2% rule impossible?
Real Estate Agent, Real Estate Investor · Arlington, VA · Member since 2014 · 62 posts · 15 votes
It seems like it's impossible to find places that rent following the guidelines of the 2% rules. If a property that's $200,000 should rent for around $4000/mo to cash flew that seems quite extreme. Or is it just that the DC area doesn't have properties like these...
Hey Jon....I've read many of your posts and I agree with some of what you say. Here's what I disagree with:
I think numbers/rules ONLY work some of the time. Focusing on a 50% rule or a 2% rule is NOT neccesarily bad, but it can miss a potentially vast and underlying long-term benefit.
I've been buying houses in the Raleigh area for the past 3-4 years. They range from $150,000-$200,000 in very good neighborhoods with good schools. I bought them for around 5%-25% below market. I put 20% down and got 30 year loans for about 4.5-5%. They each cash-flow around $300-$350/month NOT including maintenance, vacancies, legal fees, evictions. etc. So, basically they are breaking even.
Based on your thinking these will be terrible investments. And, I agree, for the first 10 years it might be a terrible investment. But, if you factor in the tax benefits, the increase in the amount of principal being paid down, and potential rent increases then the terrible investment to begin with can turn into a really good investment down the road.
For example, let's look at 1 of my properties. Paid $143,000 for it (Probably worth $155,000-160,000 now). Put down $28,600 plus $7k in closing costs/inspections and some small fix ups. So, I'm in for around $35,600. Since I have a full-time job have extra money in case I need it for an emergency.
Currently, around 3-4 years in, I'm probably making a small amount on cash flow. But, for these numbers, let's just say i'm breaking even on cash-flow. Not counting anything for appreciation, in "YEAR 1" I paid down the mortgage by $1,800. So, my cash on cash return is $1,800/$35,600 = 5%. Again, not including any appreciation, any increase in rents, or any tax savings, that is a 5% return on my money.
If we jump to "YEAR 10" then I'm paying down the mortgage by $2,900. That gives me a cash on cash return of $2,900/$35,600 = 8%. Again, NOT including tax benefits, possible rent increases or possible small price appreciation.
Obviously, that rate of return will increase in "YEAR 20" and "YEAR 30". Then, once the mortgage is paid off then the rate of return will skyrocket.
Of course, there are RISKS. Every investment has RISKS. Here are a few
1)The local area changes for the worse and the property loses value and rents go down. Nobody knows what will be in 5,10,20 years from now
2)The property gets out-dated and people don't want to rent there.
3)The economy crashes again (BUT, people still need a place to live.....so, I'm not too concerned by this as long as I didn't buy in a speculative bubble (like 2003-2007)
But, too offset these risks you have to have a solid plan. Here's my plan and why I think this plan is better than just looking at the cash on cash returns of the first few years:
1)looking big picture at Raleigh
a)Capital of State (means jobs)
b)3 main universities....UNC, NC ST, DUKE (means always an influx of young people. Many young people will stay in the area of their college if there are good jobs and a good place to start a family)
c)RTP (Research Triangle Park is a thriving technology hub in Raleigh offering good paying jobs in the technology industry.....as I think technology will play a bigger role in the future of our economy)
d)Population Growth. Raleigh is only among the 10 cities in population growth.
2)Keeping property updated and properly maintained.
So, I think, as long as rental properties aren't one's main source of income, then you can build solid wealth over long term even if the properties break-even on cash flow today.
I remember when GOOG bought YOUTUBE for $1.65 billion. All the analysts said that was a ridiculous price to pay based on how much money YOUTUBE was making (which, at the time, they were losing money). But, GOOG saw past those early numbers and looked at what the future of YOUTUBE might be in 5, 10, 20 years. So far, 8 years into that purchase, it is looking like a brilliant idea even though the numbers at the time of purchase didn't appear to be that way.
The "2% rule" only works for rents around $500. And you're applying it backwards. You have to start by figuring out what rent you can get. Then apply the 2% rule to determine the max you can pay. As rents go up, this percentage goes down. So, if rents in your target area are $2000 a month, then you might use the 2% rule to say you can afford to pay $100,000 for that property. You can actually afford to pay something closer to $150K for that property and still make a good return. Do the math yourself, based on typical rents in your area, to determine what you can pay.
You will find that many areas, perhaps even MOST areas, do not have good rentals.
Hey Jon....I've read many of your posts and I agree with some of what you say. Here's what I disagree with:
I think numbers/rules ONLY work some of the time. Focusing on a 50% rule or a 2% rule is NOT neccesarily bad, but it can miss a potentially vast and underlying long-term benefit.
I've been buying houses in the Raleigh area for the past 3-4 years. They range from $150,000-$200,000 in very good neighborhoods with good schools. I bought them for around 5%-25% below market. I put 20% down and got 30 year loans for about 4.5-5%. They each cash-flow around $300-$350/month NOT including maintenance, vacancies, legal fees, evictions. etc. So, basically they are breaking even.
Based on your thinking these will be terrible investments. And, I agree, for the first 10 years it might be a terrible investment. But, if you factor in the tax benefits, the increase in the amount of principal being paid down, and potential rent increases then the terrible investment to begin with can turn into a really good investment down the road.
For example, let's look at 1 of my properties. Paid $143,000 for it (Probably worth $155,000-160,000 now). Put down $28,600 plus $7k in closing costs/inspections and some small fix ups. So, I'm in for around $35,600. Since I have a full-time job have extra money in case I need it for an emergency.
Currently, around 3-4 years in, I'm probably making a small amount on cash flow. But, for these numbers, let's just say i'm breaking even on cash-flow. Not counting anything for appreciation, in "YEAR 1" I paid down the mortgage by $1,800. So, my cash on cash return is $1,800/$35,600 = 5%. Again, not including any appreciation, any increase in rents, or any tax savings, that is a 5% return on my money.
If we jump to "YEAR 10" then I'm paying down the mortgage by $2,900. That gives me a cash on cash return of $2,900/$35,600 = 8%. Again, NOT including tax benefits, possible rent increases or possible small price appreciation.
Obviously, that rate of return will increase in "YEAR 20" and "YEAR 30". Then, once the mortgage is paid off then the rate of return will skyrocket.
Of course, there are RISKS. Every investment has RISKS. Here are a few
1)The local area changes for the worse and the property loses value and rents go down. Nobody knows what will be in 5,10,20 years from now
2)The property gets out-dated and people don't want to rent there.
3)The economy crashes again (BUT, people still need a place to live.....so, I'm not too concerned by this as long as I didn't buy in a speculative bubble (like 2003-2007)
But, too offset these risks you have to have a solid plan. Here's my plan and why I think this plan is better than just looking at the cash on cash returns of the first few years:
1)looking big picture at Raleigh
a)Capital of State (means jobs)
b)3 main universities....UNC, NC ST, DUKE (means always an influx of young people. Many young people will stay in the area of their college if there are good jobs and a good place to start a family)
c)RTP (Research Triangle Park is a thriving technology hub in Raleigh offering good paying jobs in the technology industry.....as I think technology will play a bigger role in the future of our economy)
d)Population Growth. Raleigh is only among the 10 cities in population growth.
2)Keeping property updated and properly maintained.
So, I think, as long as rental properties aren't one's main source of income, then you can build solid wealth over long term even if the properties break-even on cash flow today.
I remember when GOOG bought YOUTUBE for $1.65 billion. All the analysts said that was a ridiculous price to pay based on how much money YOUTUBE was making (which, at the time, they were losing money). But, GOOG saw past those early numbers and looked at what the future of YOUTUBE might be in 5, 10, 20 years. So far, 8 years into that purchase, it is looking like a brilliant idea even though the numbers at the time of purchase didn't appear to be that way.
@David Ackerman I think you misread @Jon Holdman post. He was simply explaining the 2% rule, he never said it was a good rule. He also said the OP may be able to pay $150,000 for a house that rents for $2,000 and it would still be a good investment.
His best advice was "do the math yourself" No one should depend on rules.
Hey Mark,
I didn't misread Jon's post at all. I'm making the case that numbers aren't the whole story. Jon has made the case over and over again that numbers are everything, thus there are only a handful of places in the US that one can even consider to buy rentals.
I'm pointing out that a longer-term view and a bigger picture view of things can indeed build wealth in rental properties.
Please re-read my post to try to get a better sense of what I just wrote.
Thnx
@Mark Ferguson - right on!
@David Ackerman - I hate to point out the obvious, but for a guy who has been investing for 3-4 years it is a bit presumptuous to point out "long-term" benefits to @Jon Holdman . I hope, for your good, the market cooperated with you, I'll just stay with Jon's thinking on this one...:)
Hey Ben,
Trading stocks for 15 years, investing in stocks for 15 years, hard money loans NYC for 3-4 years (15-16%) and rentals for 3-4 years.
Investing is investing. Some win and some loss. But, I just would hate people to never buy an investment property just because they don't cash-flow such an extreme amount. That is very rare. Good investments can be made even though on a short term basis they might not appear to be good.
@David Ackerman your case isn't really "that numbers aren't the whole story". Of course they are. Your post is full of numbers.
Your case is really, "don't just consider immediate cash flow". I fully agree. There are lots of ways to make money on rentals besides cash flow. @Jamal Atwell is asking about immediate cash flow, though.
That is NOT cash flow. One of the, well, lies new investors are often told is "cash flow = rent - PITI". I call that phony cash flow. Then those buyers post here saying "help!!! My tenant disappeared owing me rent and now I can't pay my mortgage." The 50% rule may not be perfect. In the past, two large datasets have been provided here that support this rule very closely for thousands of units all over the country. But applying the 50% rule will serve new investors FAR, FAR better than the phony cash flow lie.
If an investor applies that rule, realizes they will have negative cash flow and chooses to invest anyway for purposes of speculation (which is in part what you're advocating, and is a perfectly acceptable strategy) then I have zero problem with them. I have a huge problem with new investors thinking they're going to have $300 a month in cash flow only to end up in a pinch with the truth rears it ugly head.
Having tenants "buying you a house" is a great thing, too. If the property is just break even, or even if its cash flow negative and you can handle that negative cash flow, then you will end up owning a very valuable asset. But, again, the new investor who goes in thinking he has positive cash flow when he or she is in fact negative can result in that investor being in a much worse position financially than if they had not bought the property.
The 2% rule of thumb, OTOH, is terrible. Do your own math.
Well thanks everyone for the very far contrasting insights. I guess I kinda learned that the 2% was a very strict rule of thumb that isn't a clear cut buy/dont buy signal. I have however learned that you need to account for vacancies/repair in your budget costs or you could end up underwater and the property is not really cash flowing. I guess as long as those expenses are covered it could be a good investment.
Well said Jon. I totally agree that new investors might be missing the boat on understanding what rentals are really about.
I was just trying to point out that a good investment needs to be analyzed from many different perspectives. Looking at numbers is one part of the equation, but it's not the whole equation.
I keep coming back to stocks because that's my expertise. But, its very similar to real estate. I bought SBUX (Starbucks) at $20 a few years back. It proceeded to go down to $7 for a 65% paper loss. They were closing stores, Howard Schultz had left, economy was tanking, etc. Every article I read was bad, and all the numbers were saying it was in big trouble. But, I maintained my long-term view with simple thinking :
1)People love coffee
2)It offers a good atmosphere to read or chat
3)they were innovative.
It took 3 years to get back to even. Now the stock is at $75 after owning it for 8 years and it is well positioned to grow further.
I think that long term thinking, like in stocks, is the key in real estate as well.
P.S = I bought SCSS (Select Comfort) at $19 in 2006. Sold it at $1 in 2009 for a 99% loss. Today it is back at $19. Investing is NOT easy, some will win and some will lose, but focus on the long term and you can come out ahead.
@David Ackerman I agree with you 99% as if you keep looking for "perfect" indicator than you will never buy anything, means you are not serious RE investors. I have been doing similar thing as you since 1997 and most of the properties have 50% loan to value and now they each cash flow 500-1200/mo! This is after i had refinance some of the properties to pay for a "gut-out rehab" my personal residence.
The only thing was diferent in my case: i had zero money to invest so i had to get creative with down payments.
An example from my early investing with less cash down: i called around for a buyer's RE agent who would accept his commission in a form a note with payments over 60 months. So i could cover my closing cost from his commission.
You will find that many areas, perhaps even MOST areas, do not have good rentals.
Based on a silly 2% rule? And using this silly rule to determine "how much" you can pay for a property! I think the market will determine what that amount is. If your silly 2% rule says "you can pay" $100,000 in a $200,000 market value environment then all you are in that market is a lookie loo, NOT an investor. Cash flow does NOT predict profitability. Hey @Ben Leybovich
this is based on almost 40 years of investing experience. Still waiting for yur call. ;-)
Take a look at my post on Dec 23 '13 on this topic: http://www.biggerpockets.com/forums/88/topics/110262-thinking-of-an-investment-in-a-hedge-fund I've heard people say 2% is impossible in metro cities, yet relatively quickly I found 2 examples of a MF investment that were 2% and 1.6%. In the second case, $3,255 monthly average rent for an (average) 1,143 sq.ft. place in metro NY/NJ with "Financial reporting cost" average $201,000 per unit.
Regarding "It seems like it's impossible to find places that rent following the guidelines of the 2% rules." In Raleigh, 2% is possible. Granted, easier in some asset classes more than others. And granted, it's harder now than 3-4 years ago. Clearly, David A. has a different investment concept than folks looking for the 'best' cash flow investments. To keep the stock market analogy applied to REI, David prefers 'buy high sell higher, no dividend' and I'd consider myself a REI value investor as in 'buy low, sell higher, large dividend.' Both can work, in REI and in stocks. In stocks, I've had 5 or 6 '10-baggers' (1000% increase or more) and all but one I bought (initial buy) when they were at all time highs (at breakouts from a handle.) In REI, my strategy is competely the opposite. For example, for a $186,048 total basis, we have a group of 6 properties with total rents at $4,170. We try to stay net income positive after all expenses, including depreciation and mortgage interest at as high a leverage point as possible.
As for carrying losses, in stocks I follow CAN-SLIM and don't let losses grow above about 8%. I apply technical and fundamental analysis rather than just fundamental analysis. In REI, I'd prefer not to carry a losing rental. IMO only, if you make a mistake, get out.
P.S. There is no right answer someone to apply or not apply the 2% rule of thumb.