3 Rules of Thumb for Real Estate Investing
The 2% rule, the 50% rule and the 70% rule are often referred to as the 3 primary rules of thumb when it comes to investing in real estate in Toronto or anywhere else in the world for that matter. These real estate investing strategies are designed to help real estate investors quickly make an educated guess on whether or not to pursue any particular real estate investment.
First off is the 2% rule, also known as the 1% rule or the 2% test and is perhaps one of the most common real estate investing rules of thumb. This rule looks specifically at the monthly rent of an investment property compared to the actual price of the property in percentage form. For those that are new to property investing let's use a super simple example to explain. If a property rents for $2,000 a month and the value is $200,000 then $2,000 divided by $200,000 equals 1%. In this example the property does not pass the 2% test, but it doesn't meet the 1% test. If the same property rented at $1,500 a month but it's worth only $120,000 the result is 1.25%. If the result is better than 1-2% the cash flow level of that property should be at a good level for the lifecycle of the investment. Of course this is just a rule-of-thumb it isn't always precise but generally speaking the higher the percentage the better the cash flow is. This rule like any other can also greatly depend on location, price and how much the expenses truly are on the investment property. This 2% rule of thumb can help an investor make some decisions on whether or not to pursue a certain property. Investment properties that fall short of 1% will likely never produce a positive cash flow and if it's above 2% which is really hard to find in today’s real estate market, it’s almost always positive that it will be a good cash flow based real estate investment.
Next up, the 50% rule of thumb basically says that overtime half of the income in a property will be spent on operating expenses or all the expenses involved with running a rental property, excluding the mortgage payment. These expenses include taxes, utilities, repairs, vacancy and any other cash that leave the property owners wallet every month. Let’s work through an example and assume that this month 50%, or $1000 will be spent on operating expenses for your rental property where say the rent is $2000. With the mortgage payment for the property of $600 you have left $400 which is what you can estimate overtime on average you might get in monthly cash-flow. Of course, estimates on operating expenses can really vary wildly depending on the property in some areas taxes and insurance might be incredibly high but other areas they might be much lower. Some rental agreements require that the landlord or property owner pay all utilities were other rental agreements allow the tenant to pay their own additional expenses. This rue is designed to again keep cash flow in check and to remind us that there are a lot of expenses that overtime at up. Although a new roof is only needed about every 20 years, if you divide the $10,000 cost of a new roof over 240 months that works out to $42 a month in expenses for that brand new roof.
Finally, we come to the 70% rule. The last couple rules of thumb that we talked about were designed to help with rental property owners. The 70% rule for real estate investing is designed more for those real estate investors interested in flipping houses. The 70% rule can be helpful in determining just how much to pay for property and states that the most you should pay for a potential flip is 70% of the after-repair value, what that property would sell for when all fixed up, minus all the needed improvement costs. An an example take a property worth $300,000, 70% is $210,000 then subtract out say $50,000 for improvement costs and you're left with $160,000.
If you are looking for any assistance with getting into real estate investing, we are always here to help, with no obligation. We have over 30 years of experience in investing in both homes and condo’s in the GTA and are more than happy to share with you our experiences and learnings from over the years.