The art of real estate investing largely centers on analyzing the market in which you're buying and analyzing the deals that exist within those markets. You can't become a successful real estate investor without both market knowledge and deal analysis skills. However, there are some simple rules that every real estate investor should know before investing in any city or state. By knowing these rules of thumb used by successful real estate investors, you can invest with confidence and never look back.
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These common rules of thumb help us determine which deals to pursue and which to pass on. The truth is, you can't analyze every deal out there, but you can filter them down to make your pool of potential opportunities more manageable. By using these rules of thumb, you can quickly screen deals and focus your energy on those with the highest potential.
The 2% rule states you should acquire rental properties with monthly rent equivalent to at least 2% of the purchase price.
Most investors are familiar with the 2% rule, even if they choose to ignore it. The general idea behind this rule is that you should only invest in cash flow positive properties. If your monthly rental income covers less than 2% of the purchase price, then it's very likely you would lose money each month on the property.
When we look at the data behind this rule, we see that it's a good estimate of risk and helps filter out most bad deals.
Let's say you want to buy a house for $100,000 and your expected rent is $1,000 per month or $12,000 per year. You'll need about 16.7 years of positive cash flow before you make back your entire $100,000 investment. If we take the purchase price and divide it by 0 .02 (or 2%) we get 500, meaning that we should look for properties that rent for at least $500 per month or $6,000 annually.
The 50% rule states that you should aim for a rental property with an expense ratio of 50%. In other words, your monthly operating costs (including mortgage payment, insurance premiums, property taxes and maintenance) should not exceed half of the total gross income.
On paper, this might seem like an easy task to accomplish, but it's actually very difficult in practice. To calculate the 50% rule, you must have perfect knowledge of your future expenses and can accurately predict your future cash flow from rent. Unfortunately, no investor has this kind of crystal ball and even if they did, it wouldn't be accurate 100% of the time.
Even though we don't know exactly what the future holds, the 50% rule is still a good way to gauge risk. If you find that your expenses are much higher than 50% of your total gross income, this may indicate issues in one or more areas of your rental property.
The 70 percent rule is a great way to determine your offer on a property. It states that your offer should equal 70% of the total after repair value of the property, less repairs.
For example, if you predict a property's ARV to be $100,00 you should spend no more than $70,000. If you anticipate that the home will require $20,000 in repairs after purchase, your purchase price should not exceed $50,000.
The 70% rule is not a guarantee of profit, but it's a good starting point to help you determine whether or not to pursue a property.
These guidelines, while useful tools for evaluating properties, have their drawbacks. To begin with, all of these rules are based on averages. Certain markets, especially expensive ones, are far more challenging to fit into these oversimplified rules of thumb. So, use these numbers as a guide, not scripture.
And lastly, never purchase a home based on these rules alone. You'll often find that the home is not the deal you thought it was once you really get into it. And with that, happy deal hunting!
Don't let deal analysis prevent you from taking action. Being indecisive and overly analytical before making an offer can cost you opportunities. There are just too many variables involved in the real estate game to be 100% certain if you're making the right decision or not. You can never be completely sure of each deal's outcome, so don't waste time deliberating over every possible outcome.
Risks and returns go hand-in-hand. Happy hunting!
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