Put to the Test: Are the 2%, 50% & 70% Rules REALLY Useful to Investors?

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Real estate investor’s have come up with a lot of rules of thumb, most notably the 70%, 50%, and 2% rule. But how useful are these rules? Well, let’s put them to the test:

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The 70% Rule

This is my favorite rule of thumb. Basically, it goes as follows:

To figure out what your strike price on a deal should be, take the After Repair Value (ARV) and multiply it by 0.7, then subtract the rehab expenses (R), and that’s your strike price.

Or:

Strike Price = (0.7 X ARV) – R

Some include holding costs in the R number, some do not. Some also prefer to use the a formula that aims at getting a certain profit number, which is also a good way to go about it. But overall, this is still a really good tool to see if you are in the ballpark. Since you can run this calculation in your head, you can figure out almost immediately whether what a seller wants is close enough to move forward or the deal just needs to be dropped before you waste anymore time on it.

So for example, let’s say you estimate a property is worth $150,000 and the rehab is $20,000. So $150,000 multiplied by 0.7 equals $105,000, minus $20,000 equals $85,000. And let’s say the seller says they won’t take a penny less than $120,000. Well, you can probably move onto the next deal.

However, just because this rule is good doesn’t mean it’s perfect. As Will Barnard points out in his podcast with regard to luxury housing, the 70% rule doesn’t hold as well with really expensive homes. That’s because margins are so much bigger. The same could go for really inexpensive homes. So let’s break it out to show why. We’ll start with that $150,000 home.

ARV = $150,000

Purchase Price: $85,000

Commission = $9,000 (6%)

Closing Costs = $1,000

Rehab Costs = $20,000

Holding Costs = $4,000

Total Costs = $119,000

Profit = $31,000

That’s a pretty solid margin, and even if you go $5,000 over on your rehab, or sell the property for a little less than you think, you will do just fine. But as you can see, if you added a zero to each number for a luxury home, the margin would be a really nice $310,000. That sounds great, but it also means you have a bit more room. And in order to get the deal, you may have to go a bit higher than 70%. (Although be careful—there are rarely good comps for luxury homes, as they are all custom, so don’t get carried away with your ARV.)

Related: 2% Rule? 50% Rule? Here’s the #1 Real Estate “Rule” I Use to Assess Property

But let’s look at cheaper homes. These are usually not very good for flipping because the margins are smaller, and that gives you less room for error. After all, a roof costs the same on a $50,000 house as it does on a $250,000 house. So cheaper homes usually make better rentals or wholesale deals than flips. But if you do flip one, you will want to use something less than 70% for the calculation, as you can see from this example:

ARV = $75,000

Purchase Price: $32,500 (70% ARV minus R)

Commission = $4,500 (6%)

Closing Costs = $1,000

Rehab Costs = $20,000

Holding Costs = $2,500

Total Costs = $60,500

Profit = $14,500

Using the same formula, your margin is substantially less than half. Now, what if you also needed to replace the HVAC when you originally thought it was fine and misjudged the sales price? All of sudden, you might have done all that work just to lose money.

The 70% rule should always be verified by running the hard numbers. But it should also be adjusted to fit the cost of the house. And in general, flipping in cheap areas isn’t recommended. It still makes for a solid rule of thumb, though.

Overall Grade: B+

The 50% Rule

The 50% rule states something like the following:

For any given apartment complex, the operating expenses (not including debt service) should be about 50% of the operating income.

I = 0.5 X E

The rule is ok at best. For one, cheap apartments often need to be turned over more because of higher tenant turnover (and more damage), which means that maintenance and turnover expenses will actually be higher on cheaper apartments than decent apartments, which goes opposite of this theory.

Older buildings also don’t have as good of insulation or HVAC and require more maintenance than newer buildings. And rents are usually less in older apartments. Furthermore, other cost-saving amenities or features (such as solar panels, small courtyards or parking lots, no interior common areas, etc.) are ignored.

It also takes property management as given. A property that is performing very well will not only bring in more income, but because you aren’t wasting money on vacant units, turnover, and utilities, your expenses will be lower too. So this rule neglects the major question of “how hard is this property to manage?”

Finally, expense ratios will usually vary based on how much of the utilities the tenants pay. Yes, if it’s all bills paid, you can usually charge more in rent. But I have found, and many others have said the same, that that increase is less than what the utilities cost in total. Therefore, the ratio of income to expenses will vary based on utilities.

The best tool to evaluate what an apartment’s expenses will be is an operating history from the seller. Failing that, trying to patch a pro forma together from every piece of information and experience you have is second best. The 50% rule comes in in a distant third. It has some use, but it should never be relied on.

Overall Grade: C

The 2% Rule

I’ve written about this abomination of a “rule” before, and the English language doesn’t have the words to describe my contempt for it. In short, it goes like this:

For a buy-and-hold property to cash flow well, the monthly rent (MR) should equal 2% of your total costs into the property (TC).

0.02 X TC = MR

The 2% rule holds everything constant to the point of absurdity. As noted regarding the 50% rule, the monthly rent and the operating expenses do not go up hand in hand. This is especially true for cheap houses. (And I should note, regarding cheap apartments, I would throw the 50% rule out the window as well.)

Related: Why I Pay More for Fix and Flips than the 70% Rule States I Should

The problem is that you can have a very good, cash flowing house that only has a rent/cost ratio of 1.5%, or even less. But if you have a home in a war zone, it could have a 5% rent/cost ratio, but it doesn’t matter because the area is so bad, tenants rarely pay rent and often destroy your house. Such a property won’t cash flow, no matter what the 2% rule says.

This rule is also dangerous because unlike the other two, to hit it, you usually have to aim at the worst areas in town. For most investors, and new investors especially, this is investment suicide. Rent/cost ratios can be useful, but only when comparing like to like. When comparing across asset classes, they are not only useless, they are downright dangerous.

Overall Grade: F- 

Investors: It’s your turn to weight in! Do YOU think these rules hold much (if any) validity?

Let me know your thoughts in the comments section below.

About Author

Andrew Syrios

Andrew Syrios is a real estate investor in Kansas City and a partner in Stewardship Properties along with his brother and father. Their company owns just over 500 units in four states.

18 Comments

  1. Frankie Woods

    I really liked your explanation with practical examples. With my new experience dealing with cheap properties in C- areas at best, your synopsis has nailed my experience. I think I need to move up in the world 🙂 Thanks for sharing!

  2. Adam Schneider

    Nice perspective. You are singing to the choir! Who really follows those rules? The reality is that many are a good initial brush stroke to see if you can DQ a deal without digging into the details. As you clearly pointed out, they are so flawed.

  3. Alex Chin

    I think these rules have their place and their use. The problem is when an investor looks to make these a “golden rule”. However, I think they make for a good filter to at least weed out properties that won’t make sense for your purposes.

    When one of my sources dumps a batch of 50-100 multi-families for me to take a look at, I’m not going to spend the time to figure out numbers for each and every one. Instead, since I have a good grasp of rent rates for the area, I can sweep through them very quickly with the 1% rule and figure out from there what is worth digging a little deeper into.

  4. David duCille

    Agree fully! Not a big believer in the 2% rule and not even full sure how to calculate it if I’m buying with leverage. I have properties that don’t come close to 2%/based on purchase price but I suppose if I truly only base it on what money I actually have in the mix then it works

  5. Jeffrey P.

    I think the 2% rule is a quick and dirty back-of-the-envelope calculation for someone trying to quickly evaluate a deal. If a deal doesn’t hit 2% and someone just immediately writes it off without doing a detailed analysis of all of the numbers then that’s their loss.

  6. James Griffin

    For homes in the $100k – $150k range in central Arkansas my partners and I use a 1% rule, not a 2% rule. The PITI for respectable homes and neighborhoods in central AR attract ideal tenants which makes the 1% rule workable here. 2% on a home of this level wouldn’t be feasible in Arkansas. The market won’t carry that rate. However, I do have homes that I’ve rehabbed and held where I make >2% merely because the purchase price was perfect. But these are rare gems.

    For quick numbers on a cheaper home I recently purchased (3 BR, 1.5 BTH):
    Purchase price: $40k
    Rehab: $21k
    Cash out: $58k (75% of appraised value)
    Rental Income: $875
    I left <$4k on the table on this deal and clear nearly $400 a month after PITI.

  7. chris carollo

    These are all great rules of thumb to start your due diligence. We are all taking advantage of potential inefficiencies in the market to find opportunities. If we can quickly utilize these “rules” to quickly review more properties then they are good guideposts for us.

    • Andrew Syrios

      I think the 70% rule is a very good rule of thumb and the 50% rule is OK, but the 2% rule is useless and IMO doesn’t allow you to quickly review a property but instead will have investors dismiss good deals and look to warzones as the only places that are remotely close to the 2% rule. In other words, it is fundamentally biased in my opinion.

    • Andrew Syrios

      That is for flipping. So you’ll pay (on average) a 6% commission to the real estate agent on the resale (assuming you aren’t an agent and are using an agent of course). On the buying side, the seller would pay any commissions.

  8. John Hamilton

    I use the 70% rule as a rehab flipper and wholesaler. It’s a good guide to quickly assess how far off the mark you are and how much work is needed to negotiate a better price. Most wholesalers are willing to negotiate. Banks? Not so much. FSBO, depends on the motivation of the seller.

    50% or 2% rules don’t apply as I don’t work on commercial or MFH. Someday, when I get in the landlord realm of my empire, I’ll dive deeper into both of these formulas to see if they even come close to reality.

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