What are real estate investing rules of thumb and how can they help you analyze investment properties?
Real estate investing for beginners can be a challenge, especially if you don’t know anything about the business. When you first start to educate yourself about the business, you’ll read that you need to do this or that to become a successful real estate investor and how to determine whether an investment property is a good deal or not – which could be stressful considering the huge amount of information out there. However, there are certain real estate investing rules of thumb (or real estate basics) that make it a whole lot easier to make smart investment decisions.
Investopedia defines a rule of thumb as “a guideline that provides simplified advice regarding a particular subject.” The term originated with carpenters who used the width of their thumb to approximate measurements. It was also associated with farmers who used their thumbs to measure the proper depth to plant seeds. In both cases, you can see that a rule of thumb is an approximation or a quick way to estimate value. This can be translated into real estate: real estate investing rules of thumb allow property investors to shorten the amount of time they take to analyze deals and investment properties while still not rushing into making a decision that isn’t right.
So, what are the most common rules of real estate investing? Keep reading as we break down 3 rules for property investors that you need to know so you can be on your way to easy investment property analysis and a successful career as a real estate investor!
The 1% Rule
The first rule is the fastest way to determine if an investment property is worth purchasing – it’ll help property investors figure out if their monthly rental income will cover and exceed their monthly mortgage payments. According to this rule of real estate investing, your investment property should rent for at least 1% of the purchase price.
Take for example a real estate investor looking to obtain a mortgage loan on a $200,000 rental property. According to the first of our real estate investing rules of thumb, this rental property needs to generate $2,000 monthly rental income in order for the real estate investor to consider it profitable and worth the investment.
The aim of the 1% rule for real estate investors is to:
- Ensure they have a rental income greater or equal to their mortgage payment so they can at least break even on the investment property.
- Provide a baseline for establishing the level of rent to charge for the rental property. This can apply to both residential and commercial real estate investment properties.
- Help property investors measure the risk and potential gain that could be achieved by investing in a rental property.
- Get a better understanding of the investment property’s monthly cash flow.
- Understand which type of mortgage loan they should seek – one which monthly payments are less than the monthly rental income.
The 50% Rule
The second on our real estate investing rules of thumb list to analyze investment properties is the 50% rule. The rule states that the total expenses associated with running a rental property (taxes, repairs, insurance, property management, turn-over costs, eviction costs, etc.) will average out to about 50% of the gross rent.
Say that you own a rental property that brings in $2,000 per month in rental income, for example. The 50% rule states that you can probably assume that this property will cost you $1,000 per month in rental expenses (excluding mortgage payments) over the long run.
The purpose of this rule for real estate investors is to:
- Allow them to look at cash flow over the long run and ensure not buying an investment property that actually costs more than what it generates (negative cash flow – something every real estate investor must avoid!).
- Ensure that they leave 50% of the rental income to cover mortgage payments. If a loan costs more than 50% of your gross income each year, then this rule would advise not to buy the property because the real estate investor will risk having negative cash flow after paying all the operating expenses.
- This rule of real estate investing is like a shortcut to estimate the costs and Net Operating Income (NOI) of a rental property – the revenue minus the operating expenses.
However, you must keep in mind that the 50% rule only gives a very general idea of what your expenses will look like. Moreover, investment properties are different from one another and include different expenses. Thus, property investors should NOT use this rule in place of an actual expense history!
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It’s important to note that, when it comes to real estate investing for beginners, you should not depend only on one rule but, rather, use them together correspondingly to make a smart investment decision. One of the other real estate investing rules of thumb to understand is the Loan-to-Value Ratio. What does this rule state, and how can you use it with the aforementioned rules of real estate investing?
In general, the typical lender is willing to finance between 60% – 80% of the rental property’s purchase price or its value. Many believe that using leverage is a perk when it comes to buying investment properties – that it’s smart to use “other people’s money.” However, property investors should understand that too much of a good thing is not always the best option.
This rule for real estate investors states that the higher the loan-to-value, the riskier the loan is. The interest rate, points, fees, etc. all affect the cost of a loan – which may rise as the risk increases. Therefore, it’s actually to the investor’s benefit to put a larger down payment and have more equity in his/her investment property. This could be the best way to assure reasonable financing for investment properties.
The LTV rule can be used along with other real estate investing rules of thumb to help property investors determine the best and safest type of loan to obtain; one which:
- Monthly rental income can cover its monthly payments.
- Costs less than 50% of your gross income each year.
- Has a low LTV.
Should Investors Always Rely on Real Estate Investing Rules of Thumb?
NO! These are just real estate basics, not a tool that will predict all costs of real estate investing. While you can use them for “back-of-the-napkin” assessments, you shouldn’t rely solely on them to make your investment decisions! Digging deeper and thorough due diligence are essential for successful real estate investing.
Property investors looking for more accurate estimations use a real estate investment tool called the Rental Property Calculator. For example, Mashvisor’s property calculator provides you with readily calculated projections of cash on cash return, cap rate, and rental income of investment properties across the US housing market (both traditional and Airbnb). It also gives you the option to do your own calculations when you find a property on the platform that interests you to invest in. Want to know how to do that? Read this: How to Use Mashvisor’s Rental Property Calculator
As you can see, using this tool instead of real estate investing rules of thumb allows you to easily compare different investment properties and identify the best one that promises the highest return on investment. Mashvisor provides other real estate investment tools that’ll give you the confidence you need to make the best investment decisions, such as the Property Finder and Heat Map. To learn more about how we will help you make faster and smarter real estate investment decisions, click here.
Final Words on Real Estate Investing Rules of Thumb
Well, there you have it – 3 real estate investing rules of thumb that every investor needs to evaluate investment properties. Keep in mind, though, that these are just quick assessments of whether a rental property is worth looking further into, not tools that will always give you accurate results. To take full advantage of the best real estate investment tools out there, sign up to Mashvisor or click here to start out your 14-day free trial!
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Are there any other real estate investing rules of thumb that you’ve heard or read about? Did any work for you? Let us know in the comments!