Stock traders and real estate investors are both familiar with the 2% rule. But in this article, we’ll be specifically talking to real estate investors on what is the 2% rule and how to apply it to buying real estate, and most importantly:
… How the 2% rule is one of the worst “rules of thumb” to go by.
What is the 2% rule for real estate investors?
The 2% rule is a buying formula that helps minimize risk for a real estate investor by ensuring that the property’s monthly rent income is at least 2% of the property’s purchase price. To use the 2% rule, multiply the purchase price by .02, or alternatively divide the rental income by .02 to see the appropriate “2% rule” purchase price of that rental income.
.02 x 100,000 = 2,000
2,000/.02 = 100,000
With the 2% rule, as long as the monthly rent is at least 2% of the purchase price then it fulfills this “rule of thumb” and makes it a deal to consider.
Here’s a video that explains it further:
Type of Properties that fall in the 2% rule
If you live in a highly populated metro area, you’ll quickly realize that the 2% rule will be hard to find in your market.
The types of properties that will qualify for the two percent rule will be properties in areas where the purchase price is way below the median price in the US.
A property that rents for $800 a month, will easily qualify for the two-percent rule if the purchase price is $40,000.
There are markets like this, that do exist.
Problems with the 2% rule
Hard to find
2% rule properties are a unicorn in most places.
Just look in your own backyard today and find a property that can cost $200,000 to purchase but rents for $4,000 a month. Or a $600,000 property that rents for $12,000. In most markets, it sounds ridiculous to even consider finding something even remotely close to that (or even HALF of it).
In markets like this, you’ll find consumers more willing to BUY than rent.
It would have to be a market where loans are very hard to get for people, but in the last 20 years, loans have been fairly easy for people to qualify for.
As mentioned before, only markets that are way below the US median home price will qualify for the two percent rule; like in the $40,000-$80,000 price range (even $80k is cutting it close as that’s a $1,600 rent — a rent that very few in these markets can afford).
Another reason why these are hard to find is because of affordability. In markets where the average price is $50,000 (the only markets where you’ll find the 2% rule), are markets where the average resident can’t afford rent above $1,000.
Doesn’t consider these factors:
- Repair costs –
Even though the purchase price checks out with the two-percent rule…. What about the repair costs? Sure you might find a property that rents for $1,000 and the purchase price is $50,000, but it could be completely dilapidated inside, and need another $30,000 to repair.
Do consider how much it will cost to fix a house before buying it and do estimate the rehab costs appropriately
- Location -We all know the cliche: “Location, location, location”. But the sad truth of the 2% rule is that most areas that check out in this buying formula, aren’t very good areas. Location in real estate determines the tenant quality, the re-sale value, the appreciation, the appreciation of rental income, the vacancy rate, etc. These are ALL important when it comes to real estate investing… not just a ratio between rental income and the purchase property.
- Other costs –
The 2% rule obviously doesn’t consider the plethora of other costs that are associated with real estate that you much consider if you want to be a well-rounded investor who knows how to maximize return while minimizing risk. Here’s a list of these costs: Taxes – how much does the government bill you every year for property taxes?
- Vacancy –
Every market area has a rate of vacancy; meaning, for how long and how often do tenants vacant your property? This IS a cost. Because every turnover costs you money (you need to make repairs; you’ll need to pay for advertising to find new tenants; you’ll need to pay for management to find a tenant (or do it yourself which still costs you your time).
- Maintenance –
Every month you should be deducting a certain amount from your rental income and deposit that portion into a bank account that will cover future maintenance and capital expenditures. Don’t neglect these real costs or it can wipe out your cash flow!
- Mortgage –
Most real estate is purchased via leveraged money; AKA: a loan. This is something to consider when it comes to your cash flow. A high mortgage will greatly reduce your cash flow. However, when it comes to the properties that will actually qualify for the 2% rule, you most likely won’t have to worry about a mortgage because at that low price range you’ll be buying with cash.
- Re-sale value –
What a well-rounded investor almost always considers is this: “Will the property still be valuable in the future?”. Now, we can’t ever predict the future, but we can make educated guesses about the trends. We want to make sure that our investment not only holds the value but also increases over time (either via appreciated home value and/or increased rental income). You might be saying, “Well I don’t plan on selling the property!”. Well even if you don’t have the intention of selling, you can’t predict the future. You don’t know if you made a bad buying decision and need to sell, or if you have better deals in the pipeline and need to free up capital.Ask yourself this before buying the property:“Is this location safe?”
– “Does it attract good owners/tenants?”
– “Is the neighborhood primarily tenants or owners?” (if it’s tenants then your end buyer will most likely be an investor who demands a discount — alternatively if its homeowners then you can get full retail value for it)
– “Are there good schools?” (Good schools increase the demand for properties in that area)
– “Are there jobs?” (Lots of jobs mean stable employment. Stable employment means long-term tenants, and short turnovers)
- Appreciation –
You might hear quite often that “appreciation is the cherry on top”, but a well-rounded investor does consider appreciation as a factor for his/her capital investment. Most areas have an appreciation rate (or depreciation rate). And appreciation is the fastest way to wealth. Unforntalty, in areas that qualify for the 2% rule, you’ll find their price exactly the same as it was 10 years ago… which means it’s actually DEPRECIATING because it’s not keeping up with inflation; in other words, it’s LOSING value not gaining.
- End buyer –
Slight mentioned earlier, but you should also consider who the buyer of this property will be if/when you ever do consider selling. Selling is an exit strategy that you must have in your investment plan. And if the neighborhood is primarily made up of tenants, then it’s more likely that your end buyer will be an investor when you do consider selling, and investors typically don’t like paying the full retail value for a property and will fight tooth-and-nail to snake you into selling at a discount.
How to find 2% rule properties
We’ve already mentioned that the 2% rule is hard to come by. Well, here are some tools and strategies to help you search for properties that fall under the two-percent rule.
Off-market property finding– One of the best ways to find good real estate deals is by finding them off the market (not on the MLS). When you do this, you’re more likely able to negotiate with the seller and lower the purchase price. You’re more likely to find discounted properties. When you do this, you can find more properties that fit the 2% rule.
Some of the ways to find off-market deals include:
- Finding distressed property
- Buying from wholesalers (people who negotiate with sellers directly, and sell the contract to you)
- Getting pocket listings from agents (agents often know of “problem” properties before it’s listed. You can get on their “buyers” list where they call you before they list it)
- Going direct to sellers yourself (using REI calling scripts and marketing methods to find motivated sellers
As mentioned before, you’ll be hard-pressed to find a market that falls under the 2% rule. That’s why you have to go after what’s called “Tertiary markets”. In these markets, you’ll find the purchase properties lower. You’ll also find the competition much lower (less population, fewer people). If you don’t live in or around a tertiary market then you’ll have to do some long-distance RE investing.
Here’s a video explaining it:
Another buying strategy to consider with the 2% rule is the Brrrr method. This is an acronym that stands for:
This is an investing strategy that has created many millionaires.
Here’s a video from one of Call Porter’s very own co-owners, explaining it:
Alternatives to the 2% rule
The two percent isn’t the only method to calculate a real estate deal. There are many (and far better) formulas.
Before I give you that list, here’s a video on some “rules of thumbs” to real estate:
Very similar to the 2% rule but the rental income must be one percent of the purchase price (instead of 2%). This makes entry into the market much easier.
Now, instead of $2,000 being the requirement for a rental income on a $100,000 purchase price… you’re looking for $1,000 rental income on a $100,000 property. This opens up the available markets you can buy it.
Of course, there are things you should consider that we’ve already covered in this article.
Not necessarily an official formula, but it’s what I’m calling the strategy for evaluating the total costs and income, and verifying if cash flows. If you’re buying for cash flow, then the number one thing to consider is, “Does it cash flow?”. That’s all that matters. Not whether or not it falls under the 2% rule or not. Evaluate ALL costs, to answer this question
One of the biggest mistakes that new investors do is only subtracting the mortgage payment from rental income to calculate cash flow.
This is NOT how you calculate cash flow.
You need to consider all costs like:
- Maintenance fees – (every now and then you’ll need to repaint, fix lighting, fix faucets, etc. Deduct a portion every month and save it.
- Taxes – (we’ve already mentioned property taxes, but this is a real expense every month —even if it’s a yearly bill. You must also consider that in some states, property taxes increase every year, like in Texas)
- Capital expenditures – (a property has big expenses that you’ll have for fork over. For example, every 10-20 years you’ll have to replace a roof. Every 10 years you’ll have to replace the water heater. Don’t forget about these costs or your cash flow will be wiped out; imagine in 5 years after buying your property, you’re spending over $10k on a new roof. If you never allocated money towards CE, and you were making $200 in cash flow… there goes all that cash flow.
- Property management – (even if you’re managing the property yourself, you still want to pay yourself. If you’re not doing it yourself, that’s a monthly fee. You also might want to consider having a bonafide lease agreement with tenant clauses to consider in your lease agreement)
- Vacancy – (There is a rate of turnover and length of re-filling a property with a tenant. This is a cost where you not only lower your cash flow for that year, but also increase your expense that year (for repairs, and finding a tenant). Make sure you allocate some of your rental income to this)
- Rent increases – (not an expense but a potential for increased income. If you’re an high appreciative area, keep in mind that you can increase the rents every year.)
Cash flow + NET Equity + Appreciation
This considers the raw cost of renting (it cash flows), PLUS the upside of appreciation growth, AND the upside of buying at a discount. If you’re able to find a property where: It’s discounted from the full value, it cash flows some, AND has a stable appreciation rate, then you might have yourself a good deal.
We’ve mentioned this buying formula but, I wanted to list it here as an alternative to the 2% rule as it’s probably the most popular buying strategy today, for real estate investors.
Financial freedom via cash flow (not the 2% rule)
If you’re searching for more information about the 2% rule, it’s most likely that you’re interested in the topic of financial freedom.
And rentals are the number one choice for people to obtain financial freedom. To obtain the financial freedom you need one important factor: Cash flow.
Cash flow determines your passive income, and passive income determines your financial freedom. Unfortunately, the 2% rule doesn’t consider cash flow. It only considers risk (a very very conservative definition of risk). To achieve financial freedom sooner than later, start buying properties according to cash flow today. Make sure that properties cash flow, and consider all costs to a rental property. Only use the 2% rule (or whatever rule) as a guide (or something interesting to look at) rather than a rule for buying real estate.