Explain This

13 Replies

Originally posted by @Bob Bowling:

If the market rents are $800 the market value will only be $40,000.

 Because 800 is 2% of 40k.   

2% rule means monthly rent = 2% of purchase price. or value.  

For me the 2% rule was really only worth paying attention to from the end of 2008 till some time around 2013.  These days 2% deals can still be found no problem but you will find vast majority of investors (especially on BP) prefer to be somewhere around 1.2 - 1.7%.  Not that they want a lower return, but they just favor the more expensive assets.  

That is my observation at least.  

Originally posted by @Ryan Mullin :
Originally posted by @Bob Bowling:

If the market rents are $800 the market value will only be $40,000.

 Because 800 is 2% of 40k.   

2% rule means monthly rent = 2% of purchase price. or value.  

For me the 2% rule was really only worth paying attention to from the end of 2008 till some time around 2013.  These days 2% deals can still be found no problem but you will find vast majority of investors (especially on BP) prefer to be somewhere around 1.2 - 1.7%.  Not that they want a lower return, but they just favor the more expensive assets.  

That is my observation at least.  

 The 2% is not a return.  In fact in general it identifies less profitable properties. 

Here is the 2% ratio:

Monthly rent / purchase price

The monthly rent does not determine the market value of the property. Properties under 5 units are appraised based on comparative market analysis (comps). Properties 5 units and more are appraised using an income approach.

The 2% rule is just a way for you to quickly scan 100 properties and in 5 minutes identify likely candidates for further investigation.

For example, if I'm looking at 100 properties on MLS and I see one that is priced at $100k that rents for $2,000/mo, that property meets the 2% rule. I then want to take that property and investigate location, comps with other properties, inspect the property, etc.

Do not base your investment decisions on the 2% rule.

It is possible to take a $100k property currently renting at $1k/mo (1%) and increase the rents. It is also possible that a 2% property has unsustainable rents, is in a poor appreciation area, or is a bad investment for any other number of reasons.

Originally posted by @Jonathan Towell :

Here is the 2% ratio:

The 2% rule is just a way for you to quickly scan 100 properties and in 5 minutes identify likely candidates for further investigation.

For example, if I'm looking at 100 properties on MLS and I see one that is priced at $100k that rents for $2,000/mo, that property meets the 2% rule. I then want to take that property and investigate location, comps with other properties, inspect the property, etc.

How does this work in real life? I am familiar with MLS in several states and the number of listings that report rent rates is probably about 1%. So are you overlooking thousands of listings just because they were not rentals or if they were the landlord/Realtor did not input a rent rate?

Why would only one property out of 100 meet the 2% and why would that property interest you?  Even the seller is saying that the property is only worth 2% of the rents.

Gee, if you are in a real 2% market wouldn't it be a lot easier to pick ANY property and offer 2% of the monthly rent?  It seems what you are doing is backwards and a waste of time.

@Bob Bowling

Those are my points exactly. Maybe you're looking at MLS listings, Loopnet, a stack of rentals sent to you by an investor exiting the business, whatever...

I was just explaining what the 2% rule was designed to do, thus attempting to answer the question "what is the 2% rule?"

The 2% rule is not that great a rule and should not be used to make investment decisions.

Real estate is LOCAL. There is no "rule" that you can use. In some markets, you're only going to get 0.7%. In some you may be able to find 2%. It all depends on where you are looking and what class of properties you are looking at. Nicer homes usually bring a lower %, where C/D/E class neighborhoods will bring higher. They will also likely have higher repair costs, vacancy, etc.

There are no real rules to RE. Everyone's goals, time availability, risk aversion, location, and everything else is different. Do what fits your style and abilities.

Originally posted by @Matthew Mason :

so if the 2% rule is not that accurate, which would be a more accurate rule to find rental property or does it depend on what works for you?

 Look for a cash flow (negative or positive) that you can live with today and then look for profit generated by 1.  rent growth and 2. appreciation.

Matthew,

The 2% rule aims to juxtapose the gross revenue of the asset to the value, and stipulates that if the revenue is as much as 2% of the purchase price, that the acquisition will make money relative to CF. There are many issues with this line of thinking:

Basically, this is a variation of what is known as GRM analysis (Gross Rent Multiplier). The 2% being the multiplier in this case. The issue, however, is that when considering the Gross Potential you are not talking about real numbers. Gross income is just the top line, and as you can understand, the income doesn't become "real" until the expenses are backed out - in this case we are talking about the NOI, of course.

Besides the obvious expenses, there are also expenses that are a function of the type and quality of asset, and those are called Economic Losses. But that's another conversation...

Now - don't you agree that you could have 2 buildings with identical top-line limbers, but very different expense structures? And since we care much less about the top line, and much more about what's left of it after expenses, we should likely base out valuation decision on that NOI figure - 2% rule does not do that, which makes it criminally incomprehensible as an analysis tool, let alone a "rule".

In order to use the NOI as the baseline income we cross over to the capitalization method of valuing property, whereby the NOI is capitalized via a multiplier know as the capitalization rate to arrive at a valuation.

Finally, to Bob's comment, since cash flows are not static and must be discounted for time, inflation, and opportunity cost, a complete analysis would underwrite to the IRR (internal rate of return), which would take into account all of the movement of cash, including the exit which captures the appreciation and rent growth, if there are any. But, that's a separate convo all together :)

Hope this helps!

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