Why the 2% Rule Can Get Beginning Investors Into Trouble

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The 2% rule has been discussed quite a bit on the forums and in blog posts.  Since I am a new blogger (I wrote my first article for Bigger Pockets last week on buying HUD homes), I figured it was okay for me to add another opinion on the 2% rule.  What peaked my interest was seeing a comment in one of the forum posts that said the 2% rule is great for beginning investors, because it helps keep them out of trouble. However- I think the 2% rule actually does a lot more harm that good with new investors.

I have been investing in long-term rentals since 2010 and I have been a licensed Realtor since 2002.  My father has been a Realtor since 1978 and the first time I heard about the 2% rule was when I discovered BiggerPockets earlier this year.  I saw the rule popping up all over the forums as a way to evaluate long-term rental properties.

I quickly discovered the 2% rule was used to determine if long-term rental properties are a good investment by using a very simple equation.  If monthly rents are equal too, or greater than 2% of the purchase price on a rental property, than the rental property is considered a good buy.  To make it really simple, If you buy a 100k house it should rent for $2,000 a month.  I quickly realized none of my rental properties come close to meeting this rule.  I am extremely patient and usually buy my properties at least 20% below market, but my best rent to purchase price ratio is 1.35% ($1,250 rent on $92,000) .

I have heard many people on the forums explain the 2% rule is great for beginners because it is simple and keeps them out of trouble.  I think it may cause more problems than it prevents, because it is actually too simple.  There are too many variables that go into evaluating a rental property for a beginner to only consider rent versus purchase price.

Seasoned investors can look at a house and determine if it is a good fit almost immediately, because evaluating deals has become second nature.  Beginning investors, need to be looking at all the details; rent, expenses, repairs, mortgage, location, etc.  They need to thoroughly analyze exactly what the returns will be based off certain estimates.  Not only does running all the numbers help a beginner figure the returns, it helps them learn the process of evaluating properties.  There is no secret calculator that can evaluate every potential rental property, each property needs be analyzed based on the most important variables.

I have seen many forum posts from beginners asking members to analyze a deal without gathering all the needed information.  I understand an investor who has done an evaluation and wants validation from experts.  However, it seems like many beginners are looking for a short cut, by having someone else figure out all the numbers for them.  A beginning investor has to be able to figure cash flow and cash on cash returns at a minimum to be able to succeed in Real Estate.  When I came up with my long-term rental plan, I ran 10 year projections for cash flow on every property I planned on buying.  My original goal was to buy 30 rentals in 10 years, but I raised that to 100 in ten years to challenge myself.

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Why the 2% Rule is Flawed

Every property and every area of the country has different expenses.  Single family is different from multi family. Low priced homes different have expenses than more expensive homes.  Different states have different tax laws and utility costs.  The most important factor may be the cost of initial repairs, which the 2% rule does not factor at all.

Single family versus multi family

Single family homes have much different expenses than multi family homes.  In many cases renters of single family homes will pay all the utilities, while the landlord may pay most of the utilities on multi family properties.  Single family renters are responsible for yard care, while the landlord is responsible on multi family.  Single family homes tend to have less turn over and may be taken care of better by the tenants.  I have found single family renters treat a rental like their own house, while those in an apartment treat it like a rental.  I personally invest in single family because single family homes have less expenses than multi-family, are more stable and have a better chance of appreciation.  I can also get a better deal on single family homes in my area then I can on multi family properties, but that may be a regional trend.  I am willing to have a much lower rent to purchase price ratio on a single family rental than a multi family because of these factors and the 2% rule does not account for any of them.

Location

The location of a rental property can be a huge factor on the properties long-term success.  There are many factors to consider when choosing a location: vacancy rate, job growth, population growth, condition of neighboring properties and values.  All of these factors will determine rent appreciation, value appreciation, expenses, maintenance and vacancies in a rental property.  Once again the 2% rule does not take into account any of these factors.

Property Taxes

States, counties and even cities have different property tax rates.  I happen to live in Colorado, with very low property tax rates.  The assessed value on one of my rentals is $130,369 and I pay $882 per year in property taxes on it.  I rent it for $1400 a month and that equals about 5% of my rent.  In other states property taxes can be 25% of rents or more.  That’s a huge difference in expenses for a rental property that the 2% rule does not take into consideration.

Price

The percentage of expenses on a rental will change based on the price point, at least on single family rentals.  Many times the lower priced rentals will require more repairs due to more turnover.  Usually homes are priced low for a reason; repairs, location, functional obsolescence, or market conditions.  In my area the very lowest priced homes, are the only properties that come close to the 2% rule.  Yet, I consider these properties to be a much worse investment, then properties I purchase in the higher price range, that don’t come close to the 2% rule.  I know I will have less repairs, less turnover and an easier time selling homes if I need to, in the higher price range.  The 2% rule, encourages investors to go after the lowest priced homes, which may have the most problems.

Initial Repairs

Another way to get close to the 2% rule is to buy a home that needs a lot of repairs.  The 2% rule does not consider any initial repairs into the equation, but this greatly affects your return on investment.  I could buy a turn-key, perfect rental for 100k that rents for $1200 month or I could buy a 60k rental that needs a ton of repairs that rents for $1200 a month.  Lets analyze the two deals to see which gives a better return.

Deal 1. price $100,000

Down payment. $20,000

Closing costs.    $3,000

Carrying costs   $500

Total cash invested  $23,500

Mortgage Payment         $382

Taxes and insurance.      $150

Maintenance                      $100

Vacancy.                              $100

Total monthly expenses $732

Monthly cash flow.            $468

Cash on cash return.        24%

Deal 2 Purchase price $60,000

Down payment.            $12,000

Closing costs.                $1,800

Repairs.                          $30,000

Carrying costs.              $1500

Total cash invested      $45,300

Mortgage Payment          $229

Taxes and insurance.      $150

Maintenance                      $100

Vacancy.                              $100

Total monthly expenses   $579

Monthly cash flow.            $621

Cash on cash return.         16%

As you can see, deal 2 meets the 2% rule, but takes much more cash and has worse returns.  The carrying costs are more, because it takes time to make the repairs and the total time that money is invested will be longer, because the repairs have to be made before the home is rented. I made up these figures and they could vary widely based on each deal, but the point is the 2% rule does not factor in these numbers at all.

There are advantages to buying a home in need of repairs.  As you can see by my figures deal 2 walks away with 10,000 more in equity than deal 1.  You may be able to get a much larger discount  for a house in need of repairs and be able to walk away with more equity.  I love to purchase houses that need work because I can add value and walk away in a great equity position.  However, the 2% rule does not take into account any of these factors.

Conclusion

A beginning investor needs to look at every factor possible when buying a rental property.  Diving into the numbers will help the beginner learn the process and become more comfortable investing.  It is not easy, it takes work to learn what numbers are important and what properties will make money. The 2% rule encourages investors to buy the cheapest home, in need of the most repairs, in the most questionable areas.  I don’t think that is a recipe for success.

Photo: Ken Teegardin

About Author

Mark Ferguson

Mark is Real Estate Broker and investor in Greeley, Colorado. Mark invests in long-term SFR rental homes and also does 8-15 fix and flips a year. Mark started a blog this year that focuses on investing in long term single family rentals.

59 Comments

  1. I once entertained buying a property that had a 4% return, a trailer park where the police were frequent visitors to settle domestic disputes, and you had to collect the rent with a baseball bat.

    Although the Cash On Cash was mouth watering, I passed

  2. I like this perspective and explanation. The 2% rule is good as a very general guideline but there is a lot more that needs to be taken into consideration when evaluating a property. Thanks Mark.

  3. I tend to cringe when I hear rules of thumb. They leave a lot to be desired. I use my past trends to help determine my future costs. My maintenance runs at 12%, property management with lease up fees and maintenance costs is 12%. The only fudge factor I throw in is 8% in vacancy assuming the unit will be vacant 1 month per year. To be honest I need to adjust that number as well.

    The problem with even those numbers is it doesn’t hold the same for all the situations you described above. Using ROI can be very helpful. Mike Zuber had a great spreadsheet he uses. Its in the BP archives under last years BP event.

    Jason

  4. For what it is worth, I have used a 1% rule, I’m that the home should rent for approximately 1% of the cost of the home our the appraised value, whichever is higher. I have found this to be in the “real” ball park. Then, I was $50.00 increments to either increase or decrease the monthly rent. Say a home is a well desired location, add 50, or not a great location deduct $50.00. Even this may not be the best method, but it had worked for me. The 2% rule is way off what a home will actually rent for in my area. Maybe the 1% rule will work for you, with minor adjustments based based on small plus or minus

    • Thank you for the comment Randy,
      All my rentals are above 1%, right around 1.2%. There are so many factors to consider, it is hard for me to base a purchase on rent/value. I especially want to know what my cash on cash return is.

  5. Steve Johnson on

    This is a very helpful article for us newer investors. I’ve read up enough now to have finally caught on to why rules of thumb aren’t the most precious thing out there. I was really stuck on Cap rate for awhile and the best way I’ve had it described was to use the rules as a quick snapshot of how the property may perform. Its not the most accurate thing so don’t rely on it only, but instead do a quick analysis with such a formula and if it looks good run your real numbers.

    And Jason, where can I find exactly that ROI spreasheet you mention Mike Zuber has?

    • I have heard this a couple times in the comments and I am probably mistaken on that part of the rule. It does make more sense that the repairs are added onto the purchase price.

      However, the rule still would not account for how much cash, some one would have into the home. My cash on cash return is very important to me. Not only does cash on cash return go down, the more money you put in for repairs, but it decreases your ability to buy more properties, because you use dup all your cash.

  6. john milliken on

    the 2% rule is the lamest of all the “rules” floating around. the break down you just did mark is a perfect example of why this “rule” is far from being a standard determining rent.

    your 2 for 2 on articles Mark.thanks for a another great read, and can’t wait for the next article.

  7. “The 2% rule does not consider any initial repairs into the equation”

    I’ve always assumed that the 2% rule meant the monthly rent is 2% or more of the purchase+rehab (to get “rent ready”) cost. That’s what I’ve been achieving (sometimes over 3%). But I completely agree that this varies per market and not everyone can achieve this. It also helps to buy properties under $50,000 (and as cheap as possible).

  8. The 2% rule works as long as you include all your cost to purchase the house. In Deal 2 the rent would need to be 2% of $90,000.00 or $1,800.00 per month. If $1,200.00 is amount of rent you can collect I would not buy the property.

  9. I agree with the author Mark. Any valuation formula that is based on only one variable is fatally flawed. Value is almost always subject to the needs of the prospective purchaser. I recently purchased a property in a “borderline” neighborhood for 22K that rents for 725 monthly. I also purchased 6.5 marsh front, high and dry acres overlooking a cove for 38K. There is no income on the acreage, but I would not trade it for 5 of the 22K/725mo houses. Why? Because of my situation and because the marsh front property is on the property tax roll at 215K. The rental property is assessed for around 30K.

    Value is always subjective. Forget quick formulas, thay are false crutches that prevent you from learning to truly analyze every opportunuity. If you are evaluating rental property, combine ALL variables to result in a spendable net annual income. Divided that by the cash investment and you will get a net return %. Even with the return rate, you need to consider the actual cash flow in monthly dollars, location of the property, developmment trends in the area, how you will ultimately dispose of the property (I.e 2 bedrooms may cash flow well, but will be more difficult to sell later).

    The are MANY variables, the most important being your goals. You need to establish a business plan then learn to determine if a prospective purchase fits within YOUR plan. If it does, buy it. If it does not, pass. There is no formula to do this for you.

    • Great comment! I completely agree and I think many investors who are just beginning want the easy answer, they don’t want to go through all that hassle. Once you do in-depth analysis a few times it gets easier and easier and you start to see what works and what does not very quickly.

  10. Most of the posts I’ve seen re 2% rule do factor up front repairs in (i.e. ARC is used as the price).

    Most of the posts I’ve seen promote the 2% rule more as an “acid test” vs. a starting point. I have houses that are a little over 1% and a couple MF that are near 4% but I always, even from the beginning, used a spreadsheet (even as a complete newbie). I always used the 2% / 50% rules as “overlays” to quickly determine how my line by line analysis stacked up. My assumption was “if my numbers are correct, the bottom lines should land in the 2% neighborhood. If not, I need to double check to make sure I didn’t forget a zero or decimal point somewhere!

  11. “In many cases renters of single family homes will pay all the utilities, while the landlord may pay most of the utilities on multi family properties.”

    Hence my preference to buy duplexes with separate meters on each side. I prefer tenants to manage their own utilities.

    I guess I just don’t get the 2% rule. I haven’t seen property in my local area that supports. My father-in-law who has owned rentals in the same area for 20 years says he has always felt good if he can make at least 1%/month, and he buys units that need maintenance relatively frequently.

    The units I bought in TX are much better quality with hardly any deferred maintenance, probably because they’re new. They have command top notch rent, probably in the 1% range. Hence my belief in something more like a “0%” rule, where the maintenance costs should be relatively close to nothing. The newer units aren’t going to break down and cost me thousands in new HVAC units, and probably be ideal for even my mother to live in.

    I fear that to find a property in the 2% rule range, I would have to find something heavily discounted and pour lots of capital into it to get out the rent I want to make it work. Stuff is heavily discounted for a reason, and I just don’t have time to manage that.

  12. Thanks! I just read a BP article on why the 2% rule was so great for beginners, and saw that he is assuming 2k /month on a 100k home….uh. yeah right. if you are getting 2k in rent, you’re NOT paying 100k for that house! Crazy talk, and too simplistic….too simple…no thought.

  13. Hey mark great article? Do you happen to have a spread sheet on how you calculate 10 year cash flow projections? I would be very interested to see how you do that!

  14. Another great article Mark! I can’t meet the 2% rule in my area either, closer to 1%, but I’m positive cash flow using the 50% rule so that makes me happy. Thanks for spelling it out in the two examples.

  15. Good article Mark-
    I agree new investors need learn all the numbers and calculations and research to be successful in this business. If anything the 2% rule is just a quick formula that should take you to the next level of the real research and digging in. The devil is in the details.

    NO SHORTCUTS !

  16. I really enjoyed all of your articles. I find myself in a similar position in that I make an above average salary, and am looking to buy and rent long term single family homes. That said I haven’t done my first deal yet. It seems to me depreciation could be a large factor in determining profit. Curious how much you take this into account given your other income could potentially be offset.

    • Hi Chris, Tom, gave a lot of great info below on deprecitaion. I personally don’t factor depreciation into my returns, because it can get very complicated with varying tax rates how much it actually saves. I think of it as a bonus. I know how much I am making cash on cash with each property and then I consider appreciation, tax benefits and equity pay down a bonus. (a rather large bonus when they are all factored together)

  17. Chris,

    Depreciation can be a hugh factor, 27.5 years for non commercial like SFR, Condos etc. and 39 years for commercial. Remember depreciation is only allowed of the structures etc. not the land.

    A huge factor is “Recapture of Depreciation” that even many Realtors® know little about.

    When you sell that “investment property” you must either pay taxes on the recapture of depreciation and at a 25% tax rate or do a 1031 Exchange.

    I have seen many Investors and Realtors® believe that if the property being sold had no profits then why do a 1031 Exchange? Well, how about deferring taxes on the recapture of Depreciation?

      • I genuinely appreciate the responses. Seems to me the depreciation has a direct impact on cash flow.
        I guess cash flow, and Cash on Cash returns are different but to me both seem important.
        I’ve read a few different articles but this is one of the huge benefits I see to investing.
        Wouldn’t it be possible in many situations to cash flow positive, but with depreciation actually show a loss?
        That’s attractive to someone my age (41) with two full time incomes if I’m actually building up equity while being cash flow positive.
        I’m a complete newbie, although I have spent a great deal of time reading on several sites / blogs etc.
        Again thanks for your time, I know how valuable someone’s times is.

        • Chris, it is a huge advantage and does effect your bottom dollar. Like I said the biggest reason I don’t actually calculate it is because it is complicated. Depreciation is one of the reasons I think rental properties are a great investment.

        • “Wouldn’t it be possible in many situations to cash flow positive, but with depreciation actually show a loss?”

          That’s why rental income is called “tax sheltered”. Depreciation is one of those big benefits of real estate. I wouldn’t craft a spreadsheet where depreciation killed the view of profit. That would be wrong, because you aren’t actually losing anything.

    • Thankfully, in my situation, cost segregation studies benefit me. They may not benefit you, but they support me. I am saving up a big stock of unused depreciation that may offer me an alternative to either paying a fistful of depreciation recapture or having to undergo a 1031 exchange. Unused depreciation provides a third option.

  18. Thanks for the article…I’ll be looking for more bc I really liked how you explained it all. I’m just starting out and reading as much as I can to learn. Your article was really concise and easy to follow except I’m hung up on one part. I can’t seem to figure out how deal 2 shows $10k more in equity. Sorry if I’m missing something obvious but can’t learn if I don’t ask! Thanks again.

  19. Jerry W.

    Thanks for the article Mark. I just use the 2% rule as an over achievement idea. I have not come any closer than about 1.7 in my area. I have exceeded that on some experimental out of state properties but that is a different matter. So many factors really make the final decision for me such as value if I resale, cost of repairs, age, obsolesence, location, ability to increase value, and even insurance costs. There is also the unfortunate problem of opportunity knocking when the cookie jar is empty. When I actually have some $ it doesn’t take long for me to find another project.

  20. Great article Mark,
    The number of responses and the quality of feedback is evidence that you have done a really good job on a subject that a lot of people needed input on. Evidence is the critical word here because the only homes for sale in my area that could do the desired #’s would still have the police ribbon up.
    Although I know that the more experienced investors have crews and can buy materials for repairs much cheaper and faster than I can. In that same vein they are generally doing multi-family and apartment complexes to pull better averages from. So for me I just want a decent neighborhood,value I can add, and a rent value that can make money within the same amounts as renters expect to pay.

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