Rules Of Thumb For Real Estate Investors – A Bad Idea

Ask anyone who’s dipped their toes in the real estate investment pool, and they’ll tell ya. There’re are rules of thumb for nearly everything. Many of ‘em are formulas. Can’t pay more than this much, based on that set formula. Even I haven’t seen ‘em all, but I’ll tell you from experience that they all work — ’til they don’t. When they don’t work, it’s usually what Dad used to call ‘an opportunity to learn’. My personal history with rules of thumb is mixed.

Serious people though, simply don’t rely on them for anything that matters more than the quality of their next cuppa coffee. Here’s my favorite example.

Buying income property based on (fill in number here) X gross scheduled rents.

In a nutshell the investor takes the monthly or yearly gross scheduled rents, and multiplies them by a number. The product of this simple formula will give them the price they should pay. An example would be the way most investors did for years in San Diego. They’d first come up with the annual rent figure. Then they’d multiply it by whatever number they felt was ‘market’. So, if the gross scheduled annual rent of a fourplex as $48,000, and the ‘multiplier’ was 13, the price would then be $624,000. Pretty neat, right? Well, like a lotta things, it’s pretty cool ’til is ain’t so cool.

Comparing apples to apples — or is it apples to dead cats?

You have enough capital to buy one fourplex. As luck would have it you boil your search down to a couple of ‘em, and they’re right across the street from each other. Here’s how they compare.

The first one, ‘A’, has current schedule rents of $48,000 annually.

The second one, ‘B’, sports a bit more, $51,000 a year.

How easy does it get? Given the multiplier our investor is using, 13, it means ‘A’ is the winner by nearly $40,000.

The fly in the ointment.

The owner of ‘B’ is offering his property at the same price as is ‘A’. Using the rule of thumb, 13 X gross annual rents, it appears the owner is selling a $663,000 fourplex for ‘just’ $624,000. These two properties were built the same year, by the same guy, with the same specs. How identical can they be? But wait just a New York minute. Seems when we closely scrutinize the last several years’ operating expenses it becomes crystal clear, that somethin’ just ain’t the way it appears. Prop ‘A’ has a much higher Net Operating Income (NOI) than ‘B’. This makes no sense, at least on the surface. ‘Course, if this wasn’t about lookin’ below the surface, there’d be no post, right?

There was an expense ‘B’ had that ‘A’ didn’t. Turns out, when they were first built, each of ‘em had just one electric meter. They’re all-electric buildings. However, a few years ago the owner of ‘A’ paid to have his units metered separately. He then was able to — duh — insist all tenants pay for their own power, dealing directly with the power company. This was a savings of no less than $6,500 a year. Funny how tenants will use way more electricity when the other guy’s payin’ for it.

All other expenses being more or less equal, the NOI for ‘B’ is roughly $3,500 a year less than ‘A’. What this means is that if he hadn’t looked at each property’s operating statements, he’d of bought ‘B’ based upon 1) The higher rents. And 2) he’d of assumed ‘B’ had much higher cash flow.

Wrong, GRM breath.

‘A’ is, in reality, the better buy. Also, if you’re following closely, you may’ve concluded that ‘B’, even with higher scheduled rents is actually a mirage. That’s especially true when you consider that ‘B’ was priced at far more than the 13 ‘multiplier’ used. Take away the extra $6,500 in expenses and its real ‘gross income’ is more like $44,500. Using our intrepid investor’s rule of thumb factor of 13, that makes it worth way less — about $578,500 or so. He’d of overpaid by around $45,000, but for his diligent analysis.

He also learned that increasing the rents was probably not gonna happen. They were lower cuz . . . the owner wasn’t payin’ for everyone’s freakin’ electricity.

BawldGuy Takeaway: Rules of thumb generally tend to do at least two things not conducive to solid investment decisions. First, they often either disguise or completely conceal crucial material facts. Second, concealed or disguised facts, more often than not, lead to more false assumptions and/or erroneously based conclusions. Either way, they smooth the way for some pretty costly mistakes.

Rules of thumb work kinda sorta reliably when comparing apples to apples, but only when the apples are clones. You might consider using ‘em to make your original ‘big net’ list of properties to consider. Even then, they can and will cause you to miss potentially solid properties, even when using a big net. In other words, when using rules of thumb, the best of all worlds is when they bring just neutral value to your investment decision process. In my experience, even that outcome is rare.

Do the analysis from Day 1. Leave rules of thumb to the amateurs, where they belong.

Let’s talk, OK? Gimme a call at 619 889-7100. Or, click on Contact BawldGuy up top and jot down a note to me. I’d love to talk with you about what’s possible. Have a good one.

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