This Deal Analysis Proves the (Disappointing) Truth About the 2% Rule
Well, I have been on the road for four days now. With two kids. In the Tesla. WITH TWO KIDS. Oy vey.
We’re headed to Arizona. Gonna see what’s what! Couldn’t be any worse than Ohio, right?!
In the meantime, I do try to find time once each day to take a look at BP, see what’s going on, who’s making waves. I have to tell you — with me mostly gone, everything sure does seem to be rather quiet and uneventful. Go figure.
I did come across something that triggered somewhat of an intellectual gag reflex. People are still talking and writing about the 2% rule as if it’s anything at all. It is such nonsense and such an easy target, I can’t help myself.
Let’s Do Some Math
Let’s take a 2% SFR, where the house can be purchase for $40,000 and rented out for $800. Since $800 is 2% of $40,000, we refer to it as a “2% house.”
Now, even if purchased without leverage — which you will most likely need to do because most lending institutions don’t want to lend small amounts under $50,000, and most don’t like the asset class — there will still be expenses, right? You know what those are, and, let’s just say in the interest of keeping things simple, that expenses are 50% of the income, or $400/month.
If we annualize this, we realize that in exchange for a $40,000 investment, we would cash flow $4,800 per annum:
$400 x 12= $4,800
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What About the Sale?
Well, typically these houses do not appreciate — which, by the way, is why banks aren’t excited to lend on them. So, best case scenario, you sell it for the same amount you bought it for — that’s the best case.
Further, in order to sell, you will have to rehab it, which will cost you at least as much as your entire cash flow for the year. So the best you can hope for in the year you sell is just to get your money back.
In a bit, we will build an IRR model to compare the investment and cash flows of two assets, but for now let’s just switch gears.
The 1% House
Here, we’ve bought a house for $100,000, and it brings in $1,000 of rent, which represents 1%. If we assume the same expense ratio of 50%, we are left with cash flow before debt of $500/month. Unlike the other house, however, this asset class is easy to mortgage, and thus our investment will be only the 25% down payment, or $25,000.
Naturally, since we will have to carry a mortgage, at, let’s say, 5% over 30 years, we will have debt service of about $400/month. And thus, the only cash flow on this house will be $100/month, or $1,200 per annum.
The exit on this house,will look very different from the 2% house, however. Why? Because this is a desirable appreciating asset, which can be sold to an owner-occupant. So, let’s just assume an exit of $140,000 in five years. And, by the way, in this five years, the tenants will pay the mortgage down from the $75,000 we started out with to $69,000.
The IRR Model
Look at this table:
Yes, the cash flow seems stronger on the 2% house. But let’s consider what happens in Year Five:
Presuming the best case scenario of actually getting a full $4,800 of cash flow but no appreciation, the exit CF would be $44,800, right? But in order to sell this house, you’ll have to remodel, which will eat the entire cash flow, which is why I show $40,000 in this line.
We start out with a sale price of $140,000. Adding in one year’s worth of cash flow of $1,200, subtracting remaining debt of about $69,000, and subtracting another $5,000 for rehab prior to sale, we arrive at distributable to you of $67,200.
I know this is very crude. I am not trying to give a math lesson, only to paint a picture with broad strokes. But which one looks better to you — 10% IRR or 25%?!
The unspoken problem in the 2% asset class is the tenant quality. It’s true — your economic losses will indeed be higher in this asset class. You will likely have to turn units more extensively between tenants. You won’t be able to raise rents, and as such, will need to absorb higher LTL (loss to lease). You will be dealing with older assets as well, and there are additional costs involved with this.
All and all, I need to caution you that the 2% scenario I outlined is really very rosy; it will likely not be as good as that.
Do you use the 2% rule when analyzing properties? Have you found any real estate rules to hold validity?
Let’s talk in the comments section below.