The 2 percent rule is a general guideline many investors use to determine if a rental property is a good deal. The basics of the 2 percent rule say the monthly rent from a rental property should be 2 percent or more of the cost of a rental property. I own 16 rental properties, but I don’t believe the 2 percent rule is a good judge of rental properties. The rule is too vague and does not account for many variables with rentals. Buying rental properties is all about the numbers in a particular market and the 2 percent rule assumes that all costs are the same with every property in every market.
What exactly is the 2 percent rule?
The 2 percent rule is very simple to calculate. If a home costs $100,000 with no repairs needed, the rent should be $2,000 a month. If the home costs $100,000 and you have to do $20,000 in repairs, then the repairs would make the cost basis $120,000 and you would have to rent the home for $2,400 a month.
If you think those are incredible rent to purchase price ratios you are right. If you think it is also virtually impossible to find properties that meet the 2 percent rule you are also right. I know 2 percent rental properties exist, but they are usually low-priced properties under $50,000. I think you can make money with low priced rentals, but I also know you can make a lot of money on more expensive homes that do not meet the 2 percent rule.
Related article: What is the 70 percent rule when flipping homes?
The 2 percent rule is too vague for rental properties
I do not like the 2 percent rule, because it only figures what rent should be based on the cost basis. There are so many other variables that need to be considered when buying rentals. The expenses from rental properties are what most people underestimate and the 2 percent rule was created to make sure investors don’t underestimate the expenses. If you use the 2 percent rule to buy properties you will make money if you can find properties that meet the guidelines. More likely you will never find a decent rental property that meets those guidelines unless you live in an area with very low prices or you buy a turn-key rental. The problem is the rule is so extreme that it makes it impossible for most people to buy a rental property.
If you live in an area with very low prices then the two percent rule may be a good guideline after you have run the numbers to see what costs are in your market. Taxes are different in every state, each rental property is different and even some homes that meet the two percent rule will have a tough time making money depending in the circumstances. My rentals don’t come close to meeting the 2 percent rule, but still make a lot of money. My rentals are much closer to the 1 percent rule, but I would not use any rules when trying to decide if a rental property is a good deal.
How much money do I make on my rentals?
It is getting harder to find great rental properties in my area. I even considered buying an out-of-state turn-key rental, because I could not find any great rentals in my area, but I recently got two rental properties under contract in the last two weeks.
The last rental property I bought (rental property 11) was purchased for 109,000, and I or about $12,000 of work into it. The 2 percent stated I should be getting $2,400 a month in rent, yet I am getting $1,400 a month in rent and I am ecstatic about it.
My mortgage payment with 20 percent down on a 5 year ARM is about $550 a month including taxes and insurance. When I account 10 percent for vacancies and 15 percent for maintenance, that adds another $350 a month. My total expense are $900 a month and my profits are $500 month. I had to invest close to $35,000 into this rental after down payments and repairs, but 17 percent on my money is a great return. That does not even factor the equity pay down, tax advantages, or possible appreciation. The biggest factor it does not consider is I bought the home below market value and I created $20,000 in equity as soon as I closed on it. In a recent article that I wrote about the advantages of rentals over the stock market, I found my one of my rentals produced almost a 70 percent return. That rental property did not come close to meeting the 2 percent rule.
Why do returns vary bases on the market you invest in?
There are many variables with rental property expenses in different areas of the country. These variables make a huge different in how much money a rental property will make or if it will make money at all. You have to know these expenses when you are deciding whether to buy a rental property, not use a blanket rule.
- Property taxes taxes are different in different states and even different within towns in the same state. My taxes in Colorado are extremely low; a rental property that is valued at $100,000 has taxes around $500 a year. Some states have taxes ten times higher than Colorado. If my taxes were $400 a month instead of $50 a month, my cash flow would $150 a month instead of $500 a month. The 2 percent rule does not account for this factor at all.
- Utilities are paid for by the tenants on many single family rentals, but on many multifamily rentals the landlord pays some or all the utilities. Who pays the utilities can mean the difference in hundreds of dollars each month, but the 2 percent rule does not account for this.
- HOA fees are an cost for many investors on condos or newer single family homes. HOA fees can be $300 a month on some condos or much more on large buildings that offer many amenities. The 2 percent rule does not account for any HOA fees.
- Maintenance expenses will be different on different types of rental properties. If you buy a brand new home and turn it into a rental property it will most likely have less expenses than a home built in 1900 that has older wiring, heating, roof, plumbing and foundation. When buying rentals you have to take these variables into consideration, which the 2 percent rule does not.
- Vacancies are another variable that is not considered with the 2 percent rule. In my area vacancies are less than 2 percent, but I still account for 10 percent, because I like to be conservative. If vacancies in one area are 15 percent and they are 1 percent in another area that will affect the performance of the rental property.
- Property management will eat into your profit as well and the 2 percent rule does not account for this. It is true that you will have to take time to manage the properties if you do not use a property manager, but you also won’t have that expense.
- Expected returns are not considered with the 2 percent rule either. Some investors are looking for a 20 percent return on their money, some want a 5 percent return on their money and others may not even care about the returns, but have other motives for investing in rentals.
- Mortgages are also not accounted for with the 2 percent rule. If you buy a potential rental as an owner occupant with 3 percent down and mortgage insurance you will have much payments than an investor who puts 25 percent down.
If you buy a $100,000 rental property with low taxes, low maintenance, low vacancies, no HOA and manage it yourself and have a mortgage you might have $900 in expenses like myself. If you buy an older rental property with an HOA, property manager, needed maintenance, a mortgage and high taxes you might have $1,500 a month in expenses or more! In one scenario you make a lot of money each month and in the other scenario you are losing money each month.
This shows why it is so important to run the numbers yourself when buying a rental; do not rely on a rule. The 50 percent rule is another blanket rule that assumes the expenses (excluding the mortgage) on a rental property will be 50 percent of the rent. This rule can also be very misleading as we saw from the previous paragraphs expense calculations. If you want to know how much money a rental property will make you have to run the numbers yourself and you have to know all the numbers to run to be accurate. If you need a little extra help figuring those numbers and deciding which numbers are important, check out my Complete Blueprint to Successful Real Estate Investing.