If you are a new investor who is looking to get into real estate and find your first deal, you may have seen that there is terminology used that you probably have not heard of outside of real estate. Today we would like to discuss some of the rules of thumb that some investors use to help them determine whether a property is worth submitting an offer on. Like all rules of thumb, they do not apply to every situation. Some of these will work just great in some areas of the country and could be completely useless in others. Below you will find a brief description of some of these rules of thumbs and how useful we feel they are to investors in Ventura County.
The first rule that we will examine is the 2% rule. This rule is mainly for buy and hold investors (landlords) and does not really equate to a fix and flip model. The 2% rule states that in order to be a good buy and hold investment, the monthly rent collected should be at least 2% of the price you purchase the property for. In other words, if you were to purchase a property for $100,000, you would need to be able to collect at least $2000 a month in rent for it to be a good investment. It is fairly obvious that you will not find too many homes in Ventura County going for $100,000, so let’s look at a more realistic example. According to the California Association of Realtors (CAR), the median home price in Ventura County as of July 2015 was just over $620,000. This means that you would have to collect over $12,000 in rent a month according to the 2% rule. Let’s look at a more optimistic scenario and say you were to purchase a home in Oxnard for $300,000. The 2% rule then says that you would have to collect $6000 a month in rent for it to be a good purchase. You may be thinking to yourself that this rule is rather stupid and that a $300,000 home could never collect that much in rent. If you are thinking that, you are not alone as most experienced investors say that you will not realistically find an opportunity in California where the 2% rule would work. Although it is a discussion for another blog post, the general consensus is that California is not a good market to buy rental properties unless you are hoping for appreciation, which the 2% rule does not take into account. For the most part, the 2% is more effective in the Midwest where decent homes can be purchased for $100,000 and less.
Like the 2% rule, the 50% rule is used for analyzing rental properties. This rule states that the operating expenses of a property will be about 50% of the operating income. In the case of single family homes, the operating income will basically be the monthly rent that you collect. The operating expenses are supposed to include things like your mortgage payment, taxes, property management fees, repairs, vacancies, etc. Using a simple example, the 50% rule is saying that if you research an area and find that the average rent for a 3 bedroom / 2 bathroom home is $2000 a month, your operating expenses should be approximately $1000 a month. Now remember, the operating expenses are supposed to include all expenses, including your mortgage. Anyone in Ventura County is going to be hard pressed to find a 3 bedroom / 2 bathroom home that they can purchase with a 20% down residential loan where the mortgage will be less than $1000. My opinion is that there are too many variables to be considered for this rule to be of any real use. For example, if you were to pay all cash for a home, then obviously you would not have a mortgage and your operating expenses would be much lower than someone who buys a home with a loan. I would caution any newer investors in Ventura County against using this rule when analyzing potential rental properties.
Lastly, we come to the 70% rule, which is mainly used by house flippers. The 70% rule states that MAO = (ARV*0.7) – repair cost, where MAO is your Maximum Allowable Offer and ARV is your After Repair Value. In other words, the MAO is the most that you should offer for a piece of property and the ARV is the price that the home will be worth after you are finished repairing/updating it. So for example, let’s say you do a walk-through of an older home that you saw listed on Redfin and estimated that it’s going to take $80,000 to repair and update it. By running comps in the area, you determine that your ARV is $500,000. By using the 70% rule, the most you should offer for the home would be (500,000 * 0.7) – 80,000 which equals $270,000. You will hear different experts debate on whether the 70% rule is really a useful rule of thumb or not. From our point of view, the sweet spot for the 70% rule seems to be in places where homes are priced between $100,000 and $300,000. As you get higher in home prices, the margin between the ARV and your MAO gets larger and larger. With a median home price in Ventura County of $620,000, as stated above, the 70% rule says that your offer would be no higher than $434,000, and that’s before taking into account any repairs/updates that need to be made. The chances of finding a seller that will sell you a home in that price range for $200,000 less than market value for an updated home are not very good, so many investors in Southern California do not use the 70% rule. It is not uncommon to see investors paying between 75% and 85% of ARV, depending on their risk tolerance. Ultimately, it will be up to the investor on whether they want to be ultra conservative and use the 70% rule, knowing that they may miss out on good opportunities, or submit higher offers knowing that they will be increasing their risk.