Does the 2% rule apply when equity gain is involved?

11 Replies

I am purchasing a small house for 70k that is worth 110k at current market value.

The 2% rule suggests that I need to rent the house for $1,400 per month. Since I am purchasing the house for 63% of the market value, it seems that buying it would be a good choice to begin with. 

So in math terms, since the house has 40k in value after the purchase and the 2% rule is based off of the house grossing the purchase price in 50 months, would I take the equity that I have in the house (40,000) and divide it by 50 then add it to my rental rate? This would equate to $1,550 per month over the course of 50 months which fits into the 2% rule...

I ask this because, in my opinion, this is a pretty good deal for me and I would like to use a simple mathematical metric for evaluating purchases like this in the future.

Does anyone have an idea on how I could evaluate this correctly?

The 2% rule is just a way for you to be able to scan through 100 deals in 5 minutes to pick out potential winners. Some good deals will not be 2%. Some 2% deals will be bad deals. That is why it is always good to run your own pro forma for every deal. That said the 2% rule is monthly rent / purchase price. Equity or a down payment in the deal does not affect that ratio.
IMO I am mor concerned about the rent I can get in relation to my all in cost. If I pay 50k all in for a house that gets 1k in rent and is worth 100k I am happy as can be.

So in essence, the 2% rule is more of a "2% guide"? 

That makes a little more sense. I see many people discussing it, but have never seen anyone touch base on if an equity gain matters in respect to this rule.

Thanks for clarifying it for me!

You can't base your rent on what you pay for a property.  You can only base your rent on what the market rents are for that area and type of property.  It has nothing to do with equity.

You buy and rehab a property and you're all-in at $100,000. You're able to rent the property for $2,000 per month. That means that you've achieved 2% rent to cost ratio. That's it.

Originally posted by @Dawn Anastasi :

You can't base your rent on what you pay for a property.  You can only base your rent on what the market rents are for that area and type of property.  It has nothing to do with equity.

You buy and rehab a property and you're all-in at $100,000. You're able to rent the property for $2,000 per month. That means that you've achieved 2% rent to cost ratio. That's it.

 I think you may have misunderstood my question. (Or perhaps I wasn't clear) I understand that the 2% rule is not about basing your rent on the purchase price.

As you will see in my original post, I never mentioned anything about basing my rent on anything other than what is it currently being rented for (which is at the current market rent value).

My question was geared more toward using the 2% rule toward deals where the buyer gains a reasonable amount of equity. 

For example, if you purchase a house that is appraised at $200,000 for $100,000, it's obviously a good deal for the buyer even if the house only rents for only 1.5% of the purchase price because you are still covering the mortgage payment as well as gaining a nice $100,000 in property value outside of the purchase price.

What percentage of equity would have to be gained in order for someone to reasonably decide to take a "hit" on rental a rental value based on the 2% rule? 

Or perhaps should this specific type of situation not relate to the 2% rule at all?

Originally posted by @Andrew Zwicker:
Originally posted by @Dawn Anastasi:

You can't base your rent on what you pay for a property.  You can only base your rent on what the market rents are for that area and type of property.  It has nothing to do with equity.

You buy and rehab a property and you're all-in at $100,000. You're able to rent the property for $2,000 per month. That means that you've achieved 2% rent to cost ratio. That's it.

 I think you may have misunderstood my question. (Or perhaps I wasn't clear) I understand that the 2% rule is not about basing your rent on the purchase price.

As you will see in my original post, I never mentioned anything about basing my rent on anything other than what is it currently being rented for (which is at the current market rent value).

My question was geared more toward using the 2% rule toward deals where the buyer gains a reasonable amount of equity. 

For example, if you purchase a house that is appraised at $200,000 for $100,000, it's obviously a good deal for the buyer even if the house only rents for only 1.5% of the purchase price because you are still covering the mortgage payment as well as gaining a nice $100,000 in property value outside of the purchase price.

What percentage of equity would have to be gained in order for someone to reasonably decide to take a "hit" on rental a rental value based on the 2% rule? 

Or perhaps should this specific type of situation not relate to the 2% rule at all?

 My apologies, I realized after my last post that I did not in fact state the fact that I am renting the property out for $750 per month. I managed to mix up another post I had made on another section of BP and this one.

I don't know if there's way to incorporate the equity into the 2% rule. I think you're getting a little bogged down in the formulas. As was said earlier, it's just a rule of thumb for quickly scanning properties, if you find what appears to be a deal, then dig deeper into the actual numbers for that specific property. In some areas the 2% rule isn't even achievable. It's a conservative rule to keep people (esp new ppl like myself) out of trouble. All that being said, buying smart is always advisable. It's good to have multiple exit strategies. If it doesn't work as a buy and hold you could always dump it if you bought well. Just be honest with yourself as to the comparables. Is the market value as-is right now $110K? If so, why's this other person selling for $70K? If you don't do anything to this house, what makes you think you could sell it for more then it's currently listed? If this is fresh on the market, maybe it's under priced and you got a deal, however if it's been on the market for awhile and has been through some price reductions then it's probably close to market value.

If you're taking a "hit" every month it's a bad deal. Do not buy a rental if it will not cash flow. Flip out of it.
Originally posted by @Edward Barnes :

I don't know if there's way to incorporate the equity into the 2% rule. I think you're getting a little bogged down in the formulas. As was said earlier, it's just a rule of thumb for quickly scanning properties, if you find what appears to be a deal, then dig deeper into the actual numbers for that specific property. In some areas the 2% rule isn't even achievable. It's a conservative rule to keep people (esp new ppl like myself) out of trouble. All that being said, buying smart is always advisable. It's good to have multiple exit strategies. If it doesn't work as a buy and hold you could always dump it if you bought well. Just be honest with yourself as to the comparables. Is the market value as-is right now $110K? If so, why's this other person selling for $70K? If you don't do anything to this house, what makes you think you could sell it for more then it's currently listed? If this is fresh on the market, maybe it's under priced and you got a deal, however if it's been on the market for awhile and has been through some price reductions then it's probably close to market value.

 This house is from someone in the family, so that's why I am getting a pretty good deal on the house. I had it appraised and it came out to be 113k after appraisal. Thank you for your response. That clears things up for me quite a bit!

Originally posted by @Chad Coates :
If you're taking a "hit" every month it's a bad deal. Do not buy a rental if it will not cash flow. Flip out of it.

 Sorry, I meant "hit" as in it being under the proposed rental rate calculated by the 2% rule even though I am still in the black.

seems like rent vs purchase price runs more like 1% in most local areas based on MLS.

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