Understanding Safety Scoring

Posted by Lou Gimbutis on Apr 3, 2020 9:00:00 AM

Understanding Safety Scoring

I recently took a call from a seller in response to a direct mail campaign, and the deal we discussed would have involved my purchasing a house by taking over debt with a monthly payment of around $250 (yep, lower end house), with a current monthly rental income of $500.  This perfect 2/1 ratio reminded me of a concept I had not consciously thought of for years, but often use subconsciously while evaluating a deal.  I learned the concept of Safety Scoring from real estate teacher John Burley.  Here’s how it works:

Gross monthly rent divided by your monthly payment equals safety score.  Using my example, if the rent is $500 and payment is $250, 500/250=2.  A safety score of 2 is wonderful- it means that for every month I collect rent on the property, I can have the property vacant and with no income for 1 month and still break even (remember to subtract your outgoing payment for the month you did collect).  If I keep it rented for a year, all other things equal, and the tenant moves out, I could take a full year to find another tenant without absorbing any financial loss!

Safety Score

To illustrate a change in safety score, suppose my monthly rent stayed at $500, but the monthly payment grew to $400.  500/400= 1.25.  The correlation is clear- a lower safety score means that there is a greater risk that the property could, if things go poorly in the future (and you have to assume that they may), will be harmful to your cash flow.  With just this one property, I’m sure the ongoing $250 or $400 per month would not bankrupt.  However, multiply that over a couple dozen properties, and you can see the importance of a portfolio with a high aggregate safety score.

Of course, this is only one factor in determining if a property would be a savvy purchase, and it can be offset by many others.  A brand new house versus a 70 year old house will yield the same safety score given the same rent and payment, but your cost of maintenance and repair over the next 10-20 years will be minimal on the new house, while with the older house you may very likely have to replace such major items as the roof, plumbing, and heating/cooling system.  A property in a poor part of town will invariably yield a higher safety score than a property in a more desirable area, but will also invariably have a much higher vacancy rate, and greater repairs with each tenant turnover (which will also be greater), and lower value appreciation.

This is what Warren Buffet calls “Back of the Envelope” math.  It is not enough to fully evaluate a deal, and there are more accurate but far more complex methods of calculating profitability such as NOI (Net Operating Income).  However, this is something you can easily do in your head, or on the “Back of the Envelope” to quickly scan through deals and get a feel for how the ratio of purchase price to rental rates relate.

Lou Gimbutis, owner of Property Solutions, LLC, https://www.123escapeforeclosure.com/, has been buying and selling houses full-time since 2004, first in Michigan, then after moving to NC in 2007.  He serves as Director of Education for the Metrolina Real Estate Investor’s Association.

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Related: What are you and your money waiting for?, Want to sell your property? Rent it out instead.

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