The 2% rule kills values

[Jay Hinrichs]

As one who had never heard of the 2% rule or 1% or any of the other terminology that floats around BP,, I just became aware of the 2% rule. I was talking with a fellow from Oregon who was lamenting that there are no 2% rule properties to be had in Oregon when I asked what is this 2% rule he said if a property cost 100k it needs 2k in rent.. Well that's not going to happen anytime soon around here. But I told him it happens in the Hood's of America fairly regularly. Mainly because you need those kinds of margins to make 1% or less when the missed rent increased maintenance etc etc of owning them comes into play.

So then I got to thinking well heck if everyone is running around wanting the 2% rule and if that is the only way folks will buy the lower end rentals then the values will never go up. As values could only rise if rents rose.. And we know rents may rise a little bit and HUD stays fairly stable year in year out.. And so many of these properties rely on hud to get some kind of consistent cash flow. So if one is buying in these areas and uses the 2% rule then justifies their investment because historically real estate rises this just won't happen if all your buyers use this rule... The values will just remain the same the neighborhoods do not turn around for the better they get worse as more renters move in etc etc. Your forever stuck with a value that is 2% no matter the condition of the house history or lack thereof of rental rolls.

[Chris Clothier]

@Shaun Reilly and @Andrew S. - I am going to give @Nathan Brooks the benefit of the doubt and believe that he mis-typed or mis-understood what @J Scott was meaning with the 50% rule.  

Each of you listed many items on the expense ledger that were probably not taken into account. I would guess - and he may say I am dead wrong - that he was only quoting his maintenance costs for the year. Factoring alone for future Capex, should approach and exceed 8%.

My properties - the good investments anyway! - have historically run between 36% and 44% of rent due.  So that factors in true vacancy. 

On my poor investments - those that mirror what some people on here have mentioned they love (lower-cost, lower tenant, higher risk investments) - my loss factor in some cases would approach 70% and I would slowly bleed to death!

[Jay Hinrichs]

@Sharad M. 

  A class at least my A class won't run anywhere near those expense numbers here is why.

1. because of the quality of the tenant I can have my bookkeeper manage them for me No Management fee... White color tenants that pay rent on time electronically and don't abuse the houses. I only pay a Realtor for tenant placement when I need that done.. No need for PM

2. always rented no lost rent to speak of

3. tenants stay 2 to 7 years I have one tenant going on 7 years.

4. yearly maintenance is next to nothing... Now these were brand new homes when I bought them. but still 5 to 7 years down the track only very minor repairs.. IE change filter I furnace type of thing  and small plumbing. 

And again being in Oregon and those houses being in Madison MS its the live well sleep well theory.. Although we did get hammered with Hail last summer and I had to replace roofs but that was an insurance claim and an act from on high.

[Jay Hinrichs]

@Ed L. 

  when I spent a year in MS I actually created a funding facility at Community bank in your fair city... We used the funds up in Jackson but the banker was in Hattisburg so I have been there many times.. I looked at a few OREO's they had.. one of them was bunker style housing west side of town...made a run at it but did not land it.. It was 100% hud.

However even those local banks have a hard time lending in the C class areas except for very prominent locals like you said.. And like you said even the locals fail at the C class.

[Nathan Brooks]

Thanks @Chris Clothier ... yes, I misspoke ... the 8% was just my actual expenses for the actual maintaining of the property. My local property manager is a flat rate, not a % ... so that helps too. Overall, I am roughly 35 - 40% of gross rent is overall expenses for PITI, management, maintenance, and cap X.

[Jason C.]

@Jay Hinrichs 

I think the level of back and forth discussion in this thread shows that not everyone is die-hard 2%. As investors struggle to make the 2%, there will be some who will accept maybe 1.75 of 1.5 or even 1% in those same areas to keep their money invested. Won't that activity help move the values upward and onward?

[Chris Clothier]

Originally posted by @Nathan Brooks:

Thanks @Chris Clothier ... yes, I misspoke ... the 8% was just my actual expenses for the actual maintaining of the property. My local property manager is a flat rate, not a % ... so that helps too. Overall, I am roughly 35 - 40% of gross rent is overall expenses for PITI, management, maintenance, and cap X.

 I figured as much.  Keep a close eye on that number.  In my experience, the longer I have held the lower properties the higher that percentage creeped and it was usually an unexpected move-out and extended vacancy that blew it out of the water.  Great job so far on keeping those costs under control. 

[Jay Hinrichs]

@Jason C. 

  agreed  that was my point if the investing public held strong to the 2% rule and rents being fairly static as they are  especially in some markets were there is huge amount of rental inventory and actually some downward pressure on rent rates... values would just really never change much... I bet in your market as hot as it is  investors are probably tickled to get 1% and your high quality properties are probably appreciating for the first time in many years from what I am hearing... I know they are at the wholesale level that's what my guys I fund deals in Texas are telling me.  But they are not in the C class areas. nicer stuff in Houston.

My other point for the thread in the beginning is when talking with a few BP members who are looking for their first buy and hold this 2% rule keeps popping up.. and they want to know where they find those on the West coast... Well answer is you don't... You can find deals for certain but the numbers are inverse... instead of 100k of property bringing in 2k in gross rent.. its a 200k house bringing in 1k in rent.  Now you can buy lower end product all up and down the west coast and get closer to 2% but you going to get into just as rough of neighborhoods as you get into in the mid west and out in the inner big cities. And you will experience the same thing with difficulties on the management side.. I had a buddy buy low end in Sacramento and after the 3rd time the houses was trashed by tenants he walked.

I like the other post about Goldilocks that's the key find that happy medium.

[Jay Hinrichs]

@Chris Clothier 

  the risk on the low end is the exclusion in many insurance policies for vacant house's when they get vandalized and stripped many times your out of pocket to fix those things and one event like that and that property will take 10 years to get back to neutral not to mention positive cash flow.. so that is why in my opinion C class or 2% rule being that most of the 2% rule I think we have determined is C class or worse.. Is a very risky investment for all BUT those that live and work it... IE house goes vacant they get it secured same day or next.. they are right on top of it.... As well all know in those areas a house left unsecured within hours can be trashed....And least the inner city C class.

I have done a bunch of funding up in Kokomo IN.. for properties that would probably be considered C class and defiantly hit the 2% rule.. but you don't have the theft issues ... YOu have issues with jobs and low wages and low rent and winter etc etc. So I can see the 2% rule in smaller satellite cities in the upper mid west that have no real demand and probably have more houses that there are people needing them.. Years ago when I first started lending there I walked through many hud homes that were vacant a year and they looked just like when the folks left.. You take a house in the big cities C class area or what I experienced in the South and any house left on its own for a year is gutted like a fish.

[Chris Clothier]

@Jay Hinrichs I recently read about a family in Dallas who has been investing in the city for probably 40 years.  They invest in the hardest, roughest and often most run down parts of the city (what you would call D class property) and they apparently do it very profitably.

A few takeaways from learning about them and their operation.  

1.  They far exceed the 2% rule and may take advantage of every twist and turn in the law to do it.

2.  They seem to run the kind of operation that is pretty hard core.  The people that work for them are hard core - their philosophy is hardcore - their actions are hardcore.  All the way to the point of saying they rent a house for $400.  The rent is set commiserate with the condition of the property.  So - if you want the roof to not leak, the rent will be $500, etc.

3.  They have been doing it for years and don't give a damn what anyone thinks of them or their operation.  However, they will fight code enforcement and anyone else who tries to regulate their properties in the court of law and often win.  ( they are lawyers)

So it takes a certain type of individual to operate successfully in these areas.  It takes someone who is willing to do whatever it takes to make money and not apologize for how it looks when they do.  I'm not willing to do that individually or with my company and I don't necessarily hold it against those who are willing to operate like this.  Just most of us aren't able to reconcile the ways you have to operate to be successful at super low priced housing....

[Account Closed]

I have always stuck to 2%.  In fact, back in 2009-11, I was buying lower income multifamiles at 3% and 4%.  Lately with values increasing, I have moved to a 1% goal.  My thinking is I'll sacrifice a bit of cashflow on a few blue chip rentals in better areas, and hopefully will experience more of an upswing in values over the next 24 months.  These are my "midterm" holds-- not short-term or long-term.   :)

[Jay Hinrichs]

@Chris Clothier 

   That's a perfect description of a slumlord :)

I had a client in Alameda CA... you probably know it. he owned 200 plus doors free and clear and had been buying these properties since the 60's when bay area prices were dirt cheap.. But driving around town you could always spot an Art Jawad house it was the most beat up place on the block... but he made millions obviously especially when his junkers became worth hundreds of thousand each... back in the 80's I was still selling large Ranch parcels up in the Wine country .. And he bought a 1200 acre ranch that I brokered to him.. Paid cash of course  LOL.  One day I was visiting him at his place on the water there and it was rent collection day.. you talk old school.. tenants had to have their rent in an envelope pinned to the front door.. we spent 2 hours before lunch driving to all these crap properties picking up all these envelopes.. the front doors looked like pin cushions from all the rents stuck to the doors over the years...  

[Account Closed]

Originally posted by @Ed L.:

Originally posted by @Account Closed:

Originally posted by @Sharad M.:

@Jay Hinrichs 

I ran the numbers with two scenarios:

An investor has $40,000 down payment to either invest in 1 Class A property or 5 Class C Properties.

1) The funds will be invested for 20 years.

2) Class A property will double in value after 20 years to $400,000

3) Class C properties will have ZERO appreciation and will be worth $200,000 after 20 years

4) Class A property have better quality tenants and only have 40% operating expenses

5) Class C properties have lower quality tenants have 50% operating expenses.

I have given benefit of doubt to Class A property, but Class C properties still get better return. Refer to Line 19 and 20. The numbers are even more in favor of Class C properties if you reinvest all your funds.

@Jay Hinrichs

 Actually class A property will be worth about $800 000 after 20 years. What rent growth did you use?

There's a pretty big hole in your calculations, and that's assuming a Class A property will still be a Class A property after 20-30 years...  In reality there's a pretty solid chance that it will be a Class B or C property.

The Class C property may see a neighborhood revitalization/gentrification and come back to a B.

 @Ed Lee  Didn't realize this was directed at me as there are two major holes in @Sharad M. s calculation.   1.  Appreciation too low and 2. No renth growth.  Totally shifts the profitability to the class A. 

As far as Nbhd decline I think @ Jay Hendricks stated it well.  Class A will be in the best location and will generally only expand. I still invest in the same NBHD since 1978.  

[Jordan Thibodeau]

Great topic.

When I started looking for my first property, I would overweight the importance of the financials as compared to the curb appeal of the property. Now, I scout the neighborhoods, check the curb appeal of the property, and then I work the numbers.

It's easy to chase that shiny white whale of a return, but many real estate dreams  are ruined chasing white whales.

[Account Closed]

2% ?  Pfffffft...!  I'm getting 6%!   Based on my purchase price.  But people say Bob you have to do current market value and you have over $400, 000 in appreciation so your rent ratio is back under 1%!  You should sell and put that into 10 properties with $100 cash flow each!  OK, so that's $12, 000 a year times 10 years, $120, 000!   But, I'm cash flowing on my ONE property and will likely gain $400, 000+ in equity over the next 10 years.  That would be killing the Golden Goose.

[Jay Hinrichs]

@Jordan Thibodeau 

  shiny object syndrome is I think what they call it.... To my knowledge I have not seen a neighborhood on the west coast go from A down hill.. I have only seen the exact opposite.

Look at East Palo Alto for example  25 years ago it was a Ghetto war zone I bought properties there sub 20k in the 80S... today prices are 500 to 800k and its no longer a war zone.  there may be some areas that have gone from A down hill just can't think of any in my travels or experiences.  ( west coast I am talking about not mid west or big inner city rust belt type places IE Detroit)

[Larry Turowski]

Originally posted by @J Scott:

 I'm one of those people.  If a property generates 2% of purchase price in gross monthly rent, and if my expenses/vacancy/capex equal about 50% of gross rents, then I'm generating about 1% of purchase price in net monthly rent.  That's 12% of purchase price in net annual rent, or about 12% return on an unleveraged purchased.

If I can't make 12% unleveraged return, I have better options for my money.  So, I will typically only buy a rental if it will hit the 2% Rule.

@Sharad M. (the @ link thing isn't working here) posted

I ran the numbers with two scenarios:

An investor has $40,000 down payment to either invest in 1 Class A property or 5 Class C Properties.

1) The funds will be invested for 20 years.

2) Class A property will double in value after 20 years to $400,000

3) Class C properties will have ZERO appreciation and will be worth $200,000 after 20 years

4) Class A property have better quality tenants and only have 40% operating expenses

5) Class C properties have lower quality tenants have 50% operating expenses.

I have given benefit of doubt to Class A property, but Class C properties still get better return. Refer to Line 19 and 20. The numbers are even more in favor of Class C properties if you reinvest all your funds.

Can I pivot the conversation a bit? What ROI (yearly cash on cash return) are you looking for?

Sharad, according to your scenario, netting only $1,141 on $4,000 gross monthly, a 2% deal yields a 34% return ($13,393 / $40,000).

J Scott, you are expecting to net $2,000 on $4,000 gross monthly, so yearly that is at 60% return ($24,000 / $40,000).

Is that right?  Sharad, are you happy with 34% and J Scott, do you look for 60%?

[Larry Turowski]

@J Scott @Sharad M. 

Please see my post above, the @ thing wasn't working right.

[Clay Manship]

Originally posted by @J Scott:

Originally posted by @Jay Hinrichs:

@Dean Letfus 

  Problem is Dean as I point out.. so many folks at least on this site think this is what they should be doing and if they don't hit that its not a good deal.

 I'm one of those people.  If a property generates 2% of purchase price in gross monthly rent, and if my expenses/vacancy/capex equal about 50% of gross rents, then I'm generating about 1% of purchase price in net monthly rent.  That's 12% of purchase price in net annual rent, or about 12% return on an unleveraged purchased.

If I can't make 12% unleveraged return, I have better options for my money.  So, I will typically only buy a rental if it will hit the 2% Rule.

If others can achieve their desired returns with different ratios, more power to them.  But, I can't...

For whatever reason, this post made a lot of sense to me. You can get close to the 2% rule in the Indianapolis market, but then you are getting into less than desirable neighborhoods...

Just a matter of what you are looking to achieve. There are several markets in the Midwest where the 2% is still available, and likely will be for the forseeable future (see "Ohio").

[Richard C.]

Originally posted by @Jay Hinrichs:

@Jordan Thibodeau 

  shiny object syndrome is I think what they call it.... To my knowledge I have not seen a neighborhood on the west coast go from A down hill.. I have only seen the exact opposite.

Look at East Palo Alto for example  25 years ago it was a Ghetto war zone I bought properties there sub 20k in the 80S... today prices are 500 to 800k and its no longer a war zone.  there may be some areas that have gone from A down hill just can't think of any in my travels or experiences.  ( west coast I am talking about not mid west or big inner city rust belt type places IE Detroit)

 And then in addition to emptying Midwestern areas with cash flow but little appreciation, or glittering West Coast markets, you have areas like mine.

It's rural.  "Neighborhoods" are not A, B or C.  PROPERTIES are.  And they don't automatically move down the scale as they age.  My rental houses were considered decent lower middle-class housing when they were built 90-120 years ago, and still are.

I'll never see gentrification, but people have been living in these villages for closing in on 400 years now, and I see no reason to think there is going to be a mass exodus any time soon.

[Jay Hinrichs]

@Richard C. 

  There are thousands of little villages all through the US that meet that critera.. Investors just have not really found them and or TK companies have not taken that approach.

When I went into Kokomo it was to fund deals for a TK company in PHX... PHX was dead at the time.. and they did not like the crime in the bigger cities so they opened up shop there and did maybe 50 deals... by and large it worked pretty good.. Like said the major benefit to a town like you describe is the lack of crime and or out right vandalism and stripping the homes which is reality in the bigger markets were the 2% rule  rules !

[J Scott]

Originally posted by @Larry Turowski:
J Scott, you are expecting to net $2,000 on $4,000 gross monthly, so yearly that is at 60% return ($24,000 / $40,000).

Nope, see my post above...I'm looking for 12% unleveraged...

One of the following is true in your example above:

1.  The $40K is a downpayment (you'll never get $4000 in gross rents on a $40K property).  So, your cash-flow is going to be much less than $24K after you pay debt service, and your return will likely be in the 15% range.

2.  The $40K is the full purchase price, in which case gross rents will be closer to $800/month, and cash flow will be closer to $5K per year, for a cash-on-cash of about 12%.

Obviously, I'd love 60% ROI, but that's not realistic in today's market...

[Jay Hinrichs]

@J Scott 

  60% can be achieved just look at the marketing pieces from the dudes in GB its happens all the time over here in Detroit Rochester etc etc  :)

[Larry Turowski]

Originally posted by @J Scott:

Originally posted by @Larry Turowski:
J Scott, you are expecting to net $2,000 on $4,000 gross monthly, so yearly that is at 60% return ($24,000 / $40,000).

Nope, see my post above...I'm looking for 12% unleveraged...

One of the following is true in your example above:

1.  The $40K is a downpayment (you'll never get $4000 in gross rents on a $40K property).  So, your cash-flow is going to be much less than $24K after you pay debt service, and your return will likely be in the 15% range.

2.  The $40K is the full purchase price, in which case gross rents will be closer to $800/month, and cash flow will be closer to $5K per year, for a cash-on-cash of about 12%.

Obviously, I'd love 60% ROI, but that's not realistic in today's market...

Ah yes, $24K not leveraged.  But Sharad example the return on cash invested (the down payment) is 34%.

I've got 70% LTV mortgages on all my properties and I'm aiming for 40% cash on cash return. Not always hitting it, but that it my goal. I was trying to figure out if I should be aiming higher.

[Larry Turowski]

@J Scott Once again the @ isn't working, hence this extra post.  See above.

[Scott Gombar]

I would say that the 2% rule is probably pretty difficult to stick with unless it's low income (which seems to have the highest income potential) or one that requires a ton of work.  That's my two cents but I am probably far from an expert.