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

## 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:

### 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 BiggerPockets Podcast. He was also featured on the cover of REI Wealth Monthly and is a public speaker at events across the country. Most recently, he invested \$20 million along with a partner into 215 units spread over two apartment communities in Phoenix. Ben is the creator of Cash Flow Freedom University and the author of House Hacking. Learn more about him at JustAskBenWhy.com.

1. 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.

• 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.

• 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.

2. Annabelle Dilworth on

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).

3. 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!

4. 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\”

5. Ben, thank you very much; I have enjoyed your writing style and your podcasts!

I am still new to this, and I realize you were making a crude comparison using two houses that are very different to highlight your points, but I am a little confused.

You show figures for collecting 5 years of cash flow, and include the 5 year mortgage paydown; however, you only included a single year of cash flow when calculating the distributed profits. It looks like your 1% house could beat the profits of even a 10% house under these conditions. Please show me what I am missing here.

Is it common to find a 1% home that will appreciate 40% reliably in the same general area that a 2% home doesn’t appreciate at all? In my area (rural coastal California) the homes that are anywhere close to 2% are very beat up, but they do still tend to appreciate. Your 40k house is maybe a class C, while the 100k is a class b?

One solid thing I got from your article; we should be careful focusing on cash flow exclusively (the 2% rule), because the real-life costs of a high cash flow property are often very significant. In some ways, your article goes against the idea that it is best to consider appreciation as icing on the cake. Without counting on appreciation, I think your 100k 1% house would look pretty weak to a potential investor, so it might get passed up. Unfortunately, I am guessing there will never be a convenient rule of thumb for planning for appreciation.

Thank you again for this article, I hope it generates an interesting discussion!

6. So I finished reading the blog but got confused on the paragraph before the conclusion

7. 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.

8. 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.

9. 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.

10. 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.

11. 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?

12. 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.

13. 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)

• 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.