This article was updated March 17, 2021.
I get why newbie real estate investors might be enticed by the 2% rule. In short, the rule states that if you can rent the property for 2% of the purchase price, it will cash flow. Is that true?
Occasionally… but in today’s hot market, that “occasionally” is more like, “very, very rarely.” When 20 buyers—all eager to escape their apartments after a full year of COVID-19 quarantine—are all competing for the same property, trying to score properties that fit neatly intoany “real estate rules” can be a serious challenge.
But does that really matter? Smart investors should never rely on one rule to dictate their strategies. Some people buy on emotion and justify with logic—and use the 2% rule as said justification. And some people see the 2% rule as a dictate, and panic when they can’t find properties that fit the mold.
Frankly, some truths need to be revealed about this infamous rule—and I’m here to share them. I can only dream of the day that I get on the BiggerPockets Forums and don’t see a single person ask any of the following questions:
- How come I can’t find any properties in my market that meet the 2% rule?
- What if I found a property I like, but it doesn’t meet the 2% rule?
- Where can I find properties that meet the 2% rule?
Sound familiar? Been asking yourself these questions? Kick the 2% rule to the background of your decision-making process. Here’s why.
Note: In no way am I suggesting that it’s your fault for thinking the 2% rule is important. You’re not dumb. If I were just starting out, I’d put some stock in the 2% rule, too. It’s not your fault. It’s misleading marketing.
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What is the 2% rule?
The 2% rule says that the rental amount a property brings in should be at least two percent of the total purchase price. That’s hard to achieve in normal times. But when rents are falling across the U.S. as Americans leave big cities and renters are struggling, even with the stimulus, its nigh-impossible
For example, let’s say you’re looking at a property that costs $100,000. In order to meet the two percent rule, you would need to collect $2,000 per month in rental income. What if you find a property for $80,000, but it only rents for $1,000? Investors dead-set on the two percent rule would eliminate that property—$1,000 is only 1.25 percent of $80,000.
What about the 1% rule?
Something to note on that $80,000 example: While the property doesn’t meet the 2% rule, it does meet the rule’s little sister—the 1% rule. It works just like the 2% rule, but it only requires that the rental amount be one percent of the purchase price.
Some investors argue that as long as you hit the 1% rule, you are still making a good rental property investment. None of these are hard, fast, or concrete rules, so you can do or use whatever you want with them. But first, let me caution you about how much you use them at all.
Related: Investors: Memorize These 11 Real Estate Metrics Now
2% rule reality checks
Yes, the 2% rule used to be really handy. I don’t want anyone to think that this rule never served a purpose—it certainly did. But here’s the truth now: In 2021, a lot of new investors are joining the real estate game. You might be one of them. And during your research, you might come across rules that have gained a lot of traction across the real estate community. Maybe you stumbled upon outdated articles or forum posts citing the 2% rule as gospel—or even the 1% rule.
Ignore them.
The market now bears no similarities to the market then. And even if we were operating under identical circ*mstances, I’d still tell you to ditch the 2% rule. Here’s why.
Inaccurate terminology
In no way is the 2% rule truly a “rule.” It is strictly a “guideline.” (Maybe someone called it a rule because “2% guideline” sounds pretty dorky.) A rule is something you should strictly follow. But investors don’t have to follow the 2% rule by any stretch—and quite honestly, following it could get you in trouble.
The 2% rule simply helped you sift through properties faster. If you’re scrolling through 100 properties in a shopping spree, you could quickly eliminate the bottom-rung options. Even in the 2% heyday, you still needed to run more stats.
Estimations vs. actual numbers
Oh man, does this one get my blood boiling. Hear me when I say—and this goes for every single investor out there—never, ever, ever use estimated numbers when you can use actual numbers! If you’re buying a rental property, the only numbers that you need to estimate are vacancy and repairs. Otherwise, you can find just about every number you need.
That’s why the 2% rule is, for the most part, bunk. It’s only an estimation. It doesn’t tell you for sure what the numbers will be—or even that they will be good.
Let’s say you find a condo unit that meets the 2% rule upon first glance. As you gather actual numbers, you realize the area has high property taxes, the condo fee is astronomical, and, for some reason, insurance isn’t cheap. Once you use those high numbers to calculate hard equations, you’ll realize the property offers minimal, zero, or negative cash flow.
But it met the 2% rule! That’s why I say don’t estimate.
Good properties don’t abide by rules of thumb
Many perfectly fine properties don’t meet the 1% or 2% rules. You might be looking at the 0.5% rule, or the 0.25% rule—or even less. Really, it’s about your budget and your goals for your portfolio.
Every investment requires trade-offs between returns, cash flow, and risk. You could find a property that meets the 2% rule but is such a high-risk investment due to location, property quality, tenant quality, or a declining market that the projected cash flow will never pan out.
Maybe there’s a quality property in an excellent location—but it would only make, say, a 0.8% rule (if one existed). Despite the lesser projected cash flow, it might be a better investment!
There are a million other factors to consider. Does it cash flow? How’s the location? What’s the condition? Is the market growing or declining? Is the tenant pool high quality? Those are the questions that matter—not any “rule.”
Times change
Just because something was once a solid rule doesn’t mean it is so now. That’s currently the case with the 2% rule. A few years ago, the 2% rule was viable. Nowadays, that’s not the case. I don’t know of a single (good) market where you could expect to find properties meeting the 2% rule—especially in our current COVID-19 housing market.
I know, I’ve crushed all of your souls. Maybe it will come back one day. Even if it does, though, don’t expect it to apply in cities like Denver or Austin.
Related: How to Calculate Cash-on-Cash Return (Made Easy!)
What doesn’t the 2% rule account for?
With all that said, should you ever pay heed to the 2% rule? Not really. The 2% rule doesn’t account for, coincidentally, two things:
- The condition of the property or location
- Your net cash flow
Let’s say you find a $35,000 deal in Florida with a monthly rent of $700. Meets the 2% rule, right? Right.
Two problems. First, I can say with fairly high certainty that any property you find in Florida for $35,000 will be a total junker. Secondly, insurance and property taxes are so high in Florida that combined with the rest of your rental expenses—including repairs on your junker property—you’ll land right at zero (or less!) for cash flow.
So much for that “good” investment.
There’s a lot more to a property than “rules” and guidelines. The closest I, personally, ever got to meeting the 2% rule was a nice rehabbed property in Atlanta I bought for $55,000. It rents for $975 per month. But this was back in the Atlanta heyday—you won’t find a similar deal there now (and if you do find it, be leery).
As the Atlanta market progressed, investors were forced to forget about the 2% rule and start thinking about the 1% rule. Now, you’re lucky to hit the 1% rule!
But did barely meeting the 1% rule mean the properties were bad investments? No way! You have to consider quality, location, and tenants—none of which have anything to do with these rules.
Related: 3 Real Estate Deal Analysis Rules Investors MUST Know
How to determine feasibility
With today’s hot market, investors are realizing they can’t buy as many cheap properties with great returns as they could even just a year ago… or a year before that… and so on. Great news for the real estate market, all of our current investments, and the economy as a whole—but it is forcing investors to settle for lower returns.
At this point in the real estate market, sub-$50,000 properties are, in my humble opinion, sketch. I personally won’t buy anything in this price range. For one, the property will need work. Worse, you’re looking at the lowest class of tenants, which can add significant vacancy, eviction, and repair expenses. An eviction followed by an empty house followed by a nasty turnover repair cost blows your two percent delight out the window, does it not?
In terms of feasibility, here is my process.
- If it doesn’t meet the 1% rule, by how much does it not meet it, and what’s the market? Properties in cooler markets that don’t meet the 1% rule might be bad buys. But if you’re in Dallas or Denver and it doesn’t meet it—well, that should be assumed.
- If it meets the 1% rule, it should be considered. Run all the numbers and know the expected cash flow.
- If it meets the 2% rule, be leery, but check it out. Again market-dependent. If your market isn’t so hot, yay! 2% rule! Check it out seriously. If you’re in Dallas… someone has officially found you a junker in a questionable neighborhood that not only needs work but will attract a raunchy tenant.
Use the 2% rule only as a guideline to get you looking at a property. Once you are diving into the numbers seriously, ignore the 1% or 2% rules entirely. In no way should they justify buying a property.
Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.
