The 2% rule is the most brilliant ever

61 Replies

The 2% rule  TEST is a quick screening tool for rentals. It says:

"The monthly rent should be about 2% of the purchase price for a rental to be a good cash flowing rental"

I really don't know when People here started using 2%. Traditionally it has been 1% but in normal interest rate climates 1% does not work very well.  

The point is, once you figure the right percentage for your goals and your market. Then this can quickly rule out 90% of deals with a quick top of your head calculation. At any given time there are thousands  of properties on the market. You obviously can't do an in depth analysis of all of them so you need a quick screening tool to eliminate the ones that are simply not even close to a deal. 

That is exactly what this tool is designed to do no more, no less.

Don't let the naysayers tell you every property deserves an in depth analysis. They want to take away a valuable screening tool. Time is your most important asset.

Of course, it isn't brilliant but I do appreciate the counter to Ben's post and I appreciate the sentiment. There are times when lots of deals cross my desk. Many are crap. Some are interesting. A few are really interesting. I don't want to miss drilling down on the really interesting ones because I was wasting time analyzing the crap and didn't get to them fast enough. There is not usually much time to make a decision on the good stuff. It takes about two seconds to apply the 2% rule (or whatever rule of thumb I am using at the time) and I can do it with one hand on the delete key. If it fails it is gone and I move to the next proposal. Will I miss some good deals this way? Maybe, but I am more concerned that I don't miss the great deals. There are much fewer of those and I am not the only one who will see them. I want to be first or, if I am not first, I want to show my interest before another offer has been accepted. I don't want to wallow in the crap.

I personally like the 2% rule for what it is.  I don't like it for what it's not.  It's definitely not the one and only metric for analyzing a property's worth.  It's a good indicator of cash flow.  But it's not a good indicator for a property's "headache value".

If a property scores high on the "2% rule" metric, and low on the "headache value" metric, then it's definitely worth an investigation.

What's the "headache value"?  Would I want to walk the neighborhood by myself at night?  If not, the headache value is higher because if it's a bad area I'm not going to be able to get good tenants and therefore that would give me a headache. There's a lot of crappy properties in Milwaukee and its important to know what would make a good solid rental versus what's just going to be a headache.

This varies by market, property type and of course location.  In my market of Tulsa, if you find anything that meets the 2% rule, you either stole from someone else, bought in an area that I wouldn't go (I'm 6'3" & 300lbs with a gun license) or you won the real estate lottery.

In markets where high property taxes deflate property values, Texas, the Northeast, California and others, sure....the 2% might be of use.  But after you factor that tax bill into your numbers, what does your overall return look like?  What....it's comparable if not worse than my property that couldn't touch the 2% rule.  No way....Say it ain't so....Can't be.

What about condos or other properties that have higher holding expenses that weighs down on value.  Same thing.  Total numbers is what counts and in my market the 2% rule is a total waste of time.  That said....with enough deals....I might hit the real estate lottery once or twice before I am done.

While there are limitations to the rules of thumb, in most cases some filtering will need to be done based on gross rents and property value.  

It maybe that as people become more experienced/knowledgeable about their markets that they get more specific about the screening criteria.  They may even know the properties/market so well that they can do the evaluation without really knowing it.  For example if rents typically top out at 2000/month, then you can't pay 600K for a property even if it might be 50-100K "under-priced".  I think those ignoring the rules of thumb, are doing so because they are so focused on potentially profitable areas, they already are ignoring what the rules of thumb filter out.

Where I think a gross ratio can be very useful is evaluating a potential new market.  Maybe you miss some, but it should allow you to pass on a market if things are completely out of balance.

It almost feels like this post is a poke in the side to mister 

@Ben Leybovich  .... NAwww couldn't be!

@Chris Simmons  

  CA  would definatly not fall into a 2% rule conversation and for that matter most of the west coast... 1% and you can get there... But 2% would be just as you state.. You stole it from a little old lady and now you have to live with that bad juju the rest of your life.. Your family gave it to you... and you won't find the 2% rule in the west coast hoods still going to be 1% or so.

2% works very well in mid west generally or any of the major mid west rust belt major cities and in the lower end areas that are really just all rental based.. No real value other than buying a property that creates a cash flow...Like buying a financial instrument only this one is made of wood brick etc and you have to work it monthly for you financial instrument to produce and pay a dividend. 

Originally posted by @Jay Hinrichs :

@Chris Simmons  

  CA  would definatly not fall into a 2% rule conversation and for that matter most of the west coast... 1% and you can get there... But 2% would be just as you state.. You stole it from a little old lady and now you have to live with that bad juju the rest of your life.. Your family gave it to you... and you won't find the 2% rule in the west coast hoods still going to be 1% or so.

2% works very well in mid west generally or any of the major mid west rust belt major cities and in the lower end areas that are really just all rental based.. No real value other than buying a property that creates a cash flow...Like buying a financial instrument only this one is made of wood brick etc and you have to work it monthly for you financial instrument to produce and pay a dividend. 

 Not finding many at 2% in most of the Northeast, either.  As for the (indisputably) high property taxes depressing values?  Hah!

Originally posted by @Jeff Rabinowitz :

... It takes about two seconds to apply the 2% rule (or whatever rule of thumb I am using at the time) and I can do it with one hand on the delete key. If it fails it is gone and I move to the next proposal. Will I miss some good deals this way? Maybe, but I am more concerned that I don't miss the great deals. ...

So you're in an area where you can't ever find a 2% deal. But there is very likely some other percentage, whether it be 1.5% or 1.25% or even 1%, that allows for the quick "no deal" decision. That's the point I think Jeff was driving at, and that is what your takeaway should be from this sort of discussion. 

@Jay Hinrichs I'm going to have to disagree with you about California. I closed on a 2% deal in November and I'm setting my sights on another as we speak. Both are located in inland desert areas of California. There are some markets in California that act more like the Midwest and don't see a ton of appreciation, but still have strong rental demand. I would imagine the same exists in the Pacific Northwest although I haven't looked extensively. Just for fun, I was looking at Tacoma properties on the MLS awhile back and many seemed to hit 1% no problem, so that tells me 2% is probably doable for those that look hard enough.

The problem is many newer investors don't want to put in the months of research. They want deals to fall in their lap like in the good ol' days of 2009-2011, so when they look at the MLS and don't see any deals after an hour of searching, they give up and declare 2% (or 1%) can't be found in their market.

I expect this thread to generate so much OUTRAGE from some that that the BP site crashes!
Anyone want to make a wager? I will bet my $2 to your $98. I do like to hedge my bets:)

John Thedford, Real Estate Agent in FL (#BK3098153)

Drama free is rule #1 for me 

@Brent Seehusen  

  Yes I was to general in my statement I know for sure you can find 2% in CA OR and WA. Its just not nearly as easily obtainable as it is in the mid west were you can buy 2% relatively easily with little effort. 

Just like you can go to a place like Cal Pines up in Altura's and buy a beautiful 1 acre buildable lot for less than 5k.. Just like you can buy desert lots in your area cheap..

I think when people put this in context they are talking the greater CA metro areas.

I have done a few loans in Tacoma one was a nightmare that I foreclosed on there is some pretty tough rental demographics there so that town has risk reward scenarios.

But just look no further than Brandon Turner of BP his holdings are in coastal central Washington the Aberdeen area you can buy low end stuff there as these are old logging towns that have died... Same with rural Oregon logging towns that have 30% unemployment... Lots of factors..

Cool Helicopter is that a R 44?  sr 22 driver here.

24% returns means that it's high risk in a soon to be vacant property.  You will never find that in NJ or NYC.

@Dawn Anastasi  

I love the term 'headache value' as a metric for analyzing rental properties and wish to state this hypothesis : The headache value of a property is directly proportional to the ROI'. Extraordinarily high ROI is a recipe for disaster and should be a red flag to any sensitive investor. That explains why C- & D neighborhoods attract the highest rents.

 The conclusion is that real estate investing is not a get-rich-quick  venture; you build wealth with time.

Thanks 

Originally posted by @Ned Carey :

The 2% rule is a quick screening tool for rentals. It says:

"The monthly rent should be about 2% of the purchase price for a rental to be a good cash flowing rental"

I really don't know when People here started using 2%. Traditionally it has been 1% but in normal interest rate climates 1% does not work very well.  

The point is, once you figure the right percentage for your goals and your market. Then this can quickly rule out 90% of deals with a quick top of your head calculation. At any given time there are thousands  of properties on the market. You obviously can't do an in depth analysis of all of them so you need a quick screening tool to eliminate the ones that are simply not even close to a deal. 

That is exactly what this tool is designed to do no more, no less.

Don't let the naysayers tell you every property deserves an in depth analysis. They want to take away a valuable screening tool. Time is your most important asset.

Ned, if the 1,000 properties are in the same market why would they rent at a different multiple of the market value?  If someone is asking over market then you would not pursue that "deal" just because the seller did not know how to price?  If it was a true 2% market then you would just make your offer accordingly and educate the seller as to his actual market value.  See how this screening out process failed?

If the 1,000 properties are in different markets then each market would have its own rent ratio and screening all markets at 2% just means you are NOT a buyer in certain markets.  I don't see how this 2% is an effective screener.  Can you explain better how you use it?

@Jay Hinrichs  is right - there are deals to be found around. I get 2% deals occasionally, but there are a LOT of factors that go into that, including high unemployment rates and deadbeat tenants. So someone's "2% Rule Deal" and my "2% Rule Deal" are completely different.  

That said, @Ned Carey   and I had a conversation tonight, and we are going to officially change the name of "The 2% Rule" to "The 2% Test" - as in "This doesn't pass the 2% Test, but it does pass the 1% test."  This makes WAY more sense and less newbies will think this is some kind of "Rule" they need to follow. 

So yes, we're creating a new term. You heard it here first. 

The 2% Test. 

What say you, @Ben Leybovich  ? Better terminology? 

How about the 2% Market and the 1% Market and the .8% Market?  Rents are established by the MARKET.  Sales prices are established by the MARKET.  Rent ratios are established by the MARKET.  In each of those markets investors are evaluating "deals" and come to the conclusion that the rent ratio they buy at is profitable.

@Brandon Turner   I like the word Test!

i think the key as with anything is determine what you "metric" for ruling something out. The thing is you want to be able to reduce time, so you can focus on the good one. I personally have a cash on cash number after mortgage/insurance/tax before "expenses". That is what I use to determine a deal for me. 

Originally posted by @Bob Bowling:

How about the 2% Market and the 1% Market and the .8% Market?  Rents are established by the MARKET.  Sales prices are established by the MARKET.  Rent ratios are established by the MARKET.  In each of those markets investors are evaluating "deals" and come to the conclusion that the rent ratio they buy at is profitable.

 I think you have markets and you have properties.  

A nice 2 BR condo might rent for the same as a 4 BR SFH that is a little dated. In most markets the SFH will cost significantly to purchase.

Originally posted by @Brandon Turner:

That said, @Ned Carey   and I had a conversation tonight, and we are going to officially change the name of "The 2% Rule" to "The 2% Test" - as in "This doesn't pass the 2% Test, but it does pass the 1% test."  This makes WAY more sense and less newbies will think this is some kind of "Rule" they need to follow. 

So yes, we're creating a new term. You heard it here first. The 2% Test.  

I think test is a much better term.  I think that is how they are used by most experienced investors.

Originally posted by @Bill Gulley :

Ned:

Horsefeathers!

Buy a calculator and sharpen a pencil. LOL 

My area is nowhere near 2%!  :)

 That is the shortest post Bill G has ever written. I don't know if I should feel honored or offended LOL. 

PS Mine neither Bill. I want my deals to be about 4%

Originally posted by @Jesse T. :
Originally posted by @Bob Bowling:

How about the 2% Market and the 1% Market and the .8% Market?  Rents are established by the MARKET.  Sales prices are established by the MARKET.  Rent ratios are established by the MARKET.  In each of those markets investors are evaluating "deals" and come to the conclusion that the rent ratio they buy at is profitable.

 I think you have markets and you have properties.  

A nice 2 BR condo might rent for the same as a 4 BR SFH that is a little dated. In most markets the SFH will cost significantly to purchase.

 EXACTLY!  Market rent ratios are specific to TIME, LOCATION & PROPERTY TYPE.  So any rule or "test" based on some static number is meaningless. 

If the condo and the SFH rent for the same but sell at different prices it is because the MARKET has determined that, for some reason, the value of the exact same rent is different.