Why 2% Rule for Buying Rentals is Not Good

The 2% Rule is a hot topic in the world of real estate investing today, specifically among newbies.  A lot of gravitas seems to be placed on the metric when people analyze rentals, which bothers me since in my experience this 2% Rule is such a poor indicator of value that in my mine it is totally irrelevant…

What is 2% Rule

2% Rule is not a rule at all.  It is a guideline, a sort of a “rule of thumb”.  Those who use it say that it provides a very high-level, bird’s eye view perspective on the rental.

The 2% Rule stipulates that the monthly Gross Potential Income (GPI) should be 2% of the value of the property.  Thus, for instance, a property which throws off $2,000/month of GPI is worth $100,000…

Why 2% Rule for Buying Rentals is Not Good

When buying income-producing assets, what we are interested in is the income.  However, since everyone knows that there are costs associated with ownership of rentals, it is not the GPI (top line income) that we care about.  We care about Cash Flow that is left after all expenses have been paid for.

Herein is the problem with the 2% Rule – it focuses entirely on the income side of the cash flow equation.  This means that it does not provide any meaningful perspective on the worth or health of an income asset.

In our example, if the property which throws of $2000/month of GPI comes with $1,000/month of expenses, it would put $1,000/month of cash flow in our pocket.  In this case it represents considerable value.  If, however, operating costs for this property are $1,800/month, meaning that only $200/month of cash flow will actually materialize in our bank account, the value is vastly different.  And you won’t know which it is unless you carefully underwrite the expense side of the equation, which the 2% Rule doe not!

To wrap up

DO NOT TRUST ANY RULES OF THUMB!!!

Learn to analyze property as it should be analyzed instead…

8 Comments

  • Jay Reply

    I’m not sure anyone is suggesting if the income is 2% then it’s a done deal, sign the papers and hand over the keys. For me, it’s a level 1 assessment of a MANY level survey of the property.

    Actually, in my market, I have to use 1% or I’d never find anything.

    I do agree with your advice though, expenses MUST ALWAYS be taken into account.

    • Ben Reply

      Hey, Jay!

      Thanks for your comment. Yes, I agree. It’s just that I see many people relying on ti much more than they should.

      Thanks indeed for posting.

  • Lisa Reply

    Well, that’s interesting! I had assumed, when I heard that investors were getting properties that worked under the 2% rule, that they had subtracted expenses from the income. I used to wonder now on earth they achieved such great returns, even for seasoned investors. If, in fact, they’re just looking at gross income, that puts everything into perspective! I feel a lot better about my 1% now. 🙂

    • Ben Reply

      Well, Lisa – I am not sure you should feel better about your 1% rentals. A rental can be great at 1% and terrible at 1%. The same can be said about a 2%, or even a 3% rental. There are just so many moving parts to consider, that any “rule” is just meaningless, which is my whole point!

      Thanks so much for your comment. Feel free to come back 🙂

  • Luis Reply

    Ben,

    if PV is the property value, and one subscribes to the 2% rule and 50% rule, then the expected monthly income is:
    (2 * PV)/(2 * 100) minus the mortgage costs which would be around $3 to $7.50 per $1000 of property value under various assumptions (10% down, 6% rate at 20 years, 30% down, 6% rate at 30 years, etc, etc.).

    That is, if both rules are applied, expect a:
    Net monthly income of $60 to $200 for a PV of $20K to $30k
    Net M.I of $120 to $400 for a PV of $40K to $60K
    Net M.I of $210 to $630 for a PV of $70k to $90K
    Net M.I of $300 to $840 for a PV of $100k to $120K
    Net M.I of $390 to $1050 for a PV of $130k to $150K
    etc.
    Those imply a very nice return. However, there are 2 issues typically: on the low end of PV, there’s just too much risk, as most of the properties are in subpar neighborhoods; and on the high end of PV, you rarely see a deal of this type.

    Like you, I think there is no substitute for proper analysis. Rules of thumb just are good to give an idea of the range above (so that one can get an idea of where in the band a specific deal is). But, as they say in my country: “You can’t improvise Experience” and it is all about perspective, thinking hard about the deals, running the numbers and using experience to decide if a deal is good or not.

    Luis
    PS. The numbers above are approximate… I think representing them this way is easier for quick comparisons… maybe I should write a post in BP about this…

    • Ben Reply

      And this is why we underwrite to the IRR – it takes into account all of the variables 🙂

      Luis – a post on BiggerPockets is a great idea. Let me know if I can help!

      • Luis Reply

        This week is busy, but let’s connect over email next week and we can put something out in BP then.

        The concept is to show what these rules of thumb mean, in terms of monthly $ for typical houses. Probably in a chart, so that folks can easily see where their deals fall.

        I think it helps in 2 fronts: as an easier comparison of any specific deal (and by the way, the rules also imply a specific IRR band, under common assumptions of cost of money, etc); and also as a calibration for retirement planning (that is, how many of these typical deals you need to get to a certain monthly income).

        The TL;DR will be (as expected): IRR is a better metric, Multi-Fam gets you faster than SFH to your goals…

        I think once you look at the numbers and their implications, it becomes clear that RE is just about the ability to get good deals come to you. There are too many dollars chasing too few of the deals that make any sense.

        • Ben Reply

          I am not convinced, Luis. Relative to IRR, since the movement of money and timing thereof is so paramount, it’s very difficult to build a “blind” model. As to the rest of it, it sorta sounds more work than it’s worth. I am willing to chat about it, though…

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