Successful real estate investing is about understanding the numbers, such as identifying the monthly expenses and accurately estimating them. For example, seasoned investors use various tools and formulas to determine a good rental property. One of the most commonly referenced by Buy & Hold investors is “The 2% rule”.
What Is the 2% Rule?
The 2% rule is a simple calculation an investor can use to quickly “test” if an investment property could generate a positive net profit also known as cash flow. This rule is only applicable to the rental type of investment properties.
The calculation is the ratio between the monthly rental income and the purchase price of the property. If the ratio is greater than or equal to 2%, then the property should cash flow.
The 2% Rule Ratio = Monthly Rental Income / Purchase Price = ratio
If the ratio > 0.02, then the property should cash flow.
For example, a property purchased for $100,000 and is rented out for $2,000 satisfies the rule ($2,000 / $100,000 = 0.02). However, if the same property is rented out for $1,000, then it does not satisfy the rule.
Is the 2% Rule Practical?
Although “The 2% Rule” is commonly known amongst real estate investors it’s not relied upon in practice. The issues with it are the following:
- Missing Actual Numbers
The first problem with “The 2% Rule” is its name. The term rule makes it seem like it’s a requirement when it’s a mild suggestion.
I don’t include it as part of my overall analysis. Even when it comes to “The 1% Rule”, I only acknowledge the fact I’ve met the “rule” after doing other forms of calculations.
Missing Actual Numbers
Although a deal may pass the test, the rule doesn’t reveal how much cash flow will be generated. The only two numbers the rule depends on to calculate are the rental income and the purchase price to determine if a property would cash flow.
Cash flow is calculated by subtracting the monthly expenses from the monthly rental income:
Cash Flow = Monthly Rental Income – Monthly Expenses
The following are a list of monthly expenses that should be accounted for with a rental property:
- Homeowners Association Fee
- Capital Expenditures
- Property Management Fee
From the list of monthly expenses above, the rental income and the purchase price alone are not enough information for an investor to make a sound decision on pursuing a deal.
For example, the mortgage payment including taxes and insurance deduct most from the rental income. Add HOA fees, property management fees, and utilities and the property could easily cash flow zero or even negative.
When I started to take real estate investing seriously, I read every book recommended to me. The 2% Rule was mentioned in one of those books. But, from my personal experience, I have yet to come across a deal where I can charge rent at least 2% of the purchase price.
The times have changed where new investors need to manage their expectations. Even if I was presented with a deal that was dirt cheap, I would still be cautious because I know that the property probably requires a lot of work.
For instance, I mentioned to my wife a property for sale in a prime location and mentioned the price. Without looking at any pictures, she already knew it was a gut job. The house was gutted down to the studs.
If an investor was determined to follow some pass/fail test, the 1% rule is more realistic. I’ve satisfied this test on a majority of my properties. The instance where I was not able to pass this test is when I purchased in a seller’s market where the prices were high.
What Is the 1% Rule?
The 1% rule is a simple calculation that investors use to quickly “test” if a rental property could generate cash flow. Similar to The 2% Rule, the calculation is the ratio between the monthly rental income and the purchase price of the property. However, if the ratio is greater than or equal to 1%, then the property should cash flow.
The 1% Rule Ratio = Monthly Rental Income / Purchase Price = ratio
If the ratio > 0.01, then the property should cash flow.
For example, a property purchased for $130,000 and is rented out for $1,600 satisfies the rule ($1,600 / $130,000 = 0.012). However, if the same property is rented out for $700, then it does not satisfy the rule.
Is It OK To Have a Negative Cash Flow?
Successful investors don’t purchase properties based on skepticism and solely hope for appreciation. Instead, they do proper analysis using conservative numbers, such as the lowest rental income in an area.
Investors should acquire properties that will provide a stable return on their investment and that can cash flow today! This is especially important for those that want to be financially independent but live off the cash flow.
Sound investing is not about being hopeful about a possible future based on a “what if” scenario. That is more of gambling than investing.
However, there might come a time when it’s acceptable, but only for a short period. An investor has to make a trade-off on one of their properties to adjust to an economic downturn. All the more, an investor needs to know their numbers and have sufficient cash reserves.
Being satisfied with breaking even or being complacent with negative cash flow for sake of appreciation is a habit that should not be adopted. Otherwise, the investor could easily be led to a terrible financial situation.
When Is a Good Time To Invest In Real Estate
No one can ever perfectly time the market. The best time to invest in real estate is always!
This doesn’t necessarily mean an investor should buy a property right now. Instead, real estate investing requires a lot of analysis before making an offer. In 2020 alone, I analyzed over 50 properties, walk-through 12 of them, and made at least 5 offers.
Regardless of the condition of the housing market, there are always opportunities to invest. For example, a buyer’s market will have a large inventory of houses for sale including foreclosures. Investors can purchase multiple foreclosed properties substantially below their market value.
In a seller’s market, the housing inventory is low and the competition is high! Yet, there are still opportunities to invest.
For example, 2020 was a seller’s market. Properties would go under contract within hours of being listed. Furthermore, I would be outbid by full-cash offers and first-time homebuyers willing to make offers $30,000 above list price.
Finding great deals just may take some creativity to find opportunities, such as searching for absentee owners who are motivated to sell. In that same seller’s market previously mentioned, I was still able to acquire a property. The owner had to relocate due to a job and was very motivated to sell.
How To Decide If a Property Is a Good Investment
Every investor has a different approach when it comes to investing. Analyzing a property can even become second nature to a seasoned pro. However, I still pull out my spreadsheet when a property meets my search criteria.
The calculation I continue to perform and that I also recommend to young investors is calculating the Cash-on-Cash (CoC) Return. The CoC is calculated by dividing the annual cash flow by the initial investment.
Cash on Cash Return = Annual Cash Flow / Initial Investment x 100%
For example, a property with an annual cash flow of $1,200 with a down payment of $20,000 will yield a return of 6% ($1,200 / $20,000 x 100%). Check out my separate post about Cash-on-Cash (CoC) Return where I go into detail including a FREE downloadable worksheet to help with future analysis.
How Much Should a Rental Property Cash Flow
I always strive to cash flow of at least $100/mo. on all my properties. Rental income tends to rise over time. However, it’s good to have a base when determining if a property is a good deal.
This becomes particularly important when an investor begins to solely rely on cash flow. For example, assuming each property cash flows $100/mo., an investor needs 20 units to generate $2,000/mo.
What Is Much Cash on Cash (CoC) Return is Good?
The Cash on Cash calculation gives an idea of what kind of return an investment property would produce. The average return in the stock market is 7%. Therefore, I like to strive for a return better than the stock market.
Here is the range I use to determine the quality of my return:
- Good: 8% to 10%
- Better: 10% to 12%
- Fantastic: 12%+
The most important skill an investor can have is knowing how to analyze deals. However, not all deals are created equal. Therefore, a simple “rule” is not enough. Other expenses need to be accounted for to give a more accurate estimation.
The 2% rule becomes relative to an investor who is very familiar with the local market they commonly invest in. I invest in various zip codes in my local market and instinctively know exactly which areas have a strong or stable rental income. This just comes with time with each property analysis and purchase.
Young investors need to do their due diligence and start off using conservative numbers. Yet, there also needs to be a balance so that young investors don’t get stuck in analysis paralysis.
I’m not recommending people go out and buy a bad deal. Instead, numbers shouldn’t cause anyone to be afraid to ever invest in real estate. Success can be achieved by action not just by the information alone.