How Accurate Is The 2% Rule?
Realtor · Denver, CO · Member since 2016 · 162 posts · 37 votes
I have been reading about the 2% rule but seriously questioning its accuracy. I got a great deal on a house in a desirable area of Austin for $297k. The rental we are getting is high ($2500) for the area. However, according to the 2% rule, the rent should be $5940. I don't know many places in New York where you would pay that for a comparable property. What % have you found when dealing with rentals?
@Brandon Turner tried to get people to call it the 2% test. That is a much better way to look at it.
The "2% test" is not even necessarily 2%. You have to figure the number that works for you with your goals and in your market. In some areas that may be 1% and others 3% may be realistic.
The point is this is a quick screening tool to see if a deal is close to being a deal. I can use this test in my head in about 5 -10 seconds. That saves me a LOT of time ruling out deals that aren't worth more than 10 seconds to look at.
Nobody says that a rental Has to be at least 2% or that a rental Should be 2%. It is a quick rule of thumb to let you know that if it is 2% you can pretty much count on that deal working from a cash flow perspective.
@Ned Carey Fascinating. If the population is dropping and there are fewer buyers, why would flipping or buy to let properties be successful there?
There are many complex factors that go into it. Today the population is not really shrinking much and may have even reversed. However the legacy of having thousands of vacant houses and an oversupply remains. I think the bigger issue is the lack of financing for many low to middle income people.
There is a disparity between nicer properties that are increasing in value and low end properties where prices are flat
Curious as to what areas you are getting on Oahu that you are getting ~1% rent/purchase price while also getting >$500 of cash flow. I've only recently gotten into real estate, but from what I've seen, the 1% properties here seem to be more like the 1.5 - 2% properties elsewhere (C Class).
Since the cost of real estate here is so high, I'm assuming we're talking about condos. If these 1%, $500+ cash flow, A/B Class areas/buildings do exist I would really like to know about them. Sorry this is slightly off topic from the original post, so please PM me when you get a chance. I would really appreciate it.
For interest sake, I ran a cash flow analysis on a range of property prices and Rent-to-Price ratios. I wanted to see why some investors indiscriminately shoot for 2% or 1% and how that translates to cash flow for a given property price. I thought I'd share these results with the BP community and hopefully shed some light as to when 1% or 2% Rules make sense.
I made the following assumptions:
1) Properties purchased with a 30 year loan, 5% fixed annual interest, and 20% down payment.
2) Expenses estimated using the 50% Rule.
Sorry if it's hard to read, but it gets larger if you open the image in a new tab.
I color coded the Cash Flow based on the following criteria.
Red: Cash Flow < 0. Yellow: 0 < Cash Flow < $100. Light Green: $100 < Cash Flow < $200. Dark Green: Cash Flow > $200
Each cell shows the calculated monthly Cash Flow for a given purchase price and Rent-to-Price ratio. For example, at 1% Rent-to-Price, the Cash Flow for a home purchased for $100,000 comes out to $71 per month. Here's the quick math: $100,000 x 1% x 50% - $429 monthly debt payment equals $71 of Cash Flow.
Major Takeaways from this table:
1) There's a minimum Rent-to-Price ratio that must be achieved in order to cash flow positive. That Rent-to-Price ratio is between 0.85% and 0.90%. The exact percent will vary on the loan assumptions, but for this case (30 year loan, 5% interest, 80% LTV) we begin to cash flow positive at a 0.86% Rent-to-Price ratio.
2) If you're goal is $100 Cash Flow per month, the 1% Rule will only work if you are buying homes that cost about $150,000 or more. So if your price point is below $150,000, then your target Rent-to-Price ratio needs to increase in order to achieve that $100 Cash Flow goal.
3) If you're goal is $200 Cash Flow per month, then the 1% Rule will only get you there at price points that are much higher. It's actually off the chart, but at around $280,000 the 1% Rule will generate about $200 in Cash Flow per month.
Here's what it takes to hit $200 Cash Flow for varying purchase prices.
From looking at the table, obviously a 2% property is generating > $200 cash flow nearly across the board. On paper, these numbers look great. Though in reality, these properties generally tend to be high risk investments. They are often located in higher crime areas and marketed to a less qualified tenants.
Ultimately, I think it's more important to focus on hitting your Cash Flow and cash-on-cash returns criteria rather than fixate on hitting the 2% or 1% Rule. Whatever % you end up getting is more of a byproduct of your investment. It shouldn't define it and it definitely shouldn't be the basis for your purchase.
Prioritize that cash flow and your returns because isn't that what it all comes down to anyways?
Nice graph! But I believe you made quite a bit of assumptions (as you stated). Given CapEx being relatively fixed (we know this), and higher rent/purchase price properties being in less favorable C and D areas (pretty constant with very few exceptions), assuming 50% of rent for expenses for a SFH is a bit silly.
Let me give you a simple example to illustrate this. Property 1 is in a D area with $500/month in rent. Property 2 is in a A area in Beverly hills and rents for $10,000 month. Do you think they both will have 50% of gross rents as expenses over the long term? Not a chance! Property 1 will have more than $500/mo. in CapEx and eviction costs alone. Not even counting the mortgage payment. Property 2 will probably have less than 30% of rents as expenses, and a huge appreciation upside. The 50% rule works in large apartments where the tenants pay the utilities.
Curious as to what areas you are getting on Oahu that you are getting ~1% rent/purchase price while also getting >$500 of cash flow. I've only recently gotten into real estate, but from what I've seen, the 1% properties here seem to be more like the 1.5 - 2% properties elsewhere (C Class).
Since the cost of real estate here is so high, I'm assuming we're talking about condos. If these 1%, $500+ cash flow, A/B Class areas/buildings do exist I would really like to know about them. Sorry this is slightly off topic from the original post, so please PM me when you get a chance. I would really appreciate it.
They do exist, well at least they did exist when I stopped buying here in 2015. Yup, they are condos. Luckily for us, condos still appreciate quite a bit in Hawaii. I think you may get lucky with hunting for an off-market deal and/or paying cash really quickly. I will be posting an example of one such property shortly, stay tuned.
Sure, the 50% rule will overestimate expenses for high-end luxury expensive SFRs and underestimate Class D sub 30k rentals. Though I'll bet that most investors here on BP aren't pursuing properties that rent for $10,000 in Beverly Hills. That's why I didn't include homes over $200k. I was looking for general trends in cash flow so I used a widely accepted rule in assuming 50% expenses to help make my life a bit easier.
Not accurate at all! https://www.biggerpockets.com/renewsblog/2015/05/06/2rule-die-horrible-death/
Sure, the 50% rule will overestimate expenses for high-end luxury expensive SFRs and underestimate Class D sub 30k rentals. Though I'll bet that most investors here on BP aren't pursuing properties that rent for $10,000 in Beverly Hills. That's why I didn't include homes over $200k. I was looking for general trends in cash flow so I used a widely accepted rule in assuming 50% expenses to help make my life a bit easier.
Fair enough. "Widely accepted" is a strong statement, though.
@Joe Splitrock 100% agree. I hate cash flow as a metric of anything. Like you said, you can put in 200K and cash flow 500 per month with an all cash purchase. But unless you are retired and depending on the cash flow to buy groceries, its mostly a meaningless metric. I care for overall ROI and IRR. And diversification and risk management. Yes appreciation is locked in until sale (not really because you could technically borrow against it) but so what? Wealth is always invested somewhere. Stocks, RE, Bonds whatever. Yes RE is less liquid but to say appreciation is no good cause its locked in is silly. Appreciation when it happens will always trump cash flow by many orders of magnitude. Having said that, there is room for both in a portfolio. I dont have only dividend stocks or only growth stocks or only appreciating RE or only cash flow RE. Dont get caught up in the dogma of 2% and 1% and cash flow vs. appreciation debates. Why cant a well balanced portfolio have all of the above?
One thing I can say that seems to be pretty on the money is the "50% rule" - or should I say 50% test.. and that is that generally speaking over the lifetime of owning the property, about 50% of the gross rent is going to go towards expenses. Take your rent, divide it in half. If you paid all cash - you now have your true net cash flow. If not, minus your mortgage P and I and THAT is now your true net cash flow (over time).
Like when you have a rehabbed rental but the market demand is very slow for your bed/bath configuration - though just 6 months ago it wasn't, that same configuration leased up pretty quickly - and you're up on a cash-out refi but have no tenant in place yet, so you'll be paying out of pocket for that mortgage shortly until it's leased.. oh and there's leaking pipe you now have fix in that same place...
ask me how I know how this test is apparently a very valid one :-)
May hold true for your market if you are in the sweet spot of narrow rent ranges and property type where it happens to work. I can tell you it is way out of whack for my market. Think about it a bit ... a 4-plex in CA rents for $2000 a unit. Take that same exact 4-plex, with the same exact floorplan, and move it to Phoenix where the rents would be $1000 a unit (and the purchase price much lower). You telling me that the same exact 4-plex would have half the expenses just by moving it to a different market? I don't think so, but that's what the 50% rule implies ... look, guys, don't follow any of these rules of thumb or believe any advise you hear from anyone on this site (including me) as gospel, as that is just a shortcut to get around thinking for yourself and will be sure to land you in trouble (especially following the 2% rule as that is the most dangerous one by far IMO)... educate yourself, try to understand the governing dynamics and rationale behind suggestions; and for goodness sake do your own independent analysis, make up your own mind, and be intimately familiar with the rationale and assumptions that lead you to that decision so that you can back test them against reality and evolve your way of thinking in the future.
I personally don't think that paying close attention to a hard and fast rule is a very good option. Look at what cash flow you want, how active you want to be, how much work you want to put into a property, and then make your decision based on an income vs. expenses approach. If your calculation regarding expenses is exhaustive (consider everything, there are tons of resources on here to do that) and you meet your personal cash flow goal then pull the trigger. Make your rule based on your cashflow goal....not an arbitrary percentage.
These rules of thumb (2% rule, expenses are 50% of gross rents) are simply shortcuts to doing a full financial analysis. Therefore they're incomplete, and need to be adjusted for your own personal investing criteria and your area.
But with that adjustment they can be very helpful in sorting potential deals in three categories - probably no, probably yes, and maybe. All would deserve further analysis if being seriously considered for investment, but it helps as a first level of screening.
For interest sake, I ran a cash flow analysis on a range of property prices and Rent-to-Price ratios. I wanted to see why some investors indiscriminately shoot for 2% or 1% and how that translates to cash flow for a given property price. I thought I'd share these results with the BP community and hopefully shed some light as to when 1% or 2% Rules make sense.
I noticed that the purchase price only goes up to $190k. I feel bad asking this but as the table is so expertly created, would you be able to extend the table to go from $350k to $750k (typical purchase price range in San Diego)?
To your request. I extended the range of the analysis between 350k and 750k. The only problem is what expense ratio to use. 50%? Probably not. I know I'll get a lot of people to gripe that expenses are being overestimated if I assume the 50% Rule. If anyone has experience owning rentals at this price range and wants to suggest a good or realist expense ratio, please do so.
For the time being, I'm assuming an expense ratio of 45% at $350k. Then I'm linearly dropping that down 0.25% for each additional 25k jump in price. This way, I'm not penalizing higher priced properties by assuming the same expense ratio.
Also, I'm adding a Cash-on-Cash table for this price range using the same cash flow numbers in the first table.
Here you go :)
@David Lowe whoops, ignore the last post with the 2 images. The data tables were mostly correct, except I forgot to update the formulas for rent/price rows 0.5%-0.7%.
Here's an updated correct version.