The 2% rule needs to die.
Now, before I go on, I’m well aware that no one would say that any rule of thumb, such as the 50% rule or the 70% rule, is applicable in every situation. A rule of thumb should be used as shorthand to figure out if a property is worth pursuing before a thorough analysis is done. That way you can cut out the clutter without wasting your time on dead ends. Most of the time, the 50% rule and 70% rule are good rules of thumb. The 2% rule is not.
The 2% rule—while rarely explicitly defined—states something like “to make a good profit on a single family home it’s rent to cost ratio should be at least 2%.” So for example, if a property rents for $1000 a month and you can purchase and rehab it for $50,000 total, it would have a 2% rent/cost ($1000 divided by $50,000 equals .02 or 2%).
There are two primary reasons this rule is bunk:
- Rent/cost ratios are not a consistent measure of cash flow potential.
- The rule, if followed, leads investors into areas only specialists should go.
Rent to Cost Ratios Aren’t a Good Measure of Cash Flow
I don’t mean that rent-to-cost ratios are useless.
In fact, I use them all the time.
But rent to cost ratios are only useful when comparing properties in like neighborhoods and price ranges. So let’s say I have House A and House B and both are in relatively similar neighborhoods (regarding average home price, income, crime rates, school rankings, etc.). I can buy and rehab House A for $60,000 and it rents for $900/month. I can be all into House B for $50,000 and rent for $800/month. With this analysis, House A has a 1.5% rent to cost and House B has a 1.6% rent to cost.
House B is probably a better investment—”probably” being the keyword. There is still more analysis to do; a comparative market analysis, a pro forma, an estimation of the cash flow and perhaps cap rate, etc. And of course, you need to make sure you are being realistic about your rehab budget.
But let’s say House A was $25,000 and rented for $500/month and House B was $100,000 and rented for $1250/month. Oh, well now, it’s easy, House A’s 2% rent/cost ratio blows House B’s paltry 1.25% out of the water!
Not so fast.
Square foot for square foot, a roof costs about the same on a $25,000 house as a $100,000 house. You may go with vinyl or builders grade carpet instead of tile and a higher quality carpet to save costs on the $25,000 house. But in the long run, that will probably cost you even more because it’s much harder to do spot repairs on vinyl as compared to tile and I don’t think I’ve ever seen builders grade carpet last for more than one turnover. Used appliances go out much quicker than new ones. Same with HVAC. Ever tried to wash marks off a wall painted with flat paint? Good luck.
Yes, you shouldn’t be putting granite countertops and Brazilian hardwoods in a lower end rental, but cheap materials and/or labor is just going to cost you more down the road. Therefore your operating expenses will not go up evenly with price. Whereas a $50,000 rental may cost you $3000 per year, a $100,000 house may cost you $4000 per year. And even though the taxes are much less, a $25,000 house may cost you closer to $5000.
Why? Because houses that are that cheap are usually in rough areas. Houses in rough areas are more likely to be treated poorly and have more delinquency. In other words, you will likely have to turnover these homes more often and repair more damage each time.
And that doesn’t even include vacancy rates!
Vacancy rates are one of the key assumptions each investor must make when they are analyzing an investment. And vacancy rates vary dramatically from one neighborhood to the next. The 2% rule would have you believe the insane notion that you can hold vacancy constant.
What I’m basically saying is that really cheap houses don’t usually cash flow. Or as Ben Leybovich puts it:
“So… You bought this house for $18,000 and spent $12,000 to put lipstick on the pig. You’ve had to work hard to keep it full. The house was trashed more often than not. You’ve evicted most tenants because people that are willing to live in this location and in a unit of this character are economically unstable…this doesn’t mean that they are bad people, just that they don’t have control of their financial lives, which often leads to evictions and frustration!”
Do you think you can honestly compare such an investment to a home in a thriving middle-class neighborhood? No? Well the 2% rule thinks you can.
The 2% Rule is Dangerous
When I first got to Kansas City, I was looking for apartments and one of the key numbers I was looking at was price per door. This is very similar to the 2% rule in that, quite obviously, the best (worst?) prices per door were in the roughest neighborhoods. Let me tell you that the first properties we bought have had much higher yearly expenses and much lower occupancy than the properties we later bought in blue collar and middle class areas.
What the 2% rule does is it pushes investors, particularly new investors, toward these rough areas. It says rent to costs equals cash flow and thereby you should go where the rent to cost’s are the best. “Hey, this property’s market rent is $600 a month and I can buy this house for only $30,000. It must be a great deal!”
Then the property doesn’t rent for months while tenant after tenant with checkered past’s are turned down. Finally it’s leased, but the tenant stops paying after a few months. They trash the unit. Then you sink a bunch of money into it. Then the whole process repeats itself.
I have unfortunately seen this madness happen more than a few times to more than a few investors and it’s all lead to more than a few foreclosures.
This is not to say there are no good tenants in rough areas or that you can’t make money investing there. There are plenty and you can. But you really need to be a specialist to make money in rough spots. And most investors and all newbies are not specialists.
You Can Make Money if The Rent to Cost is Less Than 2%
You could say that this only applies to really cheap houses in rough neighborhoods, but the reverse is also untrue. You don’t need 2% for an investment to make sense. Our average rent to cost ratio is around 1.5% and our average all-in price is usually about $60,000 to $70,000. Yet our properties generally cash flow $100 a month over a fully financed 9% interest loan (we get private loans up front and then refinance later with banks at better rates). Here’s what a typical investment of ours looks like:
All in Price: $60,000
Annual Rent: $10,800 ($900/month)
Vacancy: $1,080 (10%)
Annual Expenses: $3000
Debt Service: $5400 (9% interest only)
Cash Flow: $1,320 ($110/month)
And it gets much better after the refinance.
So should we be avoiding these 1.5% rent to cost homes? The 2% rule thinks we should.
How You Should Look at Rent to Cost Ratios
The reason rent to cost ratios work on relatively similar homes but not across categories is because you’re basically assuming 100% occupancy and that operating expenses will correlate to prices perfectly. A better way to look at it is effective rent to cost. Namely, what is the actual rent you’ll be collecting. And this still only works when you account for annual expenses, which can only be held constant when looking at relatively similar areas.
We have different rent to cost targets for different areas. In the lowest end areas we’re willing to buy (usually $30,000 to $40,000), we aim for about 2% or better. In the best areas we look at it, we aim for about 1.2% to 1.3% or better. We call these “equity plays” because they don’t cash flow much, but they’re the one’s we tend to have the biggest equity margins in.
That’s how you should look at rent to cost ratios—as a metric to compare like and like (relatively speaking), not as a blanket rule. It is, in fact, not as a rule at all.
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