Rules of Thumb for Determining Deal Quality

Speaker 1: [0:02] Welcome to the Collecting Keys Real Estate Investing Podcast with your host, Mike DeHaan and Dan Austin. From wins, losses, horror stories, and tactics for optimizing your business, Mike and Dan take a real uncensored deep dive into the ins and outs of running a full time real estate investment and wholesaling business.

Dan Austin: [0:26] Hey there. Welcome back to another episode of the Collecting Keys Friday Focus where Mike or I talk about something that is relevant to the industry or just something that is top of mind for us in our business throughout the week. Today, I will be your host, Dan Austin, aka investor man Dan. And for today's topic, I wanted to actually cover a question that one of, the folks in our instant investor program actually asked last week. And he asked us what rules of thumb, if any, are we currently using to analyze possible buy and hold deals? For example, do we still use the 1% rule? And for those that haven't heard about or don't know what the 1% rule is, it's basically just a good rule of thumb to determine if a property might be a good deal from a cash flow perspective. It's calculated by taking the gross monthly rent of a property and then dividing it by the purchase price. So for example, if you see a house for sale that's $200,000, to meet the 1% rule, the house must rent for $2,000 a month. Now there are several different types of rules of thumbs out there, including the 2% rule, which is just the 1% rule yet doubled. Most of them are focused around cash flow of a rental property or something that's a long term buy and hold. But the question still stands. Do these rules still apply in today's market? And I think if we just run through a quick example first, it will show or explain my position on this. So if we're buying a $200,000 property, assuming a 20% down payment and a 7% interest rate that you'd be paying today, your monthly principal and interest payment is $1,100 versus last year at this time when you could have got a 3.5% interest rate, you would have been paying 720.

Dan Austin: [2:09] So that's a massive increase in principal and interest payment, decrease in cash flow. I mean, it's actually that's about a 50% increase towards debt servicing. Now, of course, there's always a devil's advocate, and the devil's advocate would say, well, the $200,000 property last year should be selling for less today because interest rates have gone up. And, yes, that person would be correct. But the problem is that sellers still want last year's high prices in today's market. Sure. I think some point in 2023, maybe early twenty twenty three, get through this winter, we'll start seeing those prices break down in a meaningful way, and we'll start seeing those price reductions. And then we can maybe start looking at these rules of thumbs again. But for now, sellers still want high prices along with high rates. So back to the question again, do rules of thumb still work? I would say yes, maybe, probably not right now. But to be more specific, I think you should spend some time just running numbers on deals at the new interest rates before making a determination for you and your business. And as you dive into a specific market and become more of an expert, the less general rules of thumbs you use anyways and the more personal experience you start to use. So back to our earlier example here on the $200,000 house. In our market, if you bought a house for $200,000 on you know, say you bought it right off the MLS, that should probably rent for about 1,500 tops if it's in decent condition.

Dan Austin: [3:32] So that's more of like a point 75% rule, and I'd honestly buy that all day long. But one thing I always say is that real estate is hyper local. So in our market, we haven't been using the 1% rule for a few years now because the appreciation has kinda made it difficult to do that. But there's another nuance here in our in our home market in Spokane, and that's the taxes, the property taxes, are kinda low compared to the values. And so even though prices are appreciating, we can still cash flow on a point 75% rule deal in a pretty meaningful way. But if you go to some of the Midwestern markets we work in, you can't find buyers unless it's a turnkey 2% rule, meaning the the gross monthly rents on a 50 k property would have to be a thousand dollars a month for anybody to actually wanna buy it as a rental property. So things are local. Keep that in mind, especially when you're using rules of thumb. Sure. The 1% deal rule or 2% deal rule have been great over the last ten years. But if you're just getting into this, start analyzing deals in your market and find that minimum cash flow that you need to make it worth your time, and then start going from there and building up your rules of thumb. And if you've been using a 1% rule of thumb or 2% rule or whatever rule of thumb you've been using, I would check that. When interest rates have doubled, that really eats into the potential margins you have after principal and interest just because, as we know, that that interest payment's going up so much higher. But the other question you're probably asking yourself is like, Dan, what are you doing in your business? Are you still buying?

Dan Austin: [4:57] And the answer is yes. We're having to adapt and change our criteria, but I think it's critical as real estate investors to continue to buy in up and down markets. I don't know if you listen to the the Fed Jerome Powell's announcement last week when he, you know, increased rates another 75 bps. In doing so, he also said he'd rather overshoot and break the economy with rate increases because they have tools to repair that. What they don't have tools for is if they undershoot and start tailoring back on the rate increases and the inflation starts running away. They don't have tools to fix that. So they'd rather go with what they know, and that means they're I think they're just gonna keep chipping away. 75 bp increase. 75 bp increase until they start seeing real meaningful drop in the market, including the housing market. What that means, though, is they're gonna go hard on this. It could be 2024. It could be 2025 before we see start some real growth in our economy like we're used to seeing or feeling in a bull market. So are you going to sit on the sidelines for two, two and a half years before you buy your deal just because it doesn't feel good? I'm certainly not gonna wait to buy. I'm gonna keep buying through this market.

Dan Austin: [6:07] I'm just going to have to adapt my buying criteria, and that's what I recommend for everybody to do. First thing we're doing is we're looking at our pricing. We recognize, and it's always this way, you make your money when you buy your deal. But if you're going to go through a slower period of time or slower downturn, that means you just have less room to make your money back in the near term. So we're going in with deeper price cuts. Right now, we're going 10 to 15% lower than we would have gone earlier this year, and that's just to give us a little bit more room. We'll reassess that in 2023 and see what we need to do, but there's less deals out there. I'll be honest with you. Sellers haven't adapted. They don't wanna accept 10 to 15% less than they would have earlier this year. So, yeah, we're gonna be buying less deals because we're adapting our buying criteria. One of the second things we're doing is we're looking at delayed equity positions as I'm just gonna make up that term or just different equity positions, different exits. So one of my searches right now is locked in on a price point here in my home market for houses with a double lot. I'm looking at things that are probably around $300,000. It's not a pretty property, but it's functional.

Dan Austin: [7:10] It needs just a little bit of love. It's probably a three bed, one bath, probably rents for 16 to $1,800 a month easily, but it's on a double lot that I can easily do a lot line adjustment or a lot subplat and sell that second lot off now for, say, $6,575,000 dollars, or I can hold on to until their time is right to sell that or build on it myself and do some turnkey to rent. But it's like that delayed equity position with the option to sell it off. Because what that does is so say I can sell for 75, now it brings my property basis for the property from 300 down to 225,000. And if I had to do any repair or put a down payment on that property, now I just got that money back without having to do a cash out refinance. I literally just created my own cash out refinance without using a bank by cashing out my money of that second property, that second lot. That's another thing I'm doing. A third thing I'm doing is I'm actually looking at different asset classes. Because, you know, if single family homes or residential isn't going to provide me enough deal flow, enough ROI on my money, then I'm going to start looking at different asset classes and get better at how to analyze those deals. You know, I'll just give you an example of a deal I ran this week.

Dan Austin: [8:20] Didn't work out for me, but something I'm looking at. It was a commercial property, three three basically bays, as you call them, on the main floor, so three tenants. And then above that had two apartments that were actually pretty nice sized apartments. So five units total, three commercial, two residential. That was kind of a cool deal. It just wasn't in a part of a town that I thought that price would support, so it didn't work for me. But getting creative and looking at different deals where I can still get that same ROI I want, and it might just be me adapting and pivoting my buying criteria again. So I will leave you with that for this week. So just keep in mind, test your rules of thumb, run some numbers, don't just go off of what you've been looking at, because I think interest rates have adjusted those rules of thumbs. Look at your buying criteria, adapt and overcome, because I think you need to keep buying. Otherwise, you're gonna be sitting on the sidelines for a couple years. And lastly, because this episode is dropping on November 11, which in The United States is the day that we thank our military veterans, the men and women that serve our country. We thank them for their service. And disclaimer, I am a veteran myself, but no, I do not need or want you to thank me for my service. My other fellow veterans will understand what I'm saying, except for those shameless folks that post on Facebook in their uniform and say happy Veterans Day to myself.

Dan Austin: [9:34] I don't like that. It's not my thing. If it's your thing, good for you. But I do bring it up because it's important for us to recognize those folks that have made that sacrifice. We have some great guests coming on. David Pray, founder of Military to Millionaire, is one of them. He's an awesome he's a rock star, retired marine. We're gonna have several others just by happenstance. There's just a lot of veterans in the real estate space that are kicking ass. If you're one of them, awesome. Hit me up in the DMs. I'd love to connect. Anyhow, that's it for this week. I will see y'all next week.

Speaker 1: [10:02] Thanks for listening. Please leave us a review on iTunes or wherever you get your podcasts, and check us out at collectingkeyspodcast.com for tips and guides on starting your own real estate investment and wholesaling business.