As an investor, there isn’t enough time in the day to analyze the metrics of every single deal you come across. The 2% rule gives investors a quick and dirty way to determine whether a property is worth looking into. But what exactly is this rule, and is it really worth using in today’s market? To help, this article will give you an overview of the 2% rule in real estate investing, what it can tell you about a property, and much more.
What Is the 2% Rule?
The 2% rule is actually a formula designed to quickly determine whether a property will produce a positive cash flow. In the ideal scenario, if a property fits into this rule, then you know whether the property is worth looking further into. This allows you to save time and look through more properties at a time instead of deep diving into the metrics of every single property.
The formula is the monthly rent of the property divided by its purchase price– monthly rent/purchase price= X. If the result is two percent or greater, then it falls within the 2% rule; if not, the property is less likely to produce positive cash flow. To simplify the math, let’s look at an example.
If the property rents for $1,500, and the overall purchase price is $75,000, then the formula would look like this: 1,500/75,000= 0.02. Because 0.02 is the decimal form of 2%, this property falls in the 2% rule and should provide the investor with a positive cash flow.
Do Properties That Meet This Rule Actually Exist?
In truth, there are many properties that meet this rule, but they may not be the cash cow that investors would like to think they’d be. Many properties that fit within this rule have a low monthly rent and purchase price.
For example, a property may have a monthly rent of $900 a month with a purchase price of $40,000 and still fall within the 2% rule. It is generally difficult to find a property with a monthly rent of $9,000 and a purchase price of $450,000. The fact of the matter is, not many are going to sell something that could make them that much money. If you’re looking for something with a higher monthly rent and purchase price, you’re unlikely to find them in big cities. Often, they’ll be located in the deep south or the Midwest.
However, there are many investors who are wary of these high purchase price properties that fit the two percent rule as they can often be riddled with issues. The amount of work it would take to fix up the property would greatly diminish the return the investor thought they would receive. This isn’t to say that every high-rent, high-purchase-price property will be absolutely dilapidated. However, it does mean that you shouldn’t immediately agree to the deal just because it falls within this rule.
The Pros of the 2% Rule
Ultimately, the only thing the 2% rule can tell you about a property is the rent-to-sales price ratio—and that’s about it. What this rule is useful for is giving beginners a better idea of what they should be looking for in terms of the number range. Additionally, a property doesn’t have to fall at exactly 2% or more to be useful, but the formula can give you an overall better estimation of its worth. Unfortunately, there are many things the 2% rule doesn’t tell you about a property.
The Cons of the 2% Rule
As anyone who invests in real estate knows, the market changes and properties always don’t abide by the rules we set up for them. The 2% rule doesn’t tell you anything about insurance fees, property taxes, the local market, the current state, maintenance costs, and much more. All these things are critical components of determining whether a property is worth the investment. Because of this, you may accidentally toss aside a perfectly valuable property by strictly following this 2% rule. Any property manager will easily give you these numbers for you to do the math and determine the property’s value; it just might take you a few minutes of digging and number crunching.
In truth, the 2% rule isn’t a rule at all but rather a test. While 2% is the ideal, it certainly isn’t the standard, and using it as such can be to your detriment.
Can a Property Be Converted To Fit This Rule?
While many properties don’t fit this rule, you can buy a “lesser” property and convert it into one that can fit this rule and provide you with a positive cash flow. However, in order to get more out of these properties, you have to do some digging. While this does defeat the purpose of the 2% rule, it will prevent you from losing out on properties with serious potential. If you find the property falls at about 1.3% or even 1%, it’s still worth investing in, and these percentages are much closer to the numbers you should be shooting for.
All in all, the 2% rule can be used to give you an idea of how much positive cash flow a property can offer you, but under no circumstances should it be viewed as a hard rule. The rent for some properties is terribly undervalued in terms of rent. Some purchase prices are just as equally overpriced—and some are both! Sometimes, the best deals we find are the ones we make on our own.
What you should take away from this overview of the 2% rule in investing is that it’s not a rule you have to follow. While it’s a great way to build your intuition as an investor and get some fast metrics, it’s certainly not the end-all-be-all.
If you’re struggling to determine whether a property is worth the investment or need help finding a good deal, Excalibur Homes can help. We’re an Atlanta-based property management group with the knowledge and experience to help you tackle any of the questions you might have as an investor, and we can help you manage existing properties. We know how complex this field can be, and we’re here to help you navigate it and make money as a real estate investor.