Our Financial Rules of Thumb for buying homes // How we Decide if a property is a good investment
today we’re sharing three rules of thumb that we use to analyze all real estate investments
At the end of last year, I mentioned that the hardest posts for me to publish are the financial ones. There’s just such a stigma around talking about money these days and I am not immune. But money is a key piece of the home buying/renovating/selling/renting equation. And you guys seemed to find our previous posts on the subject valuable. So this year, Garrett and I have a goal to share more about finances and today we’re kicking it off with our house buying rules of thumb.
Three financial rules of thumb we use for analyzing properties
There are lots of rules out there to quickly assess real estate investments (1% or 2% rule, 50% rule etc.). Below are the rules that Garrett and I have used to guide our thinking and deal making over the years. This approach has worked well enough for us to retire at 34, but for the record, neither of us have business degrees or any kind of real estate training. We’ve cobbled together our approach over the years by asking questions, working with good people, making mistakes, and figuring it out as we go. We certainly won’t claim that these rules are the best for all cases. They simply provide a framework for considering the many amazing and exciting (old) properties that one could pursue (you might already know the surfing RE listings on Redfin is one of my favorite pastimes 😉).
1 // A safety net
We like to make sure that when we close on a house we could turn around and rent it out for the cost of the mortgage payment (principle, interest, taxes, and insurance). This is a safety net that means if things go south or we change our minds, we're not bleeding cash every month. This rule is probably a hold over from the Great Recession (when I got laid off and we had no way to pay our big mortgage), but it has always helped me sleep at night. That being said, this is definitely the rule that we’ve broken the most because we’ve bought properties that aren’t in good enough shape to rent at closing. So I’d say this rule is all about your comfort with risk.
2 // clear $1,000 per month
With every rental property we’ve bought, we target a minimum of $1,000/month cash flow. This is up and above equity payments associated in the mortgage and would be after renovations are complete. I’m not sure where this exact number came from, but it reflects the boat loads of time and effort we put into rehabbing our properties. Since we only have a few properties, the cashflow has to be high. It should be noted that this is a minimum number and generic. Our specific target for each property is determined in rule #3.
3 // 10% Return on cash
Early on in our real estate investment journey, a landlord we respected suggested that we think about our ‘return on cash’ when considering rental properties. And that’s really made sense to our brains. For us, 10% is the target. So for every $100 we have into a property, we aim to earn $10 back on it every year, after the renovations are complete. Here’s how we calculate that:
Below is an example using real numbers. This is for an actual rental with 2018 numbers, but if we were to analyze a new property, we’d of course have to guess the post-renovation rent (by looking at comps) and the amount of renovations necessary.
The return on cash shown here (0.20 or 20%) is higher than .10 so this property is a good investment for us. A few things to consider about ‘monthly expenses’ in this equation:
utilities - we included utilities in this calculation because we pay for them on this property (and the renters pay a higher rent to compensate us for them). If you’re doing an Airbnb, you’ll also need to include utilities in your calculation (and possibly lawn care and cleaning expenses too).
vacancy rate - over the past decade of being landlords in Seattle we’ve had a 0% vacancy rate, so that’s reflected here. But if we were unsure of the rental market or new to an area, we would include an expense to account for vacancies (say 10% of the rent or $340 in the equation above).
management fees - we manage our properties ourselves, so there’s no expense for that here.
improvements and maintenance - we have a low dollar amount allocated for improvements and maintenance ($100) because we renovated this house ourselves and know what kind of shape it is in. But of course, things can go wrong, especially with old houses so we have a small expense. If the condition was less known, or we left certain upgrades for later, this number would be higher.
principle payments - we leave the principle payment portion of the mortgage in the expense column. We do this because it’s money that we’ll never see until the house is 100% paid off (or sold) so doesn’t affect the monthly cash flow. We also feel more comfortable with our breezy expenses list knowing that we’re conservative in this respect.
This rule of thumb has become our go-to. We use it to analyze all potential investments: additional renovations on a property (like adding a second unit), converting a rental to an Airbnb, buying a new property with cash, other business opportunities, etc. If we can’t get 10% from our money in whatever real estate deal we’re considering, then a more passive investment would be a strong consideration. Something like a low-fee index fund that requires 0 physical labor and no midnight calls from tenants is always in our minds.
Here is another rule that we’ve come across and like. And please let us know what rules you’re using! Share it in the comments so we can all benefit from your experience!
the 1% rule - this rule says that the monthly rent on a property should be 1% of the purchase price. So if you’re home cost $300,000, it would need to rent for $3,000/month. I like this rule because it’s super easy to use without a calculator, but it’s also super hard to achieve on single family homes.
Those are the three financial rules of thumb we use for buying real estate. Let us know what other financial topics you’d like us to write about. We’re hoping to publish one financial post a month about our experiences with buying/selling/renting/renovating/Airbnbs/blogging/etc so let us know if you have any questions or interests!
psst: pin this post for later reference: