Listen, guys, I hate to get feisty, but some truths need to be revealed about the infamous “2% rule.” I’m going to spell out some of these truths, so listen carefully. I can only dream of the day that I get on the forums and I don’t hear a single person ask any of the following questions:
- How come I can’t find any properties in my market that meet the 2% rule?
- What if I found a property I like, but it doesn’t meet the 2% rule?
- Where can I find properties that meet the 2% rule?
Sound familiar? Been wondering about any of those yourself? Well, let’s all work to get the 2% rule concept solely to the background of any thoughts about buying properties, and I’ll tell you why.
Note: In no way do I want to suggest that if you have been asking any of these questions, it’s your fault for thinking it’s a thing or you’re a dumb investor or anything like that. If I were just starting out, I’d think I need to do something with this rule, too. It’s not your fault. It’s simply “misleading marketing.” It can get the best of anyone.
What is the 2% Rule?
Some of you might be wondering, “What is this “rule” she keeps ranting about?”
The 2% rule says that the rental amount a property brings in should be at least 2% of the total purchase price of the property. The 2% rule pertains specifically to rental properties.
So, for example, if you are looking at a property that costs $100,000, then the rent you would need to be able to collect in order to meet the 2% rule would be $2,000/month. Make sense? Because $2,000 is equivalent to 2% of $100,000. Let’s say you find a property for $80,000, but it only rents for $1,000/month. Those who are set on the 2% rule would eliminate that property because it doesn’t meet the 2% rule — $1,000 is only 1.25% of $80,000. Follow me?
Something to note on that last example — while the property doesn’t meet the 2% rule, it does meet the little sister of the 2% rule — the 1% rule. The 1% rule works in exactly the same way as the 2% rule, but it only requires that the rental amount be 1% of the purchase price. Some will argue that as long as you hit the 1% rule, you are still making a good rental property investment. None of these are hard, fast, or concrete rules, so you can do or use whatever you want with them. But first, let me caution you about how much you use them at all.
Reality Checks about the 2% Rule
To be clear, the 2% rule used to be really handy. There was a time, a few years ago, where it was completely feasible to buy rental properties that fit the 2% rule. So I don’t want anyone to think that this rule has never served a purpose because it certainly did. But here are the reality checks about this rule, and I want you to understand them very clearly.
First of all, in no way is the 2% rule a “rule.” It is strictly a “guideline.” Maybe someone just called it a rule because “2% guideline” does sound pretty dorky, but do know that there is nothing “rule-like” about it. A “rule” means that you are supposed to follow it. You don’t have to follow the 2% rule by any stretch, and quite honestly, following it could lend you to getting in some trouble (will touch on that in a few minutes).
Related: This Deal Analysis Proves the (Disappointing) Truth About the 2% Rule
The intended purpose of the 2% rule back in the day was simply to be a guideline to help you sift through properties faster. If you were scrolling through 100 properties in an initial property shopping spree, you could quickly eliminate any that didn’t hit the 2% rule. It was very simple to quickly see if a property hit it or not — you just had to know the purchase price and the rental income. Boom, done. You could eliminate properties lickety-split. That lends me to my next reality check…
Estimations vs. Actual Numbers
Oh man, does this one get my blood boiling. This one pertains to even back in the days when the 2% rule was a viable guideline! Hear me when I say — and this goes for every single investor out there, no matter what kind of investing you are doing — never, ever, ever use estimated numbers when you can use actual numbers! I have never understood why people have such a tendency to do this. If you are buying a rental property, the only numbers that you need to use estimates for are estimating future vacancy and repairs expenses. Otherwise, you can find just about every number you need.
If you have no idea what I’m talking about in terms of the numbers, check out “Rental Property Numbers So Easy You Can Calculate Them on a Napkin.” Now, where this comes into play with the 2% rule is that the whole 2% bit is leading to only an estimation. It doesn’t tell you for sure what the numbers will pan out to be — or that they will pan out to be good.
I’ll use a dramatic example. Let’s say you find a condo unit that you could buy and rent out and it meets the 2% rule upon first glance. But then as you start to gather actual numbers on it, you find that the area you are buying in has high property taxes, the condo fee is quite high, and for some reason, insurance isn’t overly cheap. Those higher numbers, once you plug them into the equations in that article, suddenly show this property projected to provide minimal, zero, or negative cash flow. But it met the 2% rule! Well, that’s why I say don’t estimate. No rule or guideline can say for sure whether you can expect cash flow on a property. So don’t use them for anything more than quick elimination of properties — if even that! Which leads me to my next reality check…
Good Properties Don’t Always Meet Rules (or Guidelines)
The fact is there are perfectly fine properties that don’t necessarily meet the 1% or 2% rules. There’s way too much to discuss as far as the details of what makes a good rental property investment to put in this article, but the short of it is that there are trade-offs between returns and cash flow and risk. You could find a property that meets the 2% rule but is such a high-risk investment (maybe because of location, property quality, tenant quality, declining market, etc.) that the projected cash flow is likely to never pan out as advertised (or even if it does, maybe the headache isn’t worth it).
Maybe there’s a property that is in an excellent location and of excellent quality and in a seriously growing market, but it would only make, say, a 0.8% rule (if one existed). That one, even despite the lesser projected cash flow, might be the better investment! So the answer to the question, “I found a property but it doesn’t meet the 2% rule — does that mean it’s not a good investment?” is who knows! There are a million other factors to look at. Does it cash flow? How’s the location? What’s the condition of the property? Is the market growing or declining? How will the quality of the tenant pool be? How high-maintenance will it be? How risky is it? Those are the questions that matter — NOT a supposed “rule.” Forget the rule. Speaking of forgetting rules, I have one last reality check for you…
Times (and Rule Applicability) Change
What used to be a good guideline or “rule” at one point, may not be a good one now. That is currently the case with the 2% rule. As I mentioned before, a few years ago, the 2% rule was actually viable. Finding good properties that met the 2% rule was a fairly easy thing (if you were looking in the right market). Nowadays, however, that’s not the case.
Why? Because the real estate economy in general is in a completely different place than it was a few years ago. A few years ago was after the big recession and crash, when housing prices dropped like crazy. It was an interesting time because in a lot of markets, despite the property prices dropping, rents didn’t drop. Since rents stayed high and prices dropped, it became very easy to obtain a property meeting the 2% rule. Since then, though, the real estate economy has stabilized — and more than that, prices have gone up significantly. Rents did go up as well, but not at the same pace as prices. So the gap between prices and rents has closed significantly from what it once was.
Today, I don’t know of a single (good) market where you could expect to find properties meeting the 2% rule. A few years ago, yes; now, no. The economy is always changing, the markets are always changing, and the numbers are always changing. Maybe the 2% rule will come back for properties, but right now it’s kind of disappeared. Honestly, you’re lucky to hit the 1% rule these days. It doesn’t mean rental properties aren’t worth it anymore, but it does mean the gaps have closed to a noticeable degree.
I know, I’ve crushed all of your 2% rule souls. It’s OK, I understand. Maybe it will come back one day. Even if it does, though, don’t expect it in cities like Los Angeles or New York City or any of those. Even when the 2% rule was a big thing, I never saw it anywhere on the West coast, much less the big, expensive cities.
As of today, I can tell you that if you find a property meeting the 2% rule, you need to be very leery. Find out why it’s priced so low compared to what it brings in for rental income. I guarantee you it’s a high-risk property. High-risk properties aren’t necessarily bad, but you’ll be doing yourself (and your bank account) a major disservice if you go into a property not knowing where exactly the risk lies and how to overcome it — should you continue to pursue that property.
And now, a moment of silence for the 2% rule.
Do you ever use the 2% rule to inform your buying decisions?
Let me know your thoughts with a comment!