How would you improve upon the 2% "rule"?

Question

I've struggled, along with others, with the 2% rule. It has some drawbacks which I think can be improved upon with BP community help.

Simply stated, the income from a house should be greater than or equal to 2% of the mortgage.*

The * is that the rule doesn't apply to some markets like much of California or most major metropolitan areas. In other markets, you can get 3% where houses are cheap and repairs are about the same, turnover is high, or crime is higher ... for Josh, we'll say, Detroit.

In certain parts of Atlanta, you can sometimes only get 1% rule houses. However, they are less desirable areas, e.g. C or worse. In the A areas, you'd do well to get an 0.75% house.

House price also has a role, right? A 1985 construction, 2000 sf house that costs $400,000 in a more desirable part of town is going to have similar repairs to the same house in a less desirable part of town where the same house costs, $50,000.

To me, houses should be graded like bonds or stocks. Risk should play a much bigger role in the evaluation.

How do you deal with or adjust for these issues, if it all?

Michael Seeker · Answer

...completely ignore the 2% rule and use a localized rule that works for the parts of town that I'm interested in investing in. As somebody who self-manages my properties, I put a lot more weight on the location and type of renters I can attract than on maxing out my returns because the returns don't factor in the additional work that is required on the higher return properties. If I were paying a PM that would manage a 3% property the same way as a 1% property and charge the same percentage, I'd go after a lot more 3% properties.

Chris Martin · Answer

the 2% rule.... it is not 2% rule of law, it is 2% rule of thumb. The real estate 2% rule, 1% rule, etc., are used to simplify the equation and are not dissimilar to anyone analyzing stocks who uses a price to growth ratio rule of thumb (PEG ratio) or price to earnings ratio (P/E) rule of thumb. Different sectors have different PEG and P/E 'norms', kind of like different areas of the US have different 'norms' of 2% and 1% applicability.

Rick Baggenstoss · Answer

Looking at my own portfolio, the income from my properties is negligible compared to appreciation. Of course, I've been buying most of them since the downturn.

@Don Konipol I'm thinking in some markets the 2% rule will encourage you to buy lower appreciating properties say 3% per year vs. 4% per year. With a $1M portfolio ... you'd lose ~$5k per year in income.

For illustrative purposes only, I'm assuming 2% house in Class C area appreciates 3% and a 1.5% house in Class B area appreciates 4%.

Rick

Don Konipol · Answer

You CAN play the 2% rule in most markets. However, except for the once in a lifetime great buy, you will end up with low income property with low price appreciation potential.

Assuming a 50% net operating income, the 2% rule yields 12% return on purchase price, as if purchase price is paid in cash.

On residential investments I buy class A high rise luxury condos, and expect a 7-8% return. Seems like I get about 1.25% rather than 2%. However the value of the condos I purchased 2 years ago has gone up about 60%.

You probably won't lose money using the 2% rule. You may not acquire much property either.

Mark Ferguson · Answer

@Gerald K. Very true about hurricanes and flood zones adding more costs. I try not to factor in any appreciation in my calculations because I can't predict the future. I think of appreciation. As a bonus.

Gerald K. · Answer

And some places have hurricanes, tornadoes, hail the size of baseballs, sink holes, known foundation problems, harsh heat in the summer and severe cold in the winter - all increasing maintenance costs. Other places have mild weather. Lots of variables. @Robert Piller 's idea about factoring in appreciation could have some value. It's quite true that some places are known to be cheap, cashflow well, but don't appreciate much, and vice versa for other places.

Mark Ferguson · Answer

Real estate is a local game. I think rules that try to encompass the entire country with broad rules simply don't work I local markets. To be successful you have to analyze each deal and all the numbers. For example; in Colorado my property taxes are aprox. .05 % of the value of a home. In other parts of the country taxes are five times that or more. On my rental house that can be. 10 to 20% difference in expenses. How can the 50% rule or 2% rule be applied to two different areas with such different costs.

Dawn Anastasi · Answer

Instead of calling it the "2% rule" maybe call it the "2% metric". The metric would be a measurement of cash flow. There would be other metrics for appreciation, etc. and you would use the metrics based on what your goals were.

Brandon Turner · Answer

Hey @Rick Baggenstoss welcome to the site! Great to have you here! If you haven't checked out the The BiggerPockets Podcast yet, I highly recommend it!

Robert Piller · Answer

Good question and thread.

Here in Austin it seems like too many people are willing to go as low as 1% of purchase price (or lower) just to "do a deal". I stay far, far away from those 1%-1.5% deals.

Whatever formula(s) you decide upon --and @Thierry Van Roy mentioned several good ones -- stick with them. Be resolute.

Depending on the neighborhood, purchase price, ARV, exit strategy and a few other factors, these can certainly be weighted.

I personally think the 2% rule is very useful -- as is Maximum Allowable Offer. Yes, they are rules of thumb, but I have had significantly better success on buy and holds on my houses under $75K -- as they are much easier to abide by the 2% rule, as they are are more affordable to a broader audience.

My houses above that price point are the ones that have yielded the lowest overall ROI to my portfolio over the years.

It is much harder to get 2% on $200K+ houses-but they may also yield the biggest appreciation when they are sold--so perhaps that should be weighted into the formula, as well.

How would you improve upon the 2% "rule"?

How would you improve upon the 2% "rule"?

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