Anyone who’s been in real estate long has heard of the various percent rules floating about; the 70 percent rule, the 50 percent rule and the dreaded 2 percent rule. These rules are, of course, just rules of thumb to be helpful guides when evaluating properties. But while I believe the 70 percent rule (multiply 0.7 by the after repair value of a property and then subtract the rehab cost to get your strike price) is good and the 50 percent rule (a multifamily property’s operating expenses will be approximately 50 percent of its income) is OK, the 2 percent rule is junk and should be discarded in its entirety.
Just to recap, the 2 percent rule states that you should aim to buy a rental property at a price where its rent is 2 percent of the total cost. So for example, if the all-in price of the property is $50,000 and it rents for $1000/month, the rent is 2 percent of the cost ($1000 / $50,000 = .02 or 2 percent).
This is a bad rule. In fact, it is a really, really bad rule.
The 2 Percent Rule, Cash Flow & Maintenance
The first problem is that the two percent rule leads investors into areas that only seasoned investors should go; namely the worst parts of town. Generally speaking, properties that will meet the 2 percent rule’s criteria are in high-crime, high-poverty and highly dilapidated areas. These are the types of areas where properties are all but given away. And yes, when you plug all the numbers into your financial calculator it will meet the 2 percent rule and cash flow spectacularly. The only problem is that your financial calculator will be the only place such a property cash flows.
It’s critical to remember that a furnace costs the same in a $30,000 house as it does in a $300,000 house. Same goes for the air conditioning unit, roof and hot water heater. The appliances, countertops, doors, lights, bathtub surround and the like might be cheaper, but by nowhere near as big a margin as the house itself. In other words, the rehab and upkeep costs on a cheap property won’t be that much less than those on a more expensive one. And when the rent is substantially lower and the costs are only a little bit lower, well, that spells problems.
Furthermore, in some ways, these cheaper properties will be more expensive to maintain. Yes, you’ll save on taxes, but properties in rough areas often have higher turnover and longer vacancies. It’s also more likely that a tenant will default on their rent and you will be forced to pay to evict them. Finally, such properties are more likely to be left in rough condition or be broken into. It takes a long time to pay for a new A/C system on $500 a month rent after a copper thief stops by!
I have seen many investors try to buy in these types of neighborhoods and very few succeed. Yes, there are good tenants in rough areas and yes, there are investors who make it work. But the one’s I know who have had success there specialize in those areas. They don’t buy there because some silly rule told them too.
Keep in Mind
Overall, what this highlights is that the 2 percent rule fails because the rent to cost ratio doesn’t correlate with cash flow very well. That doesn’t mean that the rent to cost calculation is useless. It’s not. In fact, we use it all the time. But its use comes from evaluating similar properties in a similar neighborhood. It does not work when comparing a B property to a C property. And it especially doesn’t work when comparing it to a D property. Such a comparison is definitely an apples to oranges sort of affair.
But the 2 percent rule would have you believe that the rent to cost ratio is comparable across all types of real estate and furthermore, that there is a magic number you need to hit. I hate to inform you that there is no such magic number. We’ve had properties we rent for 1 percent of their cost that cash flow far better than properties we rent for 2 percent of their cost.
So let us dispense with the 2 percent rule once and for all, and let us do it before it leads another hapless investor into buying on skid row.