2% Rule vs. Rule of Two

[Justin Foster]

I'm reading a free book on REI from http://iloverealestate.tv/ in which the author talks about a rule she made up called the Rule of Two. In this, you divide the purchase price by 1,000 and multiple that by 2 in order to get the minimum weekly rent you should charge.

(Purchase price / 1,000) X 2 = Weekly Rent

In the 2% rule, we multiply purchase price by .02 to get the monthly rent that we should try to get close to.

So lets say a property has a purchase price of $200,000.

Rule of two gets us $400 weekly rent. Multiplied by 4.3 for the average weeks in a month, we get $1,720 monthly rent to use as a starting point.

2% rule of the same price shows us to get close to $2,000 monthly rent.

While these two results are close to each other, there's still a significant difference between them. Which one would be more useful to go off of? Or would it be useful to use both and go for a number in between the two?

[Don Konipol]

The 2% rule is a very good quick analytical tool, but has a number of limitations. One of the most significant is that it does not take into account differences in property age and quality. So it assumes a ragged out property 40 years old poorly constructed with a high annual repair cost is worth the same to an investor as a brand new well constructed property - as long as the rental income is the same. This is because for the "rule" to work expenses for each property , i.e. repairs, depreciation, vacancy, taxes, insurance, management, etc. must add up to the same percentage of rental income.

In my experience real operating expenses have been anywhere from 38% to 65% of rental income. Further, the rule does not account for a risk factor, nor the probability of property value increases - or decreases.

The 2% rule seems to work best when utilized for lower blue collar type single family homes in stable areas. Outside this parameter, a different "rule" is needed.

While a good starting point - sometimes - strict adherence will cause the investor to pass on some good investments not fitting this criteria - and limit the investor to somewhat lower end properties. However, it will probably also keep the investor from making a serious mistake.