Many investors have heard of the 1% Rule, but what about the 2% rule?
Today, we’re going deep inside what the 2% rule actually is, how and when to apply it, and some things to look out for as you use it.
What Is The 2% Rule?
The 2% Rule states that if the monthly rent for a given property is at least 2% of the purchase price, it will likely cash flow nicely. It looks like this: monthly rent / purchase price = X.
If X is less than 0.02 (the decimal form of 2%) then the property is not a 2% property. If it 0.02 or greater, then you’ve found yourself a 2% property. This can then shed some light on whether or not a property is likely to cash flow.
If you haven’t already, go review the 1% Rule lesson. There we talk about how any of these rules of thumb should only be applied as a way to quickly sort through properties that require deeper analysis, prior to having exact numbers to crunch.
Most investment properties when listed on Roofstock, the MLS, or any other listing site will often have three numbers on the listing: the sales price, the monthly or annual rental income, and the selling agent’s phone number. If all you have are the property price and the monthly rental amount, you can very quickly determine if the rental property meets the 2% Rule.
Are 2% Rule Properties Unicorns or Real?
Most investors have a hard enough time finding properties that meet the 1% rule, let alone something that exceeds or even doubles that criteria. The good news for investors is that 2% properties do exist! I’ve seen them and I’ve actually purchased them.
To be fully transparent, I’ve heard of other investors purchasing many more than I have personally, but I will share a personal example with you in a bit.
What I’ve come to understand about 2% properties is this: there are some that are great, positive cash flowing properties, but many of them, arguably the vast majority of them, are riddled with issues. Why else would the owner be selling such a cash cow?
Additionally, 2% properties are often on the less expensive side of any given real estate market. What I mean is that I’ve never seen a $500,000 property that will rent for $10,000/mo. However, I’ve seen plenty of properties that sell for $40,000 and rent for $800/mo.
Before anyone gets up in arms and comes running to me to tell me how wrong I am because they purchased a house for $40,000 and it rents for $800/mo and the tenant is amazing, I want to clear the air and say I know that not every 2% rental property will be hard to own.
There are always exceptions to every rule (or guideline, in this case). You often have to work very hard to sort through the bad ones to find that one good one, and if you’ve been able to do that, I applaud and congratulate you.
What The 2% Rule Does Tell You About a Rental Property
The only thing the 2 percent rules tells you is the ratio of rent to sales price. There is no secret formula that gives investors an insight into how a property will actually perform. As investors, we must take what information we do have, both the rent amount and the sales price, and start to derive whether or not we think the property is a worthwhile investment.
Remember, that given the sale price of the property, we can reverse engineer it into becoming a 2% property, simply by manipulating that sale price.
What The 2% Rule Doesn’t Tell You About a Rental Property
While the 2% Rule is helpful in determining whether or not the property is likely to cash flow very well, there are a slew of other questions that it doesn’t answer. One of these is “Where is the rental property physically located?”
When analyzing 2% properties, it is critical to account for the specific neighborhood in which the property is located to determine what the vacancy rate will be. A few months of vacancy can eat up all the cash flow from even a 2% property.
Here’s the math to help drive this point home:
The gross rent collected on a single-family rental property that rents for $1,000/mo = $12,000/year.
- Cost of 2 weeks of vacancy: $462, or 3.85% of your annual revenue.
- Cost of 2 months of vacancy: $2,000, or 16% of your annual revenue.
Remember, the lost income is only part of the equation. All of the operating expenses remain in effect (for the most part) as monthly expenses. Property taxes, insurance, and mortgage payments (if you choose to finance the property) still need to be taken care of whether or not a tenant is living in the property.
While two months can eat away at 16% of your annual revenue, it can actually eat up 100% of your annual profit if you are only expecting to bring in $2,000/year in positive cash flow. A decent property manager should be able to shed light on vacancy rates in different neighborhoods.
Another question not answered by the 2% Rule is how much maintenance is likely to be required, based on the property’s location. Properties in harsher climates or rougher neighborhoods often have higher maintenance expenses. This needs to be taken into account when running your numbers.
Lastly, the 2% Rule does not account for property taxes. Property taxes are often the biggest deal killers of all. Not knowing how much the property taxes are for a property post-sale can provide a rude awakening for investors.
Can You Convert a Property Into One That Meets The 2% Rule?
Now that we’ve covered a lot of issues surrounding the 2% Rule itself and 2% properties, you’re probably asking yourself why anyone would want one of these things. It’s important to note that 2% properties do exist organically, but sometimes you have to be able to see the forest through the trees.
“What makes it a 2% property?” may require some further analysis beyond just the sales price and monthly rental amount. I know what some of you are thinking: ”Doesn’t digging deeper defeat the purpose of using the 2% Rule in the first place?” The answer is technically yes, but in order to find and make good deals, we often have to dig deeper, so stay with me.
If a property is listed as meeting the 2% rule, it’s a relatively safe assumption that it will cash flow, but further analysis is obviously still needed.
The additional analysis should reveal a few things like:
- How much of a headache are you buying?
- Is the cash flow actually as good as it appears based on first glance?
- What are the actual expected expenses for the property you’re analyzing?
Getting the full picture -- above and beyond whether or not it meets the 2% Rule -- is of the utmost importance.
How I Converted a 1.3% Property Into a 2.4% Property
A couple of years ago, I purchased a property from another investor who was tired of the headaches his property was causing him. It was listed with a rent-to-sale price ratio of 1.3%, which is fairly common for the area.
I analyzed the property and realized that the rents were way under value for the market and the property was overpriced…a double whammy! Therefore, when I made an offer on the property, I went in with a lower offer and it got accepted.
The owner didn’t care because they purchased the property for pennies on the dollar in 2011. During my due diligence, I found a few ways to increase revenue and decrease expenses, thus I proceeded with the purchase.
As soon as I closed on the deal, I gave the tenants notice that the rent would be raised to market rate, and almost overnight had a 2.4% property on my hands. It took some massaging and a little bit of work, but, in the end, it was absolutely worth it.
What did I learn?
You often have to create the best deals, as they can be extremely difficult or impossible to simply find. Had I simply looked at the property as listed and seen the 1.3% and passed because it didn’t meet the 2% rule on the surface, I would have missed out on this amazing opportunity.
Just because a property isn’t advertised as a 2% property doesn’t mean it doesn’t have the potential to become one. This is why I’m such a big advocate of buy and hold investing. Rent tends to increase over time, while the price you purchased at obviously remains the same.
Lastly, good investors are able to see the potential in things, rather than simply seeing them as they are today. This is not to say that you need to be a visionary to be a great real estate investor. However, I can honestly say that being able to envision something’s potential makes real estate investing a lot easier.
Similar to the 1% Rule, the 2% Rule is a great place to start your analysis and get a quick read for how well a property will perform. Ultimately though, there is no better way to develop your intuition than to make assumptions about a property and then prove them to yourself as either true or false.
Remember, the 2% Rule is a back of the napkin calculation as to whether or not we anticipate a property to cash flow. It is by no means a substitute or replacement for solid underwriting and good, old-fashioned deal analysis.
Do not get stuck seeing things only as they are; make sure to see them for what they have the potential to be. If this is not something that is currently in your repertoire, practice. Find properties online that either don’t meet your investment criteria or the 2% Rule and see if you can mentally make them work.
Remember, the brain is a muscle and if we don’t use it and exercise it, it can atrophy. Most real estate investors weren’t born great. They had to work hard and repeatedly fail in order to get where they are today.
Don’t worry if you struggle to find or make 2% deals; they’re only one tool in the real estate investor’s tool belt.