What Are the Five Rules of Thumb in Real Estate Investment?

By: Gabriel Magan

Real estate investing is an exciting venture that offers the potential for substantial returns. Maybe the reason why you are here is that you are in the market searching for a House and Lot for Sale. However, it’s essential to have a solid understanding of key financial ratios to make informed investment decisions. In this thorough guide, we will explore the rules of thumb in real estate investing, break-even ratio, and debt service coverage ratio (DSCR). By grasping these concepts, you can maximize your chances of success and minimize risks. Let’s dive in!

The Rule of Thumb in Real Estate Investing:

When it comes to real estate investing, the rule of thumb serves as a helpful guideline for evaluating properties. It provides a general idea of whether an investment is likely to be profitable. The rule of thumb suggests that a property’s net operating income (NOI) should be a certain percentage of the purchase price. If you are an investor or an aspiring one, This ratio will help you determine if a property is worth pursuing or if it may lead to financial challenges down the road.

When it comes to real estate investment, there are several rules of thumb that investors often follow to assess the viability of a property. While these rules can vary, here are five commonly mentioned rules of thumb in real estate investment:

The 1% Rule:

The 1% rule suggests that the monthly rental income from a property should be at least 1% of its total purchase price.

Imagine you’re considering buying a property worth 2,000,000 PHP. According to the 1% rule, the monthly rental income should ideally be 1% of the purchase price. So, 1% of 2,000,000 PHP is 20,000 PHP. This means that the monthly rental income from the property should be 20,000 PHP or higher. This rule helps ensure that the property generates enough income compared to its cost.

The 50% Rule:

The 50% rule estimates that approximately 50% of the rental income will go towards operating expenses, such as property taxes, insurancemaintenance, and vacancies. By considering this rule of thumb, investors can get a rough estimate of the cash flow potential of a property.

Let’s say you’ve rented out the property mentioned earlier for 20,000 PHP per month. The 50% rule suggests that approximately 50% of the rental income will be used for expenses. So, half of the 20,000 PHP, which is 10,000 PHP, would go towards expenses such as property taxes, insurance, maintenance, and vacancies.

It is important to note that this rule does not account for mortgage payments.

The Cash-on-Cash Return Rule:

The cash-on-cash return rule is used to assess the return on investment (ROI) based on the cash invested in a property. It is calculated by dividing the annual pre-tax cash flow by the total cash invested (down payment, closing costs, and renovations).

Suppose you purchased a property for 1,500,000 PHP. Your total cash investment, including the down payment, closing costs, and renovations, amounts to 400,000 PHP. After deducting all expenses, you expect an annual pre-tax cash flow of 40,000 PHP. To calculate the cash-on-cash return, divide the annual cash flow (40,000 PHP) by the total cash invested (400,000 PHP) and multiply by 100 to get a percentage. In this case, the cash-on-cash return would be 10%. This rule helps assess the return on your invested cash.

A common guideline is to aim for a cash-on-cash return of at least 8% or higher to ensure a favorable return on the invested capital.

The 70% Rule:

Ever wondered how investors make money through fix-and-flip or renovation projects? Well, here’s a little secret they often rely on the 70% rule. This nifty guideline is like their secret sauce for success. It basically says that when buying a property, investors should aim to snag it for no more than 70% of its after-repair value (ARV).

Hold on, what’s ARV? It’s the estimated value of the property once all the necessary repairs or renovations are done. Following this rule helps these savvy investors factor in renovation costs and possible risks, and of course, leave room for a nice profit at the end. It’s like a magic formula for making those projects really pay off!

Imagine you’re interested in a fix-and-flip project for a property with an estimated after-repair value (ARV) of 3,000,000 PHP. According to the 70% rule, you should aim to purchase the property for no more than 70% of its ARV. So, 70% of 3,000,000 PHP is 2,100,000 PHP. This means that you should negotiate to buy the property for 2,100,000 PHP or less. This rule helps ensure there is room for renovation costs, potential risks, and a profit margin.

The Equity Capture Rule:

Ever heard of the equity capture rule? It’s an awesome strategy for investors looking to get a head start in the real estate game. Here’s the deal: the rule suggests that investors should try to nab properties below their market value, giving them instant equity right off the bat. So how do they do it?

Well, it’s all about being a savvy negotiator, seeking out distressed properties, or finding motivated sellers who are willing to part ways with their property for a good deal. By following this rule, investors can set themselves up for potential long-term gains. It’s like getting a head start on the investment race!

Suppose you come across a property with a market value of 1,800,000 PHP, but the owner is motivated to sell quickly. By negotiating, you manage to purchase the property for 1,500,000 PHP. The difference between the market value and the purchase price (1,800,000 PHP – 1,500,000 PHP) is 300,000 PHP. This 300,000 PHP represents equity that you have captured immediately. This rule helps you acquire properties at a lower price than their market value, allowing for potential gains in the future.

But here’s the thing, while these rules of thumb can be super helpful, it’s crucial to remember that every real estate investment is unique, and market conditions can be unpredictable. That’s why it’s important to roll up your sleeves and do your homework. Research like a pro, perform due diligence and don’t be afraid to seek advice from experienced folks in the industry. After all, rules of thumb are just the starting point. To make smart investment choices in the ever-changing real estate market, you need to back them up with comprehensive financial evaluations and thorough market research.

Now that we’ve explored some clever strategies with the rules of thumb in real estate investing, it’s time to explore the financial side of things. If you want to maximize your chances of success in this dynamic market, understanding key financial ratios is essential too! These ratios serve as powerful tools that help investors assess the profitability, sustainability, and overall health of their real estate investments.

Understanding the Break-Even Ratio:

The break-even ratio is a critical metric for assessing the financial viability of a real estate investment. It indicates the point at which the property’s cash flow covers all operating expenses, resulting in a break-even scenario. To calculate the break-even ratio, divide the property’s operating expenses by its gross income. This ratio reveals how much income is needed to cover expenses and helps determine the property’s financial stability.

Debt Service Coverage Ratio (DSCR):

The debt service coverage ratio (DSCR) is another vital financial indicator used in real estate investing. This ratio measures the property’s ability to generate enough income to cover its debt obligations, such as mortgage payments. It’s calculated by dividing the property’s net operating income by its total debt service. Lenders often use the DSCR to assess the risk of providing financing for a real estate investment.

Applying Financial Ratios in Practice:

To better understand the practical application of these financial ratios, let’s consider an example. Suppose you want to invest in a commercial property with a purchase price of ₱5,500,000. You estimate the operating expenses to be ₱2,000,000 per year, and the gross income from the property is projected to be ₱4,000,000 annually.

Using the rule of thumb, you aim for a 10% NOI to purchase price ratio. Thus, you expect the property’s NOI to be at least ₱550,000 (₱5,500,000 x 10%). This ratio provides a baseline for evaluating the property’s income potential.

Next, you calculate the break-even ratio by dividing the operating expenses (₱2,000,000) by the gross income (₱4,000,000). In this case, the break-even ratio is 0.5, indicating that the property’s income covers 50% of its expenses. This ratio shows the level at which the property begins generating positive cash flow.

Finally, you compute the Debt Service Coverage Ratio (DSCR) by dividing the property’s NOI (₱550,000) by the total debt service, including the mortgage payments. A DSCR of 1.5 or higher is generally considered favorable by lenders, indicating that the property generates sufficient income to cover its debts.

Going Forward

Understanding vital financial ratios is essential for successful real estate investing. The 5 rules of thumb, break-even ratio, and debt service coverage ratio provide valuable insights into a property’s income potential, financial stability, and risk assessment. By diligently calculating and analyzing these ratios, you can make informed investment decisions and increase your chances of achieving profitable outcomes.

Hey, just a friendly reminder: when it comes to real estate investing, you gotta do your homework! It’s all about digging into that research, analyzing the market, and doing your due diligence.

Sure, financial ratios are handy tools but don’t rely on them alone to make your investment decisions. It’s always a smart move to consult with professionals, do those thorough evaluations, and keep up with the latest market trends. That way, you’ll be able to navigate the exciting world of real estate investing like a pro.

So, gear up, harness the power of those financial ratios, and let your knowledge guide you to unlock some amazing opportunities. Build that impressive real estate investment portfolio and watch your success grow!

Read more: A Comprehensive Guide to Real Estate Investment in the Philippines

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