A long time ago I was introduced to a rule called the rule of 2 and many of you reading this will know it well and know the person it is attributed to. It is a simple way of determining if a real estate investment could be cash flow positive based on the purchase price. It involves dividing the purchase price by 1000 and multiplying the result by two. The answer is the amount of rent needed from the investment for it to be cash flow neutral. Any variation in the rent, up or down, would make the investment either positively or negatively geared. The only problem is the calculation is only reasonably accurate when interest rates are approximately 8.2% and that is a problem when the rates are rarely that amount.
What I discovered is the calculation is really suggesting that 41 weeks of rent are required to pay the loan interest while 11 weeks could be used to pay other expenses. Why 41 weeks you ask! It is simply a matter or reversing the calculation made by the rule of two. Instead of starting with the purchase price I started with the interest rate. Then, instead of dividing the price by 1000 and multiplying by 2 I divided the interest rate (expressed as 0.082) by two and multiplied by 1000 and the answer is 41. So, 41 weeks and 8.2% are synonymous.
To prove the calculation, I will use the example of a property selling for $485,000 and apply the rule of two. So, divide by 1000 = $485 and multiply by two = $970 and it would be neutral with an interest rate of 8.2% (or 41 weeks rent). If we multiply the rent by 41, we get $39,770 and if we take 8.2% of the purchase price $485,000, we get $39,770. Simple, isn’t it?
At some point I realised it is not the 41 weeks that is the significant factor in the calculation, it is the 11 weeks needed to pay expenses that can be more variable. Interest rates are generally static and apply equally to every person or project, but the amounts needed to pay expenses can vary depending on the person, the investment strategy, and the investment property. For example, the person who came up with the rule of two is an accountant and probably did her own tax returns while I to pay to have it done. That means for me at least, I need an extra two weeks rent every year to pay for my tax returns, so I only have 39 weeks available to pay interest. There can be other variations depending on the investment strategy. Those investing in rooming houses or AirBnB may need more weeks rent to pay for utilities and cleaning while those investing in rural towns may not need to pay Land Tax. Then there are those who do their own property management and repairs and maintenance. It is also worth noting that a lot of expenses rise in proportion to the purchase price or rent so the rule works regardless of the numbers when the rule of two is used.
To use this simple rule successfully, each investor needs to know what the number of weeks rent are needed to pay for expenses that is appropriate for their strategy and personal circumstances and when that is known the following rules come into play.
If there is an investment opportunity where the purchase price and interest rate is known, we can calculate the rent needed to make it neutral with the following formula:
(The weeks referred to in each case is the number of weeks needed to pay expenses)
Purchase Price x Interest Rate / Weeks = Rent needed to be neutral.
If the rent and interest rates are known, we can calculate the purchase price needed to be neutral as follows:
Rent / Interest Rate x Weeks = Purchase Price at which the investment will be neutral.
If the purchase price and rent are known, we can calculate the amount of interest rate we can afford with the following formula.
Rent / Purchase Price x Weeks = the interest rate at which the investment will be neutral.
The common denominator in each of these calculations is the number of weeks rent needed to pay expenses. As I mentioned, in my case I need an extra few weeks rent to pay expenses so 13 weeks leaves me with 39 weeks rent to pay loan interest which equates to an interest rate of 7.8% (0.078 divided by 2 and multiplied by 1000 = 39). To simplify the formulae above, in my case they would be –
Rent / Interest x 39 = Price
Price x Interest / 39 = Rent
Rent / Price x 39 = Interest
Any variation it what might transpire as the real price, rent, or interest rate, either up or down will determine whether the investment has a positive or negative cash flow and the difference will determine the degree.
Now for one last example. If the property mentioned in the previous example will only achieve a rent of $800 per week and my interest rate is 6.8%, how will it cash flow if I pay $485,000 for it.
I divide the rent $800 by 0.068 and get $11764.70 and multiply by 39 and the result is $458,824 which is the maximum I can afford to pay for it to be neutral. If I subtract that amount from the advertised price and then multiply the difference by the interest rate it would suggest a negative cash flow of $1,780 per year. I would need to raise the rent by $45.64 per week ($1,780 / 39) for it to be neutral.
As always, these simple rules should not be used as the basis for your financial decisions. Seek professional advice where and when appropriate.
