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…