As you build your real estate portfolio, you will run into many types of formulas and metrics to help you analyze properties. There are dozens of these metrics out there, and one popular one is the 2% rule.
The 2% rule can help you analyze potential investment properties — and avoid expensive mistakes. Want to find out what other real estate investing mistakes could be costing you thousands? Take a look at our free guide that helps you avoid the most expensive mistakes in real estate.
Ready to learn a useful metric for your real estate investment journey? We will explore what is the 2% rule in real estate today.
What is the 2% rule in real estate investing?
As a real estate investor, you may have heard of the 1% rule. Essentially, the 2% rule is a more stringent version of the 1% rule.
So what is the 2% rule in real estate investing?
The 2% rule is a rule of thumb in real estate that can help you decide if a property is a good deal. With the rule, you will compare the monthly gross rental to the property’s purchase price plus any necessary repairs. The rule states that your monthly gross rent should be equal to, or at least, 2% of the total investment in the property.
The 2% rule is a good starting point to help you weed out properties that don’t fit within your investment goals. With that, you can quickly scan the listings to find deals that meet the requirements of the 2% rule.
How do you calculate the 2% rule in real estate
The 2% rule is not a complicated formula, so don’t let the idea of math turn you away from this useful rule. With the help of this easy back-of-the-envelope calculation, you can sort through properties quickly.
Here’s the formula for the 2% rule:
(Purchase price + upfront renovations) X 2% = 2% of the purchase price
2% of the purchase price < gross monthly rent
For example, let’s say you buy a home for $95,000 and spend $5,00 on upfront renovations. The formula would lead you to a total cost of $100,000. With that, 2% of the purchase price would be $2,000 in gross monthly rent.
In the best-case scenario, you would want the gross monthly rent that you expect to bring in from a property to be higher than the 2% threshold. For example, let’s say you buy a property for $200,000. If you are only able to rent out the property for $500, then it wouldn’t satisfy the 2% rule. But if you were able to rent out the property for $4,500, it would more than satisfy the 2% rule.
Is the 2% rule practical?
As you peruse the examples above, you might have noticed that the numbers aren’t practical in every market. Unfortunately, the 2% rule is only a rule of thumb. And it won’t help you in every real estate market. In fact, it would likely prevent you from ever finding a ‘good’ deal in many markets across the country.
Although the 2% is practical in some markets, it is absolutely not feasible in others. Here are a few markets to consider when thinking about the 2% rule:
- In Los Angeles, California, the median home value is $826,566. But the median rent price is $2,353. With that, you would have a difficult time satisfying the 2% rule.
- In Miami, Florida, the median home value is $396,659. But the median rent price is $1,737. With that, you would have a difficult time finding a property that meets the 2% rule.
- In Baton Rouge, Louisiana, the median home value is $191,075. The median rent price is $1,029. Although it might still be difficult to find properties that meet the 2% rule, it could be more manageable in this market.
These are a few examples to show that the 2% rule is not always possible. If you want to abide by the 2% rule in those markets, then you would be stuck searching for properties for a long time. In fact, you may never come across a property that satisfies the 2% rule in those markets.
But that doesn’t mean that the 2% rule is not a practical tool to use. You can still use this rule as a starting point to assess the potential of a cash-flowing property. You can adjust your search to a realistic rate based on the market conditions where you are looking.
If you want to achieve the 2% rule, then you may need to consider looking at other real estate markets. As a long-distance landlord, you could capitalize on the possibilities offered by the 2% rule.
Pros of the 2% rule
With the 2% rule, you can quickly assess the profitability of a property. Without diving too deeply into the specifics of the property, you can make comparisons to the other rental rates in the market. You can make a decision to continue looking into the property or rule it out, knowing that it wouldn’t fit into your investment goals.
As you sift through dozens of properties, this can be a good way to filter down towards deals that align with your investment goals.
Cons of the 2% rule
The 2% rule is not the only metric you should look at when evaluating a potential investment property. You can make some quick assumptions based on the math. But you’ll still need to investigate the numbers of the property more deeply to decide if it is a good deal.
Don’t make an investment decision solely based on the 2% rule.
Is using the 2% rule smart investing?
You’ll have to decide for yourself whether or not using the 2% rule is smart investing. And your answer will depend on the market you invest in.
Suppose you are working in a market that offers an opportunity to regularly find properties that meet the requirements of the 2% rule. In that case, you should consider taking advantage of that opportunity. But if you work in a market that doesn’t have deals anywhere near the 2% rule, then sticking to this rule would force you to pass up reasonably good deals in your market.
Take some time to consider your investment goals. You may need to adjust the 2% rule to a percentage that meets your expectations for the market you want to invest in.
Want to invest smart and avoid big mistakes? Learn the top expensive mistakes to avoid in our free guide.
Other factors that will influence your return
Beyond the initial numbers you use to assess the property’s potential, there are other factors that will influence your return. A few include:
Researching the area will give you a better idea of the possibilities. In an area with a large population and a wide variety of jobs, the 2% rule might be harder to satisfy. But the long-term potential could be worth it.
Do your research about the area before investing.
Your personal risk tolerance will come into play when selecting an investment property. If you have a lower risk tolerance, you might decide to stick with the 2% rule no matter what. But if you are comfortable with more risk, you might choose properties that don’t quite satisfy this rule of thumb.
Cash flow is not the only way to make money with real estate. Appreciation also provides an opportunity to make money in real estate.
Appreciation is simply the rise in a property’s value over time. In some cases, it can be a viable way to grow your net worth. But remember that you cannot predict the future. With that, appreciation can be a dangerous game to play if you are solely relying on appreciation for your returns.
Vacancies will happen along the way. Although you will try to keep tenants happily installed and turn over the unit quickly, you will lose some potential cash flow due to vacancies.
Repairs are another certainty in real estate investments. You’ll encounter repairs at some point along the way. To prepare for this eventuality, build an emergency fund for your properties. You never know when a major repair bill is coming your way.
Should you use the 2% rule?
The 2% rule is useful. However, it is not the right rule for everyone. You’ll need to assess your goals and the market you plan to invest in to determine if the 2% rule is practical for you.
The bottom line
The 2% rule is a great rule of thumb to help you learn more about a potential property. Although it should not be the only metric you look at, it will help you sort through properties quickly as you look for a great deal.
With the help of the 2% rule, you can avoid some major investment mistakes. Want to avoid all of the expensive mistakes? Use our free guide to learn more about expensive investment mistakes that could hurt your investment goals.