Five Rules to Buying Rental Property
After 100 deals, I have “5 Rules” to buying rental property. You are not going to like them, because they are difficult, but they are necessary to thrive.
by Daniel Hart
These 5 rules have kept me in business for almost 20 years. They are not theory, and are actual formulas that I really use, can be used by anyone, and should be used by everyone on all rental property deals. They have helped me guide countless investors to building highly successful portfolios.
At first glance, they may seem impossible to meet, but keep in mind that professional investors are marketing for motivated sellers and CREATING deals, not simply finding them. So, before you say that you can’t “find” these kinds of deals, keep an open mind, because all of these rules CAN be met, IF you commit to motivated seller marketing, building rapport by listening to a seller’s needs, and using what they’ve told you to negotiate a solution for them that is also profitable for you. It’s as simple as that. That’s how it works, and that’s how my peers and I do our deals.
“The 2% rule”
The 2% rule ensures that your rental property produces adequate cash flow to pay all of your expenses with enough income left over. It does not take financing into consideration, but it can and should be used for evaluation whether or not you are using financing.
The 2% rule is a target percentage for your market rent divided by your total acquisition cost of a property. If you reach that target percentage you will typically receive adequate income after paying all expenses associated with a property.
If you only reach a 1% threshold you will often not produce income, even if it appears you are in the beginning. Maintenance and vacancy are real expenses that must be accounted for when evaluating a prospective purchase. Most people fail to calculate for them, and think they are making money, but are actually in the red over the long haul.
Many of the best deals are going to need private or hard money financing, and you will typically need a 2% deal in order to safely accommodate that financing until you pay it off or refinance.
“The 1/2 rent rule”
The 1/2 rent rule exists to protect you from over leveraging (over financing) your property. Do not allow your PITI payment (principal, interest, taxes, and insurance) to exceed 1/2 of the market rent.
Your new property may meet the 2% rule with a strong rental income, but if you have over leveraged it, you may not be leaving a safe margin for error.
This rule is only for use on deals with financing, and it can be applied to creative owner financing deals, but in some creative financing transactions it can be overlooked.
“The $ 200 rule”
The $ 200 rule came into existence because during many rental property analyzations I noticed that it was possible to meet both the 2% rule, and the 1/2 rent rule, but still have a mediocre deal. The $ 200 rule ensures that you only purchase properties for which you can justify your time.
Do not purchase a property that will net less than $ 200 a month after all expenses, including maintenance and vacancy estimates. If I purchase some of the cheapest property available it may meet both rules, but it also may net so little income that it is simply not worth the time and headache to own.
The $ 200 rule applies whether or not you use financing, and it can be applied to creative owner financing, but in some creative transactions it can be overlooked due to other benefits that outweigh cash flow.
“The 15% rule”
The 15% rule is one that represents your annual return after all expenses, without taking financing into consideration, but it can and should be used for evaluation whether or not you are using financing. It does not apply to creative owner financing transactions.
The 15% rule is used in the same manner as a CAP rate (capitalization rate) calculation, which is a measure of the ROI (return on investment). It is typically applied to commercial properties, but can still be useful with individual residential properties.
It is calculated by dividing the NOI (net operating income) by the purchase or sales price. The NOI is your total net income expressed annually, but it does not take financing into considering, so the cap rate calculation evaluates a return on investment based on the property merits alone.
“The 25% return rule”
This rule ensures that your initial investment will be returned to you in a reasonable period of time. While cap rate measurements and my 15% rule do not apply to properties with financing, it is still important to look at your real-world cash on cash return when you do use financing.
As I mentioned earlier, if I am financing nearly 100% of my purchase with a private lender, or with owner financing, my cash-on-cash return will be close to infinite, and is an irrelevant measurement. As my cash out of pocket increases, it becomes increasingly more important to look closely at the cash-on-cash return to see how long it will take to recoup the initial out of pocket investment.
If I have a creative financing deal that requires a $ 5,000 or $ 10,000 down payment, I will certainly calculate my annual net income, after all expenses, to determine my cash-on-cash return. If I am using a bank loan, with a 20% or 25% down payment, I will definitely be looking at my cash-on-cash return. The larger the amount out of pocket, the more concerned I am with my true return on investment.
I know, you’re still thinking that you can’t “find these deals,” but remember, you have to create them. It’s what I do, and it’s what my friends and peers do, so I know it’s possible, and I know it can be done over and over. The sooner you believe that it can be done, the sooner you’ll start creating those deals. Our biggest roadblock is ourselves and belief in what we are capable of. Overcome this, and anything is possible.
Daniel Hart, Owner of Hart Homes and author of The Real Estate Roadmap (available on Amazon) has been investing in New Jersey and North Carolina real estate since 2004, and has purchased over 100 properties, almost all using creative financing strategies to create passive income. He is a former board member of the Metrolina REIA in Charlotte, NC.
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