How to use The 2% Rule to Analyze Rental Property
Finding and analyzing rental property is a daunting task.
You may find a hundred or more potential deals in your target market and each one has its own income and expenses to consider.
It could very well take weeks to analyze every deal... and by the time you get through the list everything will have been sold!
Obviously that's not going to work. So how do we get around this.
It's simple. Use screening tools.
One great screening tool is called the 2% rule. Keep reading to find out more.
What is the 2% Rule?
There are a lot of "rules of thumb" floating out on the internet, and this is one of the more popular.
The 2% rule states that if your monthly rent is roughly equal to or greater than 2% of the total property price, then you will be able to generate positive cash-flow on the property.
- A $100,000 property should generate $2,000 per month in rent
- A $75,000 house that requires $50,000 in renovations should have an after repair value of $125,000 and rent of $2,500.
The 2% rule isn't just a random rule someone made up - it is a simple concept created using the Gross Rent Multiplier (read an in depth article about it).
GRM is generally calculated on a yearly basis whereas the 2% rule uses monthly rent. If you're familiar with GRM already, it's pretty simple to convert the 2% rule over the gross rent multiplier:
$2,000/month * 12 months = $24,000 rent/year
We remember the formula for Gross Rent Multiplier from my article (linked above):
GRM = Asking Price / Gross Rents
So, the GRM for the above example:
GRM = $100,000 / $24,000 = 4.17
It's important that I point out that the gross rent multiplier and the 2% rule are inversely related to each other.
The higher the rent as a percent of value, the lower the GRM is. So basically, the lower the GRM and the higher the rent %, the more potential income.
It makes sense, right? The GRM is how many years of rent you need to cover the cost of the property. The more rent you collect, the fewer years it takes to pay off. More rent means fewer years, that is an inverse relationship.
Anyhow, let's just round the answer and say that the 2% rule means you need a GRM of 4.2 or lower. So, I'll just round and say that the 2% rule means you should find property with a Gross Rent Multiplier of 4.2 or lower.
How to Use the 2% Rule
As I mentioned before, the 2% rule should be used as a screening tool for investment property. It is not an accurate reflection of net income because it uses only the gross rent and doesn't include any expenses at all.
Just like you wouldn't buy every stock with a low P/E ratio, you may not want every property with a very low GRM, or one that meets the 2% rule.
A company with a very low stock price to earnings ratio may be undervalued, or it may actually be a company that is likely to fail. A property with an extremely low price compared to its rent may be a property with an immense amount of deferred maintenance, be in a C or D class neighborhood, or have any number of other issues with it. So, the gross rent multiplier is to real estate as the P/E is to a stock.
There are so many potential risks in real estate that you may not even be considering that could be affected the GRM of the property, so think carefully before jumping on any property that looks too good.
USE THE 2% RULE AS A SCREENING TOOL
We want to block out bugs but we still want to let the air in. So, just like we install screens instead of walls, we want our real estate screening tools to allow enough deals through to look at.
The process is very simple.
- Filter through all your potential properties and make a list of the asking price and total rents. If possible, give a very rough estimate of repairs necessary as well and add that to the asking price. Using this information, calculate what % the rent is of the total price.
- Sort the list from highest to lowest
- Take a closer look at every property that has a gross rent multiplier below 4.2, or exceeds the 2% rule.
By using this method, you may be able to exclude 80-90% of all the potential deals so you can focus on the ones that have the best potential. Hopefully you can make some offers and close a deal.
If not, you can adjust the rule to fit your needs - keep reading to see how.
THE 2% RULE ISN'T A RULE, So Make it Your Own
Now, you could stop here and take the basic information and run off into the world trying to buy property.
-and the readership on this page just dropped off the map-
For the rest of you that hung in there, let's take a deeper look into the income expense ratio.
The reality is that real estate is very local, so it's pretty obvious that nothing can be a 'rule'. That why it's so hard to learn about real estate, because there is so much different information out there and it may work in that market.
You wouldn't expect the ratios to be the same in Florida, Oklahoma, or California. Anyone who says they can use the exact same analysis for each place is lying to you.
Just a quick anecdote - insurance rates in Florida are at least double the rates of where I'm from in Massachusetts. I'd have to add another percent to the expense assumptions to account for that.
Sure, 1% won't break your numbers, but make a few mistakes like that and soon you're losing money.
What's more valuable is learning how people derive these rules and then learning how to apply it to your own situation and market.
How to Determine a Good income Ratio in Any Market
You create your ratio by working backwards in order to determine it. Remember, the 2% rule and gross rent multiplier only take income into consideration and exclude all expenses. It uses certain assumptions - primarily the 50% rule, in order to come up with this ratio.
In a nutshell, the 50% rule assumes that half of your rent will go toward expenses. You can read more about the 50% rule in this article if you want to see why.
So, let's see how the 50% rule can be used to work backwards to calculate the 2% rule.
1) Determine Your Cash on Cash Return Goals
The first thing you want to do is to create a goal for the return on your cash investment. Personally, I aim for 40% or higher but I'm willing to accept a 35% return on my money. Let's use 35% for our calculations.
- If I buy a $100,000 property, that will require around $20,000 down payment.
- I need to return $7,000 per year in order to earn 35%
You can use any percent you want, but make sure it is pretty high. Properties with leverage should have high returns.
2) Estimate Your Expense Ratio
This is where the 50% rule comes in. Again, no rule works in all markets, so you should understand the expenses in your particular market before using any rule. You may find your expenses are 55% or 40% or whatever. Check out the article I linked above.
Estimate all the costs of holding the property, including taxes, insurance, waste removal, vacancy, savings for capital improvements, etc... Another major thing to remember is calculating the cost of property management.
Even if you manage it yourself, you should count your time as if you were running a property management business. A lot of new investors forget this and fail to pay themselves for their time.
You can estimate these expenses and calculate this ratio based upon current rents at a few existing properties. By taking a few real world examples in your local market, you can create some fairly accurate assumptions about expenses.
For our example let's just go with the 50% rule and assume that expenses are equal to 50% of our collected rents.
3) Estimate Mortgage Expenses
Use a mortgage calculator in order to calculate your monthly mortgage amount.
It's best to calculate mortgage as a percent of total value.
If we assume you can get 4% interest on a 30 year fixed rate loan with 20% down, your P&I payments will be .04584, or 4.584% of the total value of the property each year.
Calculate this by going to a mortgage calculator and figuring out the monthly payments, an $80,000 loan on a $100,000 property is $382 per month or $4,584 per year. Dividing this by $100k, you get 4.584%.
4) Calculate Your Own "2% Rule" using income and expense ratios
Alright, so I used to have pages worth of calculations on this page, but I decided to carve those calculations off to another page to keep the reading easy here. If you are really interested in knowing exactly how I derive the results, please check out my page on calculating your own income ratio.
For everybody else that doesn't care how I got here, just read the formula below.
With this you can easily change your desired rate of return, down payment requirements, expense ratios, and mortgage rates. It is a very powerful calculation!
Real Estate Screening Example 1
Let's say you find that your expense ratio is low, around 40%, you're able to manage to find a loan program with 10% down (or owner financing) and it's at 6% for 25 years, and you want to return 40%. Let's see what your rent screening criteria will give us:
X = .4Cash/.4MV + Mort/.4MV
X = .1 + .0696/.4
X = .274
.274/12 = .0228
You should follow the 2.3% rule
Real Estate Screening Example 2
You have an expense ratio of 50%, can get a loan with 10% down at 4% for 30 years. You want a 35% cash on cash return
X = .35 Cash/.5MV + Mort/.5MV
X = .7(.1) + 2(.04584)
X = .07 + .092
X = .162/12
Your rule is 1.35%
Use Caution when Using the 2% Rule (or any other Rule)
As you can see with my calculation, the ratio is affected by your down payment, interest rates, expense ratio, and desired return. By changing any one of these, you will come out with a different "rule" to follow and every market will likely have a different result.
We are fortunate though that it is extremely conservative. Whoever created this concept made it very vague and set the expected returns very high. It is generally said that by following the 2% rule, a property should have positive cash flow.
This wide margin of error is what makes the rule so successful for so many people - it can almost never be wrong. Well, positive cash flow is definitely a long way off from 35% cash return. Either way, there is a psychological effect of losing money vs earning nothing, so the 2% rule will continue to be widely used in the foreseeable future.
Remember, being 'not wrong' does not mean the rule is successful. Don't use the 2% rule expected huge returns because your variables may lead you to just barely be cash-flow positive.
Money tends to flow toward high returns, so markets with consistently high returns will find capital flowing into those areas. That money will cause properties to appreciate until profits shrink to a "normal" level (as compared to other investment such as the S&P 500). Because of this, it may be hard to actually find properties that fit the 2% rule criteria.
Problems With the 2% Rule and Calculating Your Own Real Estate Screening Ratio
This equation begins to fall apart under two circumstances. First, if the down payment becomes very small then the ratio will become very low, well under 1%. Since the 2% rule is based upon cash on cash return instead of return on equity, the less cash you have in the deal, the less you need to reach your 35% profit.
Think about it, if you were so fortunate to only have to put $1 down to buy a property, you only need 35 cents per year in order to reach your goal of 35% return. Doesn't take a mathematician to figure out this won't work out well for you.
The other situation where the equation begins to fall apart is when the down payment becomes too large and the mortgage amount drops. As this happens, the ratio will begin to approach:
X = Cash Return/Expense Ratio
This will create very high ratio. It intuitively makes sense though - the more money you put down, the lower of a GRM (higher rent as a percent of value) in order to achieve that very high cash on cash return.
For example: with a 35% goal for return with a 50% expense ratio, we would follow a "5.8% Rule", which is pretty high.
The Failings of This Screening Tool Simply Confirms What We Intrinsically Know About Real Estate Investing
That is - the less you put down then the higher the return on your cash investment. Of course, earning $100 on a $200 investment is a far higher return than earning $5,000 on a $100,000 investment.
I am not saying that you should always strive to put 0 down and I'm not saying you should avoid higher down payments. There are obvious and good reasons to approach investments in different ways depending on the circumstances, I'm just saying that the problems of the 2% rule simply reinforce our already existing understanding of real estate investing.
Avoiding the problems of the 2% Rule
If you run a solid analysis on several properties using your mortgage rates and actual down payment requirements, then stick to that number regardless of how much you will be putting down.
So, if you are required to have a 25% down payment, use the formula to determine your 'Rule'. Let's say you calculate that your rule is actually the 2.1% rule. Stick to the goal of finding properties that rents are 2.1% of the value, regardless if you plan to put 50% down, or somehow find a way to get below 25% down.
By calculating it based upon what your mortgage should be, you can avoid the formula on the edges where it begins to give inaccurate numbers. Since virtually all loans on rental property will require 20-40% down, this can work.
Also, don't forge that different types of properties require different amounts of maintenance. Older properties will also require significantly more mainenance.
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