In my opinion, it is extremely important to perform enough due diligence with the real estate properties that you are considering to purchase. Although it is always the case, here is the problem when it comes to great investment opportunities.
Great real estate deal sell very quickly. Let me emphasize- very quickly... like within 20 - 30 minutes time or even less...
For those kind of deals, it is crucial for you to have quick measuring stick to assess if the properties are to buy or not to buy. Again, because great deals are always sold very quickly, all the deals will be long gone if you perform a traditional cash flow calculation which can take 30 minutes or even longer. In this blog, I will reveal my quick screening process for purchasing properties so that readers can follow the same protocols:
1. 2% rule
When I see the potential property, I first use the 2% rule to see if the property I see is to buy or not to buy. Basically, the 2% rule states that rent should be or exceed 2% of the purchase price (Although many people use the 1% rule, it is my belief that we can only breakeven at the best or even negative cash flow in many occasion) . Here is an example:
Purchase price: $50,000
Rent: $1,000 (2% of purchasing price)
If the property satisfied this requirement, it is pretty much a signal for me to buy since it is almost a no-brainer in terms of return and cashflow. This is very simple to implement. It virtually takes only a minute to decide if I go ahead to buy or not.
Although the 2% rule is easy to implement, it is extremely hard to find the deals that satisfies the 2% rule since it is a very conservative measuring stick. If the 2% rule does not satisfy, then I will apply the 50% rule which is a little bit more complicated than the 2% rule and requires to have a financial calculator to assess the deal.
2. 50% rule
Basically, the 50% rule assumes operating expense (all the expenses such as vacancy, eviction, all other repair cost, etc, excluding mortgage payment) is 50% of the rent. Here is an example of the 50% rule:
If you find the property that costs $50,000 and rent is $700, is it a great buy based on the 50% rule?
Purchase price = $50,000
Rent = $700
Operating expense = $350 (50% of $700)
But, we need to make a monthly cashflow for our profit so we can't take $350 as a mortgage payment. Conservatively, we will put $100 aside as cashflow. Then the mortgage payment must be:
$350 - $100 (cashflow) = $250 (Mortgage payment)
We then use the financial calculator based on a 30-year fixed rate debt with 5% in order to get how much we are willing to pay based on the above information.
N = Number of mortgage payments over 30 years = 360 (30 years x 12 months)
I/YR = Interest Rate = 5% (Annual interest rate of 5%)
PV = Present Value = Amount we are willing to pay for this property = ?
PMT = Maximum Monthly Mortgage Payment we are willing to pay = $250
FV = Loan value outstanding after 30 years = 0
If we calculate based on the information above, the Present Value will be $46,764 and the price of the house is $50,000. Since the price of the house is exceeding the maximum amount that we are willing to pay, we are not going to get this deal.
These two formulas help me quickly decide if this is a good or a bad deal. In my case, it takes virtually a minute to obtain it if I go with the deal or not. It appears to be very complicated especially the 50% rule, but believe me, it gets easier and easier once you go through many deals.
Word of caution: It is easy to perform quick assessments of the deal by using those two methods. The hardest part is to find the great real estate deals. However, after few years of struggling, I finally found the great real estate investment deal source that allows us to invest our money with almost no money down. This is truly unprecedented. Read Zero $ Down Real Estate Investment for more information.
Related Blogs and Articles
Published: 15 April 2012