pay ourselves.


arebelspy

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Re: Challenging the 50% rule
« Reply #33 on: August 08, 2012, 11:24:08 AM »
Good point about the water, as well as all utilities during vacancies.  That adds up, trust me.  =/

I wonder if it's safe to assume that our entire $750 left over after PIT is eaten up R&M plus the items you list above and there is nothing to pay ourselves.

That assumption would basically put you at a "33% rule" (instead of 50%).

Basically 2900 gross rent - 1940 P&I = $960 to expenses.  960/2900 = 33% to expenses.

That leaves you beating the 50% rule by 17%, which is very high, but most of the amount you're beating it by is due to managing it yourself (for 8-10%). 

If you add in 8-10% management fee (to yourself), it puts you at spending about 41-43% on expenses.  Beating the 50% rule by 5-10%.  That seems reasonable given the current condition of the house.  I think you could see expenses only totaling 40-42% long term (counting management in that), or 33% expenses not counting your management fee.

(This is how/why we calculate based on an individual property... now you have to come back in 30 years so we can see how accurate our assumptions were.)

So no cash flow from the property, but your "free" work basically generates you a paid off home (as the tenants will be paying it off for you).  That's not necessarily a bad return on labor.  We'll work on calculating that next, if everyone's okay with the numbers then?

(As an aside, umbrella insurance is cheap.. usually a few hundred a year for a few million in liability protection.  Highly recommend it for a landlord.  You never know when someone will slip and fall and hurt themselves.)
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Re: Challenging the 50% rule
« Reply #34 on: August 08, 2012, 12:23:08 PM »
So no cash flow from the property, but your "free" work basically generates you a paid off home (as the tenants will be paying it off for you).  That's not necessarily a bad return on labor.  We'll work on calculating that next, if everyone's okay with the numbers then?

Yes, this is a big question I've wanted answered: even if there is no cash flow for the next 25 years, what about the fact that we get a "free" house after 25 years? 

tooqk4u22

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Re: Challenging the 50% rule
« Reply #35 on: August 08, 2012, 12:54:55 PM »
So no cash flow from the property, but your "free" work basically generates you a paid off home (as the tenants will be paying it off for you).  That's not necessarily a bad return on labor.  We'll work on calculating that next, if everyone's okay with the numbers then?

Yes, this is a big question I've wanted answered: even if there is no cash flow for the next 25 years, what about the fact that we get a "free" house after 25 years?

There are a couple of ways to tackle this but let's start with a the back of the envelop (simple) approach assuming it is cash flow neutral over 25 years.

Initial Equity - $125,000 ($535,000 value/price - $410,000 mortgage).
Sweat Equity - $3,480/year (based on 10% of rents) x 25 = $87,000. 
Total Equity - $212,000

House value - $535k
Equity - $212k
Gain - 323k
Total Return - 152%
Average Return - 6%

This ignores opportunity cost and inflation.  This is probably too simplistic even for back of the envelope and is probably not counting a bunch of factors - but if not 6% isn't too shabby.


totoro

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Re: Challenging the 50% rule
« Reply #36 on: August 08, 2012, 01:30:17 PM »
I think those numbers are pretty good ballparks.  One risk you have not accounted for is changes in interest rates.  We pay more in Canada.  I went with 10 years at 3.69 with ING direct because of this risk.  Given the largish mortgage a few points up can play havoc with the numbers at renewal time.  The conventional wisdom is that it is better to go with variable overall but rates are so low that I was fine with 3.69 - I don't mind paying for lower risk.

As for laminate, I do use it in my rentals.  Not sure if this is a wise decision overall but Scott from the Income Property series recommends it highly: http://homeandgarden.homes-extra.ca/Renovation/2010/08/24/15121646.html  I don't have any carpeting at all.


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Re: Challenging the 50% rule
« Reply #37 on: August 08, 2012, 02:54:22 PM »
I think those numbers are pretty good ballparks.  One risk you have not accounted for is changes in interest rates.  We pay more in Canada.  I went with 10 years at 3.69 with ING direct because of this risk.  Given the largish mortgage a few points up can play havoc with the numbers at renewal time.  The conventional wisdom is that it is better to go with variable overall but rates are so low that I was fine with 3.69 - I don't mind paying for lower risk.

As for laminate, I do use it in my rentals.  Not sure if this is a wise decision overall but Scott from the Income Property series recommends it highly: http://homeandgarden.homes-extra.ca/Renovation/2010/08/24/15121646.html  I don't have any carpeting at all.

You are right, I didn't account for this and made the assumption that it was fixed for 25 years. Generally though if rates are rising then economic conditions are better and values/rents are rising - although timing may not be aligned.  Do you have 25 year loan term or a 10 year loan term?  If it is 10 then you would have refinance risk as well as interest rate risk.

totoro

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Re: Challenging the 50% rule
« Reply #38 on: August 08, 2012, 02:57:52 PM »
I have a 30 year term with ten years fixed at 3.69.

arebelspy

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Re: Challenging the 50% rule
« Reply #39 on: August 08, 2012, 03:05:18 PM »
So let's go back to the OP's scenario:
Mortgage: $410,000 at 3.29 over 25 years

Is this a fixed rate?
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Re: Challenging the 50% rule
« Reply #40 on: August 08, 2012, 03:09:48 PM »
My understanding is that she has five years fixed only - don't know when this is up for renewal.

eldub

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Re: Challenging the 50% rule
« Reply #41 on: August 08, 2012, 03:10:30 PM »
Just refinanced in June 2012 at 3.29% fixed for 5 years. Loan amortized over 25 years. Even since June, rates have crept down somewhat.

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Re: Challenging the 50% rule
« Reply #42 on: August 08, 2012, 03:23:51 PM »
This can potentially be a significant risk.  Keep in mind that rates came down rather quick and can increase equally as quick and a 1% increase in rate will cost you another $4100 a year. Cash flow neutral could become cash flow negative.

totoro

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Re: Challenging the 50% rule
« Reply #43 on: August 08, 2012, 03:52:30 PM »
Yes, exactly.  At the point you choose to convert to a rental this needs to be considered.  In addition, the rules around borrowing to invest and buying another primary residence should be considered (Smith Manouvre).

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Re: Challenging the 50% rule
« Reply #44 on: August 08, 2012, 04:07:08 PM »
Just refinanced in June 2012 at 3.29% fixed for 5 years. Loan amortized over 25 years. Even since June, rates have crept down somewhat.

Are 30 year fixed rates not available in Canada?

eldub

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Re: Challenging the 50% rule
« Reply #45 on: August 08, 2012, 04:28:25 PM »
Just refinanced in June 2012 at 3.29% fixed for 5 years. Loan amortized over 25 years. Even since June, rates have crept down somewhat.

Are 30 year fixed rates not available in Canada?

Nope, no dice!

totoro

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Re: Challenging the 50% rule
« Reply #46 on: August 08, 2012, 04:36:57 PM »
We can get 25 year at 8.35 best rate which makes no sense whatsoever.  Ten year at 3.69 is the best long-term rate available. http://www.ratehub.ca/best-mortgage-rates/10-year/fixed

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Re: Challenging the 50% rule
« Reply #47 on: August 08, 2012, 04:49:06 PM »
Hmm... the cheap leverage I can get in the form of locking in today's low interest rates for the long term is the one thing that tips landlording into an option I'm interested in.  Without that, I would I'd need a killer deal to drop into my lap for me to be at all interested. 

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Re: Challenging the 50% rule
« Reply #48 on: August 08, 2012, 05:03:51 PM »
I would I'd need a killer deal to drop into my lap for me to be at all interested.

It's not really a question of whether I'm interested, or of it dropping into my lap.  We already own this house, and one day we're probably going to outgrow it. The questions is really does it make sense to try to hang onto this house as a rental and go off an buy our next home, or to just sell it, take the cash and buy our next home.

Perhaps we need to run numbers on those two scenarios instead, and weigh the two outcomes rather than simply try to debate whether this home would turn a profit or not.

arebelspy

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Re: Challenging the 50% rule
« Reply #49 on: August 08, 2012, 06:08:51 PM »
This can potentially be a significant risk.  Keep in mind that rates came down rather quick and can increase equally as quick and a 1% increase in rate will cost you another $4100 a year. Cash flow neutral could become cash flow negative.

Yikes.. Rates jumping 2-3% suddenly costing you 5 figures a year would be bad.

Probably selling would be the optimal move, but you're correct that you'd want to run the numbers.
We are two former teachers who accumulated a bunch of real estate, retired at 29, spent some time traveling the world full time and are now settled with two kids.
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