The 2% rule kills values

211 Replies

As one who had never heard of the 2% rule or 1% or any of the other terminology that floats around BP,, I just became aware of the 2% rule. I was talking with a fellow from Oregon who was lamenting that there are no 2% rule properties to be had in Oregon when I asked what is this 2% rule he said if a property cost 100k it needs 2k in rent.. Well that's not going to happen anytime soon around here. But I told him it happens in the Hood's of America fairly regularly. Mainly because you need those kinds of margins to make 1% or less when the missed rent increased maintenance etc etc of owning them comes into play.

So then I got to thinking well heck if everyone is running around wanting the 2% rule and if that is the only way folks will buy the lower end rentals then the values will never go up. As values could only rise if rents rose.. And we know rents may rise a little bit and HUD stays fairly stable year in year out.. And so many of these properties rely on hud to get some kind of consistent cash flow. So if one is buying in these areas and uses the 2% rule then justifies their investment because historically real estate rises this just won't happen if all your buyers use this rule... The values will just remain the same the neighborhoods do not turn around for the better they get worse as more renters move in etc etc. Your forever stuck with a value that is 2% no matter the condition of the house history or lack thereof of rental rolls.

@Jay Hinrichs  

2% rule would kill the values if majority of the deals selling were to buy and hold investors, but that's not the case. Majority of the houses sell to owner occupants and that's what drives the values for the most part.

What you mentioned will apply in the very low end areas where there are no owner occupants looking to move. Even those areas will start seeing some uptick in price because there is more investor activity as investors get priced out of other areas. At least, that's what seems to be happening in the area that I invest in. I buy in the areas where there is owner occupant activity also, because that's where the upside on appreciation happens.

@Sharad M.  

  Agreed Sharad  however if there is this well trained well educated group of BP buy and hold investors that hold stead fast to the 2% rule  and 700 rent will sell for 35k period.. they are not going to pay anymore than that for it and go against what they are taught.

NOw I know this is not reality.. but its something top consider

@Jay Hinrichs  

In that case best thing would be to buy properties at 3% rule and sell them at 2% rule :-)

Originally posted by @Jay Hinrichs:
So if one is buying in these areas and uses the 2% rule then justifies their investment because historically real estate rises this just won't happen if all your buyers use this rule... The values will just remain the same the neighborhoods do not turn around for the better they get worse as more renters move in etc etc. Your forever stuck with a value that is 2% no matter the condition of the house history or lack thereof of rental rolls.

Jay - I think you need to start buying all these properties at WAY below the 2%, so that everyone else can see some appreciation in their properties!  Take one for the team!

@Jay  Thanks for pointing out that the 2%...or 1%....or even 0.5% seems to be almost impossible to achieve in ANY of the metropolitan markets in Washington or Oregon.  Since finding out about BiggerPockets, all I've done is beat myself up about how VERY far my personal residence is from achieving that rule.  Even when buying bargain basement here, you're usually looking at $100+K + significant repairs...and the house you can get for that just isn't going to pull $2000/mo in rent.  No way.  When we were renting a couple of years ago, while looking for our current house, we rented a 3/1.5, 1400sq/ft, for $1850, which was fairly average for our area.  Not shabby rent for the size....but our landlady paid $299K. That would be $5980/mo, by the 2% rule....not gonna happen.

@J Scott 

  been there done that bought 350 of them  got bought out in Oct happiest day of my life :)

although we killed it in Atlanta.. When I had to sell a few of my REO at 35k for a 10 year old home in Atlanta a year later I turned around and bought 50 of them then sold to hedge fund for nice gain. ONe way to make money is not look at hedge fund as killing a market just follow them and figure out how to buy a head of them and then sell to them.. that's what I am doing now in the space.

@Karyn T.  

I know see were this big West coast Mid west deep south divide comes from.. You have this huge rental industry in the Mid west... Its so much larger than the west coast. When you have whole huge cities like Memphis with 50% or better of all SFR's are rentals. How is that going to ever turn around and all of a sudden become owner occ neighborhoods I think the owner occs move to new construction or better areas while they flee the old rental hoods.. but that's just my thought.

If every thing being equal and you did not know any better and you thought you were not getting a good deal unless it was a 2% deal and your west coast based I can now see why there is this disconnect and also those get frustrated because they can 't get 2% and think that is what they should be doing and flood out to the mid west. Where in fact they probably would do far better staying closer to home over time, when you add in ease of management and TRUE appreciation. When you look at our market the Northwest less than 10% of SFR's are rentals.. so you can't find an area that is all rentals they don't exist.

Originally posted by @Jay Hinrichs:
ONe way to make money is not look at hedge fund as killing a market just follow them and figure out how to buy a head of them and then sell to them.. that's what I am doing now in the space.

 We sold a couple dozen Atlanta properties to big institutional money last year...agreed that it's a great strategy...until prices run up so much that there's no room for a spread...

This is a classic example of mass stupidity IMHO.  Someone invented the 2% rule because that was the sweet spot AT THE TIME.  It was never a "rule" it was simply a calculation that fitted good deals at that moment.

It is no more valid than saying you should never pay more than 2 grand for a brand new car. That was a sound rule in 1970 but it is laughable now.

Unless value to rent ratios remain static there is no such rule.

Just like the 2% rule.........

@J Scott 

 right now I am in 2 markets providing funds for the wholesalers that are providing product to the hedge funds  its a volume play.. and being a lender type we are used to small margin and lots of deals..... But they are fickle bunch those hedge funds and they are running into the same issues that private investors run into.

IE:   management sucks and or stole their money, rents are not what they were told ( go figure) rehabs lasted a year or so then major issues.

So now what we provide is.. New roof new AC  new sewer line to the street pretty tight product. we don't make a bunch on a deal ( no one on BP would touch it thinking its too little of profit) but its consistent once we hit their metrics.

@Dean Letfus  

  Problem is Dean as I point out.. so many folks at least on this site think this is what they should be doing and if they don't hit that its not a good deal. So I think reality is.. those that live in a community have access to true wholesale deals like Sharad they make this metric easy but those living on the coast they can't come close get frustrated then migrate and try areas that maybe they should not have.

@Dean Letfus  

 I saw that Andrew Waite is part of your company.. that seems strange for an independent journalist to endorse a particular TK company ... And be a principle or at least the appearance of a principle in your company.. maybe that's for the foreigners benefit, being a fellow Kiwi.

I have never bought a property that would meet that rule, (as far as I know), and we have bought and sold hundreds and hundreds of houses. IT simply is an outdated number.

The only relevant number that never changes I reckon for a flipper or wholesaler are minimum $XX margin on a deal and/or minimum XX% below market value. Also the 100/10/1 rule of course/

Nothing else remains constant.

Andrew is a long time friend and consultant. He has been the best thing that ever happened to us to be honest. He has kept us out of trouble and introduced us to many great, great people. We wouldn't have such a successful business without him.

He receives no financial benefit from our company in any way, he is just a trusted professional advisor.  I am sure he has his faults, after all he left New Zealand to live in America so he sure ain't perfect :-)

Originally posted by @Jay Hinrichs:

@Dean Letfus  

  Problem is Dean as I point out.. so many folks at least on this site think this is what they should be doing and if they don't hit that its not a good deal.

 I'm one of those people.  If a property generates 2% of purchase price in gross monthly rent, and if my expenses/vacancy/capex equal about 50% of gross rents, then I'm generating about 1% of purchase price in net monthly rent.  That's 12% of purchase price in net annual rent, or about 12% return on an unleveraged purchased.

If I can't make 12% unleveraged return, I have better options for my money.  So, I will typically only buy a rental if it will hit the 2% Rule.

If others can achieve their desired returns with different ratios, more power to them.  But, I can't...

@J Scott you will be operating in markets where that is achievable though which is awesome. But in most markets as far as I am aware, particularly Memphis where we are it doesn't happen anymore.

Bottom line is KNOW WHAT YOUA RE DOING, which you obviously do :-)

Originally posted by @Dean Letfus:

@J Scott you will be operating in markets where that is achievable though which is awesome. But in most markets as far as I am aware, particularly Memphis where we are it doesn't happen anymore.

 100% agreed.  But remember that not every investing strategy is going to work in every market or for every investor -- while accepting lower returns is always an option if a particular strategy doesn't work in your market, the other options are to forgo that strategy or find a new market.  I'd prefer to forgo a strategy or find a new market before I would accept returns that don't meet my goals...

Originally posted by @Jay Hinrichs:

@Karyn T.  

I know see were this big West coast Mid west deep south divide comes from.. You have this huge rental industry in the Mid west... Its so much larger than the west coast. When you have whole huge cities like Memphis with 50% or better of all SFR's are rentals. How is that going to ever turn around and all of a sudden become owner occ neighborhoods I think the owner occs move to new construction or better areas while they flee the old rental hoods.. but that's just my thought.

If every thing being equal and you did not know any better and you thought you were not getting a good deal unless it was a 2% deal and your west coast based I can now see why there is this disconnect and also those get frustrated because they can 't get 2% and think that is what they should be doing and flood out to the mid west. Where in fact they probably would do far better staying closer to home over time, when you add in ease of management and TRUE appreciation. When you look at our market the Northwest less than 10% of SFR's are rentals.. so you can't find an area that is all rentals they don't exist.

I see the 50% number for Memphis thrown around a lot and it is often cited incorrectly.  Sorry to the poster that this is off topic, but the number - the way you cited it - is incorrect.  It is estimated that 50% of the Memphis proper population rents their housing and that includes multi-family.   That is only an estimate and it does take into account that there are parts of the city, very near the urban core where 60% or more of the housing units, single family and multi family are rentals.  But the 50% of Memphis single family houses are rentals is incorrect.  I have attached a report from 2012 showing that 37% of the single family houses are rental units.  That would be about even with the national average - maybe a little higher.

What I also find fascinating is the cities in the country with the highest population of renters.  According to FNMA 7 out of the top 10 markets with the highest percentage of renter occupied single family houses are located in California and Idaho.  The other other three are Oklahoma City, Tulsa and Kansas City.  Memphis comes in at #`12 behind Youngstown, OH at 42%.  

The best data I could find on Beaverton, OR., which I believe is a suburb of Portland was from a 2010 study and it said that Portland had a homeownership rate overall of 57% ( or 43% of the properties were not owner occupied).  It could have been saying that 57% of the residents own their housing, but that would still mean that 43% of the people rent.  It was not clear.  Either way, that is a lot more than 10%.  I think the real divide between west coast, midwest and southern investors may simply come from not knowing the data and making big leaps of assumption.    

I just hate how easy it is to throw incorrect numbers around or use them incorrectly.  I know....I have mis-cited this exact piece of info. before!  Even many of the Memphis companies cite this data wrong.  When I am asked about this today, I point out that the Memphis populace may have a natural pre-disposition towards renting single family housing rather than the upward mobility of owning and buying like you might find elsewhere since it is estimated that 50% of the population rents their housing.  That does take into account multi-family as well.  It's funny, when you look on the list, there are many west coast markets where it appears the same thing can be said.

------------------- 

As for the 2% rule.  I had never even heard of it before getting onto BiggerPockets.com and it  has never been a hard and fast rule for me.  For a beginner - and I was once a very dumb and naive beginner - it would have saved me a lot of headache if I had known about and followed it.  

If a newbie is going to follow no other advice, that simple rule - as flawed as it is - may keep them out of trouble.

http://www.portlandonline.com/portlandplan/index.c...

http://www.fanniemae.com/resources/file/research/d...

http://www.huduser.org/publications/pdf/MemphisTN_...

@Chris Clothier  

Chris good points... I can flat guarantee you that In the SFR's in the PDX area that it is no more than 10% rentals... What your looking at is apartments.. and we have loads of them way more than you have in the mid west .. And they are by and large A class properties that sell for 4 to 5 caps and in Beaverton these apartments support Nike and Intel along with Genentech Fujitsu and many other high tech companies they call it the silicon forest so our multi here is nothing like you see in Memphis.. Last time I was in Memphis I probably drove by 4 or 5 large apartment complexs that were boarded up.. you just would not see that here in Beaverton. Our apartments sell for 80 to 100k a door.....friend of mine bought an 80 unit in Memphis two years ago for 4k a door.. I told him don't do it.. he dropped another 10k a door in it.. and of course it being c class it got destroyed he sold it and lost 400k ..

We build 12k housing units a year here up until the crash but its coming back...  4 to 5 thousand are multi family the rest SFRs I would venture to guess there is a fraction of that kind of activity in new construction for multi in Memphis but I could be wrong....

The reason is houses are not rentals is because medium price is 270k and rent for 1k so its not a real hot bed for investors wanting SFR's as rental houses, it just is not... The rental market is in multi and plex's I don't disagree with total population being renters and owners like you point out.. and my information may be flawed as well about Memphis and I just use Memphis as an example. that's just what many have told me over the years. And when I was foreclosing on dead beat owners from LA there in Memphis when I talked to PM's trying to figure out what to do this was the info I was given.

There is no denying though there is a whole new paradigm  shift from home ownership to rentals for the rest of one's life.

Back to the 2% rule my main point on that was,, if investors stick to the 2% rule and rents never rise which they don't much values will never rise either unless investors are willing to lower their % return... Like J Scott said he is not lowering his return # so he seeks out those areas that it can be achieved and I suspect he has a full blown machine that can make that work.. the average investors trying to buy their first rental if they follow the 2% rule in my personal opinion will be buying in a very tough to manage Ghetto type situation.

I am would venture to guess that the properties you sell don't hit the 2% rule and you would never suggest that investors buy in those neighborhoods.

Originally posted by @Jay Hinrichs:

@Dean Letfus  

  Problem is Dean as I point out.. so many folks at least on this site think this is what they should be doing and if they don't hit that its not a good deal. So I think reality is.. those that live in a community have access to true wholesale deals like Sharad they make this metric easy but those living on the coast they can't come close get frustrated then migrate and try areas that maybe they should not have.

 Jay, you are right, it definitely helps being in a very favorable market like the one I operate in. I had zero RE experience before I joined BP, so all the basics I have learned about RE have come from spending time on BP, including the 2% and 50% rule. I am glad I came across the 2% rule on BP before I bought anything.

Operating in a market where I have (not so much now) access to properties that meet the 2% rule provided a good baseline to quickly analyze a deal. It's a quick and easy way to rule out some properties that don't hit a minimum number that I am looking for.

I went to school in NY and moved to Chicago for my job and that is probably the best thing that happened to my RE career that I was able to get access to my current market. If I lived in a more expensive area, I would probably have chosen either a different strategy or invested in a different market (probably the latter)

I work with overseas and out of state investors that have money to invest, but don't want to have all their funds tied up in one property, so they would rather buy 3-4 diversified properties with a mix of rentals and flips than buy one property. When people come on BP and see other investors in different parts of country getting a much better rate of return than they can get in their own market, it is hard not to seriously look into those markets.

Originally posted by @Dean Letfus:

The only relevant number that never changes I reckon for a flipper or wholesaler are minimum $XX margin on a deal and/or minimum XX% below market value. Also the 100/10/1 rule of course/

 The 2% Rule is for buy-and-hold, not flipping or wholesaling...

And for long-term buy-and-hold, minimum $XX margin or minimum XX% below market value is meaningless...

Perhaps we're talking about two different things?

Oh, and for what it's worth, I'm certainly not saying that anyone should only buy properties that meet the 2% Rule.  People should buy properties that meet their investment criteria, which may be higher or lower than the 2% Rule.  It just so happens that the 2% Rule typically translates to about 12% unleveraged return, which just so happens to be about what I look for.  There's nothing more special about 2% to me...it just happens to work for my needs/wants...

@Jay Hinrichs  - To be fair, I do not know where many 2% deals are located and I would bet that most are found through direct mail, tough digging, great negotiating as well as really good relationships with those that helps find those kinds of deals.

That is for the true 2% deals that actually perform.

I now know where you are coming from on the ghetto type houses and the 2% "on paper" deals and those can only be achieved at super low prices, IMO.  And I think that was your point.  The low priced stuff never performs the way it pencils out.  

Like @Dean Letfus  , I'm trying to rack my brain for parts of this city where you can legitimately achieve a 2% ratio on a consistent basis and the only parts of the city i can think where that may even look possible are areas I would not invest.  I don't think the challenging areas ever perform the way they are penciled on paper.

Now the occasional gem comes along, but like I said above - they only come along rarely and that is because of 10 years of great relationships.

As for your market, you know it best.  I was just pointing out data and how often it can be used or cited in certain ways to say certain things.  Same thing in Memphis and Dallas and Houston.  It takes real experience to be able to say what is really happening and we often have to remind ourselves that markets are fractured even more and it is hard to get data on the street level.  Simply looking at market data can be very deceiving.

@Sharad M.  

  good points  and the 2% rule is alive and well in those mid west markets but not on the coasts.. Why is that??  can anyone answer that question.  Why is the price to rent ratios so good in one area and so poor in another? 

Is it supply demand?

Is it tenant demographic?

Is it low median income  so cant afford higher rents.

Is it ceiling on rents.?

Is it the fact that there is a lot of risk in that asset class and not in others.

Believe me I am all for the 2% rule in the proper context.. And I think your on the right track where you can bring investors in to your program and help them spread risk and return. My point again though is with the 2% rule how will properties ever increase in value if rents never rise or only rise very minimally.?  J Scott won't be buying those you won't buy them then who will buy them.. the less knowledgeable investor?

Just playing devils advocate here :)

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