What is the 2% Rule?
The 2% rule is a screening criteria for real estate that says the monthly income from rent should be at least 2% of the value of the property. For example if the purchase price of a property was $100,000, then the minimum monthly rent to meet the criteria would be $2,000 or $100,000 X .02 = $2,000.
Where did the 2% Rule Come From?
The 2% Rule is a repackaging of the Gross Rent Multiplier or GRM. The GRM is defined as GRM = Purchase price / Gross Rents. Where the GRM is primarily used in commercial property, doing the calculation for the 2% Rule or the 1% Rule, or whichever percentage you choose as your screening criteria are primarily used for single families and small multi-family purchases.
The GRM is essentially another way of saying how many years it would take to pay off the asset with 100% of the gross rents.
It is inversely proportional to the 2% Rule. Where the GRM goes down the higher the rents are relative to the purchase price. The percentage calculated for the 2% rule will go up.
Example of using the 2% Rule
Here is an example of how to use the 2% Rule as a screening criteria. This was on a brief look through a neighborhood, I spent a minute or two looking at what is currently available in this area. Which is really how a screening tool should be used. Taking a list of properties and quickly going through them to decide if they are worth further review.
1422 Cedar Ave
I found this listing on Zillow. Looking at the photos, I figure it could be rent ready for about 5-10,000. It has been the current price for over a month so there is a good chance there is a bit of wiggle room on the purchase price.
The next step is to evaluate the market rent. A quick way to do this is to go to Rentometer and enter the address and how many bedrooms it has. I then use the median rent and go from there for the screening stage. It requires more work to do the full underwriting before a purchase, but this search will do for now.
- List price $85,000
- Closing cost allowance $5,000
- Remodel allowance $5,000
- Median rent $950
- Total Invested $95,000
- $950 / $95,000 = .01 or 1%
This property meets the 1% Rule. Which can be an acceptable return. In today's market, it is very unlikely to achieve a 2% return in a decent neighborhood with a SFR without some forced appreciation. You have to decide for yourself what ratio you will pursue. Which ones will help you reach your goal.
Challenges with the 2% Rule
It is not an immutable law for investing. Because assets are typically priced according to their expected income and risk, the ratio of expected rent income compared to purchase price raises as the quality of the asset drops. The two big things to look out for that cause the investment quality to drop are:
- Lower quality neighborhood
- Lower quality product
- More deferred maintenance
By sliding up and down the scale of quality, you will get very different rental incomes for the same value of asset. For instance, a relatively new construction duplex in a more affluent neighborhood might be $400,000 and rent for $2500 a month. Putting it at .5%. This asset may be a fit for a specific model, and may be a good investment for someone.
If you place your sole focus on the 2% Rule, you will be ignoring other important criteria that go into making a purchase. I see this all the time with out of town investors. Part of it may be from lack of experience, part of it may be from being further disconnected from the asset, where they do not let emotional issues like owning a "nice" asset get in the way of their decision. I see many people purchasing rentals that have glaring issues and are in areas where property management is difficult simply because it looked good on paper.
Neighborhoods where property management is difficult are usually ones where you will have trouble finding tenants that meet industry standard screening criteria at anything close to the median rent of the neighborhood. These are not impossible to manage, but will require a more hands on approach or a property manager that really knows how to deal with that asset class.
How NOT to Use the 2% Rule
Do not use the 2% rule as the end all be all for underwriting of an income property. It will leave you making questionable decisions.
Do not let it drive you to asset classes or neighborhoods where you are not comfortable owning.
Do not ignore differences in operating costs because a property met the 2% Rule.
How to use the 2% Rule
You can use the 2% Rule as a screening criteria to weed out properties that do not match your model(s). There are thousands of properties available in most markets, and running full underwriting on every property is not feasible. So you need a few quick ways to sift through the noise. The 2% rule can be helpful for that.
The specific number of the 2% Rule needs to be adjusted to your market and investment model. Many people use the 1% Rule, or 1.5%. Since there are trade offs of long term appreciation potential, potential for the home to go down in value due to being in a "warzone", etc. To determine the screening criteria to use for a specific model, you will need to run the full numbers on a few properties and determine what is acceptable for you. Then you back out what the required rent to value ratio is and you have a screening criteria to find more similarly priced assets.
You should use it to compare similar assets. Comparing a multi-family with great amenities and a SFR in a run down neighborhood using the same 2% Rule factor will not lead to great results. You should compare SFR's of similar size in what you determine to be similar neighborhoods.
The 2% Rule can be a great tool to help with screening. You can use it to quickly process through hundreds or thousands of listings to determine which properties that warrant further investigation.