The 2% Rule: Fact, Fiction, or Feasible?
It’s whatever you want it to be.
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Have you ever heard the reasoning of why people buy something being that they “buy on emotion and justify with logic”? I think the 2% rule, as well as the 50% rule and any other related rule, falls into this realm of reasoning. I’m not sure how exactly, but I’m certain it does.
The “2% rule” isn’t really a rule as much as it is a guideline that was created by real estate investors at some point in history that I’m really not sure of. The 2% rule says that for a rental property investment to be “good”, the monthly rent should be equal to or higher than 2% of the purchase price. For a $100,000 property, the monthly rent collected needs to be $2,000/month or higher to meet this guideline. There are various versions of this rule, the next most popular being the 1% rule, meaning you’d have to get $1,000 in monthly rent on the same $100,000 purchase.
The fact is, this guideline does exist and can be met with rental properties today.
Where this guideline gets sketchy is it doesn’t tell you two things: 1. the condition of the property or location and 2. Your net cash flow. Let’s say you find a $35k deal in Florida, with a monthly rent of $700. Meets the 2% rule, right? Right. Two problems. First of all, I can say with fairly high certainty say that any property you find in Florida for $35k is going to be a total junker. Secondly, insurance and property taxes are so high in Florida that joining those with the rest of your expenses, including repairs on your junker property, will most likely put you right at zero or less for cash flow. So much for that “good” investment.
Ok, yes, a bit of a stretch there on my hypothetical example, but it’s a good demonstration of why you need to realize there is a lot more to a property than “rules” and guidelines. I cringe when I hear people say they are looking for a property that meets those. Yes, I get that those are nice numbers to see, but they are far from what matters.
For example, the closest I ever got to meeting the 2% rule was a really nice property, newer and fully rehabbed, in Atlanta I bought for $55k and it rents for $975/month. However, this was back in the Atlanta hay day and can’t be found there now (if you do find it, be leery). As the Atlanta market progressed, investors were forced to forget about the 2% rule and start thinking about the 1% rule, otherwise they’d never buy anything in Atlanta. By the end of last year, you were lucky to hit the 1% rule! I say all this in reference to good quality nice properties, not cheaper low-income properties. Did barely meeting the 1% rule mean the properties were bad investments? No way! You have to consider quality, location, and tenants in any investment purchase, none of which have a thing to do with a 1 or 2% rule.
Are there properties out there now that meet the 2% rule? Absolutely. Are they getting harder to come by? Absolutely. While the Atlanta market has been skyrocketing quicker than a lot, the real estate market as a whole is on the upswing. In just a couple years, and more so in the last couple of months, I’ve seen cap rates really settle out below 10% for the first time. Investors are realizing they can’t get a property for as cheap and with as nice of returns as they could even just a year ago. It’s great news for the real estate market, all of our current investments, and the economy as a whole, but it is forcing investors to settle for lower returns.
Related: Battle of the Cap Rates
Back to this 2% thing. Yes, you can find properties that meet the 2% rule. However, it is almost a sure thing you will only see this on the lower side of purchase prices, likely the sub-$50k properties. At this point in the real estate market, sub-$50k is (in my humble opinion) sketch. I personally won’t buy anything in this price range. For one, the property is most likely going to need work to some unknown degree, and worse, you’re looking at the lower-class of tenants which most often cause a lot of expense in vacancy (evictions) and repairs. An eviction, followed by an empty house, followed by a nasty turnover repair cost really kind of blows your 2% delight out the window, does it not?
In terms of feasibility, here is my process with it when I’m analyzing a set of properties.
- If it doesn’t meet the 1% rule, by how much does it not meet it and what market are you talking about? If you’re in Kansas City and it doesn’t meet it, bail. If you’re in Dallas and it doesn’t meet it, well, that should be assumed.
- If it meets the 1% rule, it should be considered. Move on from there and run all the numbers on the property and check out what the cash flow will be.
- If it meets the 2% rule, be leery, but check it out. Again market-dependent, if you’re in Kansas City, yay! 2% rule! Check it out seriously. If you’re in Dallas, someone has officially found you a junker in a questionable neighborhood that not only needs work but is going to attract a raunchy tenant who will never give you the full amount of rent anyway.
Again, my personal investing stance is centered on more expensive nicer properties. If your investing focus is higher cash flow, which means you are probably working with older cheaper properties, then the 2% rule is probably an okay guideline for you.
Point is, use the 2% rule or whichever one you want only as a guideline to get you looking at a property. Once you are into the numbers of a property and evaluating it for serious purchase, the 1 or 2% rule should never be brought up. In no way should it be a justification for buying a property. Simply use it to get your list started of properties worth considering.
That’s right. I said it. The 2% rule is stupid. Okay maybe I didn’t. What is stupid is if you buy a property because it meets the 2% rule.
Photo Credit: ralphunden