## This Deal Analysis Proves the (Disappointing) Truth About the 2% Rule

Expertise: Mortgages & Creative Financing, Personal Development, Landlording & Rental Properties, Personal Finance, Real Estate News & Commentary, Real Estate Deal Analysis & Advice, Real Estate Investing Basics, Business Management, Commercial Real Estate
173 Articles Written

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.

## 2% Rule

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.

Related: Case Study: My Latest Deal Proves the 70% Rule Doesn’t Always Work

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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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:

### 2% House

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.

Related: Put to the Test: Are the 2%, 50% & 70% Rules REALLY Useful to Investors?

### 1% House

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.

## Conclusion

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.

Ben has been investing in multifamily residential real estate for over a decade. An expert in creative financing, he has been a guest on numerous real estate-related podcasts, including the
Annabelle Dilworth
Replied over 3 years ago
Firs of all “Realtors” aren’t licensed by States; one joins the State & National Associations of Realtors, which are trade organizations, if one wants to join. States license real estate sales people and real estate brokers; states do not license Realtors — and one can be a State licensee without being a Realtor, without being a member of the trade organizations whose members use the trademarked name of “Realtor.” — completely separate things, although most Multiple Listing Services require their members to join the State & National Associations of Realtors since most MLS organizations are run by Relator Associations. As far as investing goes location and potential growth for any location is most important, and not, in my opinion percentage formulas and rules; quality of tenant and vacancy risks and potential future growth and community development of overall area — things which cannot be easily boiled down to percentage formulas & rules which would be universally applicable to all potential situations and making text book simplicity out of every location (universally) — in my opinion these are very sloppy recipes for real estate “success.”. I am a real estate appraiser & rental (commercial & residential) property owner; “investor” (for over 50 years).
Jerry Kisasonak Residential Real Estate Agent from Mc Keesport, Pennsylvania
Replied over 3 years ago
I disagree on two assumptions: 1. A bank won’t lend on a property below 50K. Thas not been our experience. Do some say no? Absolutely. Do some say yes? Absolutely. Find the ones that say yes – aka build your team. 2. You can only sell properties under 50K to investors. That has not been our experience. There are plenty of people looking for an inexpensive starter home in marginal areas.
Dawn A. Rental Property Investor from Milwaukee, WI
Replied over 3 years ago
I purchased a house for \$39,900 and put down 15% and financed the rest with the lender. It’s rented out since I bought it to the same people for \$900/mo. If you keep up on the maintenance items and keep the place looking good, you don’t have to do a huge remodel all at once. Make sure to rent to quality renters who will keep the place looking good. If someone doesn’t take care of the house, then don’t rent to them.
Matthew Ward from Cynthiana, Kentucky
Replied over 3 years ago
Thanks for the ray of hope in these situations. I plan to do the same as you. I live in a town that is close to a major factory where workers are making any where from \$40,000 to \$100,000 a year with strong job security. The rentals in that city are extremely high, but in my town, which is a short commute, I feel I can rent for cheaper but still gain high cash flow.
Mike McKinzie Investor from Westminster, CO
Replied over 3 years ago
Ben, once again We agree 100%. While not a straight line, I have always said that the higher the GM, the lower the chance for appreciation. For instance, in OC, CA, you would need to spend \$750,000 to get \$3,000 a month rent. But the chances of that house being worth \$850,000 in a year or two is 90%. But go to Detroit and buy a house worth \$40,000 and rent it for \$800 and in a year or two, the house will be lucky if it sells for \$40,000!
James E. \"Jim\" Gorman IV
Replied over 3 years ago
Interesting post. Please do not rush into any RE investment with out doing your best to evaluate it on a NET PRESENT VALUE basis, even if you have to book-it to get this done, Please also do not disregard ACA \”Obamacare\” taxes, Depreciation recapture taxes, Capital Gains Taxes (both State & Fed.) – and the loss of buying power of the \”DOLLAR\’ over time. \”All that glistens is NOT gold, even in real estate\”
Peter C. Investor from Felton, California
Replied over 3 years ago
Efren Aguirre from Monmouth, Oregon
Replied over 3 years ago
So I finished reading the blog but got confused on the paragraph before the conclusion
Michael Williams Investor from Palmetto, Georgia
Replied over 3 years ago
I think the Class B house is more attractive to me, because as Ben said the quality of tenant is better and typically this house will need a little less TLC…Typically. I am assuming (I know what they say about assuming) that both of these scenarios are solely based on the 5 year exit. Another thing I think will be a factor is that the chance of the Class C tenant with the rent mentality is not going to be as caring of the property is the !% house renter. I know this is about the 2% rule but to really make this scenario a bit more realistic you have to factor in this possibility. But then again it’s only five years. But as Dawn said, screening the tenant is very important. I am lucky to have found one of the best tenants of all time for my first rental. Ain’t nothing like it.
Account Closed from Indianapolis, Indiana
Replied over 3 years ago
Renters are renters, I do not care if they are a \$500 or a \$5000, \$10,000 tenant. Just because they pay more does not constitute a good tenant. I have seen first hand what renters do to properties on both ends of the spectrum. The mentality is the same. They will destroy a property if they are unhappy with the landlord or how the property has been taken care of. Remember a tenant thinks that if a landlord can afford a rental property then they must be rich and I mean Donald Trump or Warren Buffet rich. That is the mentality of renters. Dawn is right, If your screening processes is good and you maintain your property then the tenants will stay. Trust me, I have tenants who stay in my properties specifically for that reason. Annabelle is right, a \$40K property can be done if bought correctly and in areas that are moving forward. They are not all loser properties with horrible tenants as Ben likes to make you think they are. Sorry Ben but the argument is getting old and just because you do not like them doesn’t mean that they won’t work for someone else. These 1% 2% rules are not “rules” they are made up non-sense. I have never used any of the percentages and I have done just fine. As a matter of fact I have never even heard of these “rules’ until I became a BP member. That’s probably why I have been doing just fine. If I had listened to or adhered to these “rules” I would have never of bought anything.
Domenic Fragomeni
Replied 9 months ago
Totally agree, I couldn’t care less about rules and percentages.. I care about cash flow
Susan Maneck Investor from Jackson, Mississippi
Replied over 3 years ago
In regards to getting financing on houses which cost 40K or less, not entirely true. I usually do pay cash for the houses I buy at 30-35K but Wells Fargo will do HELOCs of the properties value even on rental properties after you’ve owned them for a year. Also, most local banks will make loans for less than 50K as long as they are owner occupied so don’t assume you have to sell the property to an investor. I know this because I discussed it with a real estate lawyer. It is apparently illegal for a local bank to refuse financing to a house being purchased owner-occupied because it cost too little. They don’t have to give you the best terms, but they do have make the loan if a person is otherwise qualified. This is prevent red-lining. Mind you this is only true for local banks and is not the case for regional and national banks.
William Jenkins Real Estate Broker from St. Louis, MO
Replied over 3 years ago
I see a lot of incorrect assumptions in your post and in some of the comments supporting your conclusion. 1. You are comparing levered returns vs non-levered which does not properly account for the added risk of leverage. Try risk adjusting the return. 2. You are 100% incorrect in saying that \$40k properties cannot be financed. 3. Your “appreciation” assumptions on the 100k house is VERY generous and goes back to the 2006 “houses never go down in value” attitude. 4. Your appreciation assumption, or lack there of, on the \$40k house is made up drivel. Your whole argument boils down to the ability to finance and “guaranteed” appreciation. Good luck keeping that Tesla if we hit a neutral or negative market. Oy Vey.
Bill Schrimpf Real Estate Agent from Reno, NV
Replied over 3 years ago
This is an appreciation play. Your right about the 2% rule and it’s general implications but then you ASSUME appreciation. Lools like your replacing one mistake with another. Counting on appreciation is a fools errand in the residential world. Enjoy the family time, but why on earth would yo go to Arizona in August?
Jeff Kehl Rental Property Investor from Charlottesville, VA
Replied over 3 years ago
Your blog post seems to be more about higher priced houses being better investments than lower priced ones which generally I agree with. But I think what’s more important than the price point is if it’s a good deal. Coincidentally I have two homes under contract right now which just about match up to your hypotheticals. House 1 – Price \$110,000 rent \$1200/month value \$150,000 House 2 – Price \$44,000 rent \$850/month value \$80,000 Both houses need minimal repairs. Which of these should I buy? According to what you wrote I should be buying house 1. Instead I’m buying both of them. I will flip house 1 for a quick profit and rent house 2. Local banks will finance both of these. I would like to have both of them as rentals but I think over time house 2 will give me better cashflow.
Jeff Kehl Rental Property Investor from Charlottesville, VA
Replied over 3 years ago
Your blog post seems to be more about higher priced houses being better investments than lower priced ones which generally I agree with. But I think what’s more important than the price point is if it’s a good deal. Coincidentally I have two homes under contract right now which just about match up to your hypotheticals. House 1 – Price \$110,000 rent \$1200/month value \$150,000 House 2 – Price \$44,000 rent \$850/month value \$80,000 Both houses need minimal repairs. Which of these should I buy? According to what you wrote I should be buying house 1. Instead I’m buying both of them. I will flip house 1 for a quick profit and rent house 2. Local banks will finance both of these. I would like to have both of them as rentals but I think over time house 2 will give me better cashflow.
William Powers from Waukegan, Illinois
Replied over 3 years ago
Ben, Your experience is different in OH than northern IL, and we continue to have success with the 2% rule or “\$200/month for every \$10K invested” as I used to call if before I went on BP. The 2% Rule is alive and well up here. Here are some numbers: Acquisition Purchase \$45,000 Rehab and closing costs \$30,000 (basically everything rehabbed including mechanicals, granite, SS, and all) Total cost \$75,000 After we invested cash like this, we always want to make sure we have IE (Instant Equity) for ourselves or our clients – at least \$30K – which means I know I could sell it for \$120K NOW. Usually it is much more, but at least \$30K Debt We do have local banks and credit unions that will put debt on 1 home for \$50K, but typically our clients bundle these homes in groups of 3, 4 or 5 homes, and put debt on them. Typically 80% of the total invested, so in the case of the home above, that would be \$60K. Lease Numbers \$1500 Monthly Payment \$250 interest payment (5% on \$60K – 80% of a \$75K total investment) \$50 insurance \$210 maintenance/accounting/management fee (15%) \$200 taxes (we work hard to keep these down) \$100 capex/vacany/reserve (we don’t have vacancy to speak of, and capex is almost non existent – at least so far- since our rehab is very extensive.) \$810 total expense \$790 Net (\$240 of this is principal payment on 15 year am – so \$550 free cash flow) Appreciation What we have experienced over the past 5 years is nothing short of amazing. Homes that we purchased for \$20-\$30K and rehabbed for \$25-\$30K are now worth \$120-\$140K. It is very important to know areas that an area is not consumed by public housing, so you give yourself a chance for appreciation. To be honest, we never expected the homes to go up in value 1 dollar. We based everything on cash flow, and the knowledge that the areas we where purchasing had a lot of hardworking, blue collar residents, and the housing stock was good. For me, Waukegan IL is that market. Beach Park is also very good. Zion is definitely NOT where you want to go, it is all Section 8 with a building department that is very difficult to deal with. Ouch!! Resident Quality This is a place that our roads definitely go in different directions when you reference a \$40K house (which I have many since I started to purchase in 2011). We focused on folks that were victims of predatory lending – they had great jobs, but some unscrupulous loan officer told them they should borrow \$200K on a variable rate mortgage in 2006. I can’t tell you home many resident we have that work with us that have lowered their payments, and increased the quality of the home they live in, while lowering the cost of home the own or are in the processing of buying. One such example is Roy on 9th Parkway in Waukegan. He had a \$200,000 mortgage with a payment of \$1976, while the house needed work and was worth \$30K at most. He moved to one of our homes – Rent to Own price of \$109,900 on new 4 bed, 2 bath home that is now worth \$140,000+, and he can buy it for \$109K less credits. He has worked in a distribution center for 17 years, wife at a credit union for 8, they have 3 kids, with 1 going off to college. Great results for everyone, and a very high quality tenant – it can be done. Would love to compare notes and markets some time, as we can all learn from another experience and expertise. All the best, Bill Powers (BP)
William Powers from Waukegan, Illinois
Replied over 3 years ago
Ben, Your experience is different in OH than northern IL, and we continue to have success with the 2% rule or “\$200/month for every \$10K invested” as I used to call if before I went on BP. The 2% Rule is alive and well up here. Here are some numbers: Acquisition Purchase \$45,000 Rehab and closing costs \$30,000 (basically everything rehabbed including mechanicals, granite, SS, and all) Total cost \$75,000 After we invested cash like this, we always want to make sure we have IE (Instant Equity) for ourselves or our clients – at least \$30K – which means I know I could sell it for \$120K NOW. Usually it is much more, but at least \$30K Debt We do have local banks and credit unions that will put debt on 1 home for \$50K, but typically our clients bundle these homes in groups of 3, 4 or 5 homes, and put debt on them. Typically 80% of the total invested, so in the case of the home above, that would be \$60K. Lease Numbers \$1500 Monthly Payment \$250 interest payment (5% on \$60K – 80% of a \$75K total investment) \$50 insurance \$210 maintenance/accounting/management fee (15%) \$200 taxes (we work hard to keep these down) \$100 capex/vacany/reserve (we don’t have vacancy to speak of, and capex is almost non existent – at least so far- since our rehab is very extensive.) \$810 total expense \$790 Net (\$240 of this is principal payment on 15 year am – so \$550 free cash flow) Appreciation What we have experienced over the past 5 years is nothing short of amazing. Homes that we purchased for \$20-\$30K and rehabbed for \$25-\$30K are now worth \$120-\$140K. It is very important to know areas that an area is not consumed by public housing, so you give yourself a chance for appreciation. To be honest, we never expected the homes to go up in value 1 dollar. We based everything on cash flow, and the knowledge that the areas we where purchasing had a lot of hardworking, blue collar residents, and the housing stock was good. For me, Waukegan IL is that market. Beach Park is also very good. Zion is definitely NOT where you want to go, it is all Section 8 with a building department that is very difficult to deal with. Ouch!! Resident Quality This is a place that our roads definitely go in different directions when you reference a \$40K house (which I have many since I started to purchase in 2011). We focused on folks that were victims of predatory lending – they had great jobs, but some unscrupulous loan officer told them they should borrow \$200K on a variable rate mortgage in 2006. I can’t tell you home many resident we have that work with us that have lowered their payments, and increased the quality of the home they live in, while lowering the cost of home the own or are in the processing of buying. One such example is Roy on 9th Parkway in Waukegan. He had a \$200,000 mortgage with a payment of \$1976, while the house needed work and was worth \$30K at most. He moved to one of our homes – Rent to Own price of \$109,900 on new 4 bed, 2 bath home that is now worth \$140,000+, and he can buy it for \$109K less credits. He has worked in a distribution center for 17 years, wife at a credit union for 8, they have 3 kids, with 1 going off to college. Great results for everyone, and a very high quality tenant – it can be done. Would love to compare notes and markets some time, as we can all learn from another experience and expertise. All the best, Bill Powers (BP)
Dan Heuschele Investor from Poway, CA
Replied over 3 years ago
IMO not calculating and using a cap expense worksheet to determine the monthly cap expense just because the expense is in the future is short-sighted and does not accurately convey your monthly profit. With your positive cash flow there is no doubt that you would still have positive cash flow if subtracting cap expense but you would have a more accurate predictor of your actual cash flow if you included expected monthly cap expense calculated using expected lifespan and expected cost. Without calculating in an expected cap expense calculated via a logical means you do not know your actual monthly cash flow.
Domenic Fragomeni
Replied 9 months ago
Couldn’t disagree more.. What you refer to as nonsense has made me a millionaire (in Ohio). You can very easily leverage these properties in a variety of ways, either lenders (they are there, you just have to find them)… or otherwise – like pulling equity out of your car, 0% credit card loans, etc. And when you assume 50% expense ratio, I have to ask… were you sleeping when you walked through the house? Honestly I think this article does a great disservice to Ohio investors, which is one of the few places in the country where this investing makes a ton of sense.
Lewis Christman Financial Advisor from Macungie, PA
Replied 9 months ago
How about you do equivalent math and do 1% at a 40,000 purchase price to compare it to the 2% example or do 2% at the 100,000 purchase price and the same variable. Please do apples to apples.
Steve B. Investor from Centralia, IL
Replied 9 months ago
I enjoy reading the article and all comments on this as all parties offer great insight from different views which in turn creates a broader view. Thanks to Ben and all who reply.
Shawn T Sawyer from Muskogee, OK
Replied 9 months ago
I am a sponge. I think Ben posted this article just for the reason of the responses he got. And I thank him for it and all subsequent comments.
Vaughn K. from Seattle, WA
Replied 9 months ago
That’s an awful lot of assumptions that aren’t always true to arrive at your end destination. Properties don’t always appreciate rapidly, even in nice areas. As a matter of fact, that level of appreciation is UNHEARD OF over the long haul. Even SF or NYC don’t AVERAGE OUT to figures like that over the long haul. So that is totally bunk. Next, cheap areas can appreciate… Just more slowly. For instance a lot of places might only appreciate at about the rate of inflation, but it is still adding nominal dollars and cents to the value. I would bet my life that a neighborhood that stays the same quality (IE doesn’t get nicer or worse) will go up 2-3% a year over 10, 20, 30 years. If you’re looking for a 5 year horizon, it won’t add up to much… But the thing is such areas ALSO aren’t likely to go down, whereas your magical high appreciation area is likely to take a bath during a downturn. You ignore that you CAN in fact finance cheaper properties, via many methods. As mentioned some banks WILL do it. You ever heard of owner financing? It’s a thing! Also, 2% rule houses don’t HAVE to be under \$50K either. They might be \$60k, or even higher in some places. So that again destroys your entire premise, which relied entirely upon comparing leveraged returns to non leveraged and unrealistically high appreciation to unrealistically low appreciation. The whole argument doesn’t hold water, because almost every assumption is incorrect. The one thing that IS true is that you will end up having higher expenses as a percentage of income on a cheaper property. If comparing 2 houses in the same city, a roof will cost you the same on a \$100K property as \$50K if the same size. Ditto for other things. But the extra cash flow covers it, and usually then some. Try not being so biased and completely ignoring facts that you don’t like to try to make a point next time. You’ve written a lot of other interesting articles, but this is just over the top with the level of incorrectness.