Why the 2% Rule Can Get Beginning Investors Into Trouble
The 2% rule has been discussed quite a bit on the forums and in blog posts. Since I am a new blogger (I wrote my first article for Bigger Pockets last week on buying HUD homes), I figured it was okay for me to add another opinion on the 2% rule. What peaked my interest was seeing a comment in one of the forum posts that said the 2% rule is great for beginning investors, because it helps keep them out of trouble. However- I think the 2% rule actually does a lot more harm that good with new investors.
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I have been investing in long-term rentals since 2010 and I have been a licensed Realtor since 2002. My father has been a Realtor since 1978 and the first time I heard about the 2% rule was when I discovered BiggerPockets earlier this year. I saw the rule popping up all over the forums as a way to evaluate long-term rental properties.
I quickly discovered the 2% rule was used to determine if long-term rental properties are a good investment by using a very simple equation. If monthly rents are equal too, or greater than 2% of the purchase price on a rental property, than the rental property is considered a good buy. To make it really simple, If you buy a 100k house it should rent for $2,000 a month. I quickly realized none of my rental properties come close to meeting this rule. I am extremely patient and usually buy my properties at least 20% below market, but my best rent to purchase price ratio is 1.35% ($1,250 rent on $92,000) .
I have heard many people on the forums explain the 2% rule is great for beginners because it is simple and keeps them out of trouble. I think it may cause more problems than it prevents, because it is actually too simple. There are too many variables that go into evaluating a rental property for a beginner to only consider rent versus purchase price.
Seasoned investors can look at a house and determine if it is a good fit almost immediately, because evaluating deals has become second nature. Beginning investors, need to be looking at all the details; rent, expenses, repairs, mortgage, location, etc. They need to thoroughly analyze exactly what the returns will be based off certain estimates. Not only does running all the numbers help a beginner figure the returns, it helps them learn the process of evaluating properties. There is no secret calculator that can evaluate every potential rental property, each property needs be analyzed based on the most important variables.
I have seen many forum posts from beginners asking members to analyze a deal without gathering all the needed information. I understand an investor who has done an evaluation and wants validation from experts. However, it seems like many beginners are looking for a short cut, by having someone else figure out all the numbers for them. A beginning investor has to be able to figure cash flow and cash on cash returns at a minimum to be able to succeed in Real Estate. When I came up with my long-term rental plan, I ran 10 year projections for cash flow on every property I planned on buying. My original goal was to buy 30 rentals in 10 years, but I raised that to 100 in ten years to challenge myself.
Why the 2% Rule is Flawed
Every property and every area of the country has different expenses. Single family is different from multi family. Low priced homes different have expenses than more expensive homes. Different states have different tax laws and utility costs. The most important factor may be the cost of initial repairs, which the 2% rule does not factor at all.
Single family versus multi family
Single family homes have much different expenses than multi family homes. In many cases renters of single family homes will pay all the utilities, while the landlord may pay most of the utilities on multi family properties. Single family renters are responsible for yard care, while the landlord is responsible on multi family. Single family homes tend to have less turn over and may be taken care of better by the tenants. I have found single family renters treat a rental like their own house, while those in an apartment treat it like a rental. I personally invest in single family because single family homes have less expenses than multi-family, are more stable and have a better chance of appreciation. I can also get a better deal on single family homes in my area then I can on multi family properties, but that may be a regional trend. I am willing to have a much lower rent to purchase price ratio on a single family rental than a multi family because of these factors and the 2% rule does not account for any of them.
The location of a rental property can be a huge factor on the properties long-term success. There are many factors to consider when choosing a location: vacancy rate, job growth, population growth, condition of neighboring properties and values. All of these factors will determine rent appreciation, value appreciation, expenses, maintenance and vacancies in a rental property. Once again the 2% rule does not take into account any of these factors.
States, counties and even cities have different property tax rates. I happen to live in Colorado, with very low property tax rates. The assessed value on one of my rentals is $130,369 and I pay $882 per year in property taxes on it. I rent it for $1400 a month and that equals about 5% of my rent. In other states property taxes can be 25% of rents or more. That’s a huge difference in expenses for a rental property that the 2% rule does not take into consideration.
The percentage of expenses on a rental will change based on the price point, at least on single family rentals. Many times the lower priced rentals will require more repairs due to more turnover. Usually homes are priced low for a reason; repairs, location, functional obsolescence, or market conditions. In my area the very lowest priced homes, are the only properties that come close to the 2% rule. Yet, I consider these properties to be a much worse investment, then properties I purchase in the higher price range, that don’t come close to the 2% rule. I know I will have less repairs, less turnover and an easier time selling homes if I need to, in the higher price range. The 2% rule, encourages investors to go after the lowest priced homes, which may have the most problems.
Another way to get close to the 2% rule is to buy a home that needs a lot of repairs. The 2% rule does not consider any initial repairs into the equation, but this greatly affects your return on investment. I could buy a turn-key, perfect rental for 100k that rents for $1200 month or I could buy a 60k rental that needs a ton of repairs that rents for $1200 a month. Lets analyze the two deals to see which gives a better return.
Deal 1. price $100,000
Down payment. $20,000
Closing costs. $3,000
Carrying costs $500
Total cash invested $23,500
Mortgage Payment $382
Taxes and insurance. $150
Total monthly expenses $732
Monthly cash flow. $468
Cash on cash return. 24%
Deal 2 Purchase price $60,000
Down payment. $12,000
Closing costs. $1,800
Carrying costs. $1500
Total cash invested $45,300
Mortgage Payment $229
Taxes and insurance. $150
Total monthly expenses $579
Monthly cash flow. $621
Cash on cash return. 16%
As you can see, deal 2 meets the 2% rule, but takes much more cash and has worse returns. The carrying costs are more, because it takes time to make the repairs and the total time that money is invested will be longer, because the repairs have to be made before the home is rented. I made up these figures and they could vary widely based on each deal, but the point is the 2% rule does not factor in these numbers at all.
There are advantages to buying a home in need of repairs. As you can see by my figures deal 2 walks away with 10,000 more in equity than deal 1. You may be able to get a much larger discount for a house in need of repairs and be able to walk away with more equity. I love to purchase houses that need work because I can add value and walk away in a great equity position. However, the 2% rule does not take into account any of these factors.
A beginning investor needs to look at every factor possible when buying a rental property. Diving into the numbers will help the beginner learn the process and become more comfortable investing. It is not easy, it takes work to learn what numbers are important and what properties will make money. The 2% rule encourages investors to buy the cheapest home, in need of the most repairs, in the most questionable areas. I don’t think that is a recipe for success.
Photo: Ken Teegardin