Free Cash Flow and the 30% Rule

What’s the 30% Rule?

Whether you are a new investor looking to get started, or a current investor, you must have metrics to determine whether a property is worth pursuing and/or performing as expected. Without a metric to measure against it will be tough to qualify a “good deal” and impossible to clearly assess if your existing portfolio is performing well. As investors we all want our properties to produce positive cash flow. But how do you determine a cash flow target?

1% Rule

If you’ve spent any time as a real estate investor you’ve come across the 1% rule. The rule is meant to be a quick way to determine if you want to spend more time assessing whether a property is a positive cash flowing investment. In the event this rule is new to you, it simply means, if a property can fetch $1,000 in rent then the purchase price of the property (plus the amount needed in rehab to make rent-ready, if any) should be no more than $100,000.

Adhering to the 1% rule will not result in positive cash flow for every property, in every market, but it is still a helpful tool. As you become familiar with the markets you invest in, it is a quick way to begin to size up a deal.

50% Rule

Another guidepost used to size up the profitability of a potential investment property is the 50% rule. This rule says that operating expenses (and therefore net operating income) will be approximately 50% of the rent. Operating expenses include all expenses incurred to operate the property and exclude principal and interest payments on any debt against the property.

So, if monthly rent is $1,000, then the 50% rule says that your operating expenses & net operating income (“NOI”, calculated as gross rent – operating expenses) will be $500. Across a portfolio of properties, and over a period of time, I have found this rule to hold true.

Free Cash Flow

Now, assuming you are someone that uses debt to fund part of your real estate investments you are left with how much free cash flow (“FCF”, equals NOI minus principal payments minus interest payments) the property produces. At the end of the day most of us are investing in real estate for cash flow first. Forced and/or market appreciation, equity realized through reduction in debt principal, depreciation and tax advantages of investment real estate are all important to consider. However, the cash flow of a property is the lifeblood that allows us to hold properties long term and realize the true wealth building that comes from real estate.

So, how do you measure how much FCF is enough? I like to think about each property as its own business and that each business needs to stand on its own and produce positive FCF. From this viewpoint I go back to my days as a commercial loan underwriter and all of the businesses analyzed over a 14-year career in banking. No matter what type of business being underwritten one of the most important numbers to assess the ability to repay was EBITDA (earnings before interest, taxes, depreciation and amortization). For REI purposes this is simply our NOI. Your CPA may include interest expense and depreciation to get to the profit/loss of a property for tax purposes, but as investors these expenses are “below the line”. More clearly, they are not generally included as part of operating expenses. EBITDA is a way to determine the true operating profitability of a business. Depending on the business type the EBITDA margins (EBITDA as a percent of total revenue) can vary greatly. However, having looked at hundreds (if not thousands) of company’s financial statements, I can reasonably say that a company that is producing an EBITDA margin of 20% or better would be a company that is healthy and profitable. With this line of thinking, and considering the 50% rule, I determined that each property should be able to yield 20% in FCF. With this in mind, and using our previous example, if a property is getting $1,000 in monthly rent, then FCF should be at least $200 per month.

The 30% Rule

So, you have found a property that meets the 1% rule, and you are comfortable that it will also meet the 50% rule. It will rent for $1,000 per month, which means you will be able to realize $500 in average monthly NOI. However, the only way to assess whether it will meet your FCF margin is to back into a monthly debt service payment. If you determine that 20% is the minimum FCF margin your property needs to yield then you know that your monthly debt service cannot be more than 30%, or a mortgage payment of $300. So, let’s see how this looks with the following reasonable assumptions:

75% LTV/LTC (loan to value/cost)

4% interest rate

30-year amortization

This results in a monthly payment of $358.06 on a $75,000 loan.

With $1,000 in monthly rent, you can very quickly assess that this monthly debt service payment represents 35.8% of your monthly rent and therefore would not result in a 20% FCF margin. $1,000 rent minus $500 in operating expenses minus $358.06 mortgage payment equals $141.94 in FCF, or 14.2%.

Your bank will likely lend on this deal because $500 in monthly NOI represents a healthy 1.40x debt service coverage ratio ($500 NOI divided by $358.06 debt service payment). So, the 1% rule works, you feel comfortable the 50% rule holds true and your bank is willing to lend you the $75,000 to help purchase the $100,000 property. Should you buy it?

If you are sticking to your 20% FCF rule, then the answer is a quick ‘no’. If you are confident that market rent is $1,000 and you have spoken with multiple bankers to know that 75% LTV, 30-year amortization and 4% interest rates are what the lending market is offering then $100,000 is too much to pay for the property. Someone could argue that you can simply put more money down to reduce your monthly mortgage payment to reach the 30% rule but let’s see what happens to your cash-on-cash (CoC) returns:

Using the same loan terms of 4% interest rate and 30-year amortization you would have to put down ~$37,100 (37.1%) on this property to arrive at a monthly mortgage payment of $300 (30% of $1,000 monthly rent). $200 in monthly FCF results in a COC return of 6.5% (ignoring closing costs here for simplicity). That is, $2,400 in annual FCF divided by a $37,100 down payment. A 6.5% CoC return may work for some investors, but most would agree it is quite low. So, putting down more money to reach your desired FCF will not produce adequate returns from a CoC perspective.

The 30% rule is a great tool to have in order to back into your desired FCF metric. In our example we’d need to get the property for a reduced price of $83,700, which results in a $299.70 monthly mortgage payment, 20% FCF and strong CoC return of 11.5% ($2,400 annual FCF divided by $20,925 down payment ($83,700 x 25%) ).

Like the 1% rule and the 50% rule, the 30% rule is not meant to be a rigid metric. It is meant to be another tool in your belt to assess deals and the ongoing FCF metrics you set for your portfolio. If you have questions on this, agree/disagree with this approach, have other ways you determine the health of your portfolio’s cash flow please leave a comment.