You’re getting into the real estate investing business for a reason: to generate cash flow. Even if you enjoy finding great real estate deals, renovating them, and helping people meet their housing needs, there’s still a financial component to your decision. And for an investor to profit from the investment, the asking rents and monthly income need to exceed your cash outflows.
So, how do you know if the monthly rent will be enough to cover expenses and leave some revenue left over? Enter the 2% Rule. This real estate investing guideline can help you estimate cash flow and returns on rental properties to see if it’s worth exploring the potential investment further.
Learn all you need to know about the 2% rule and how to apply it to your real estate investing.
What is the 2% Rule?
The basic premise of the 2% rule comes from equity and stock market trading. In this application, the guideline is to never invest more than 2% of your capital in a single stock. It encourages diversity as a method of risk management.
Applied to real estate, the 2% rule advises that for an investment property to have a positive cash flow, the monthly rent should be equal to or greater than two percent of the purchase price.
For example, let’s say you purchase a rental property for $200,000. According to the 2% Rule, your cash flow will only be profitable if the monthly rent equals or exceeds $4,000 ($200,000 x 0.02 = $4,000).
Put another way, divide the monthly rent by the purchase price. If the amount is less than 0.02, it’s not meeting the 2% rule. If it’s equal to or greater, it’s a 2% property.
The 2% Rule is a fast way to guess cash flow potential and serves as a benchmark when evaluating investment opportunities. When you’re a beginner at property investing, it’s easy to calculate.
What are the benefits of using the 2% Rule?
Investors need to move fast, as there is high competition in some housing markets for the best investment properties. As soon as a property that fits the criteria comes on the real estate market, you’ve got to decide: keep searching or do a deep-dive analysis to see if this could be a good investment.
The 2% Rule is one of those down-and-dirty fast tools that help estimate if a rental property could be a solid investment opportunity. By no means should it be taken as a concrete rule! So many factors impact a property’s cash flow and valuation.
In addition to sorting new listings, you can use the 2% Rule to quickly compare prospective rental properties and decide which one might bring in more income.
What are the 2% rule’s limitations?
Using the 2% rule is all about figuring out the rent-to-sales price ratio. However, a positive number doesn’t guarantee every property will be a profitable return on investment.
Some investors consider the 2% rule a “unicorn” rule. Think about it: if you purchase a vacation rental property for $500,000, can you rent it for $10,000 a month? Not likely. That’s why finding a property that genuinely meets the 2% rule can be challenging. It’s not an accurate metric of a potential investment’s performance. Think of any “percent rule” as a guideline for further exploration.
It’s important to note that while real estate investing has many significant advantages for building passive income, cash flow is key to your success.
The 2% rule relies on averages rather than an individual property analysis. It doesn’t consider the many variables that determine whether an investment is profitable in the long run, like property appreciation or the cash-on-cash return. That’s why beginners shouldn’t rely on it alone.
Let’s say you find a condo unit that meets the 2% rule. As you start looking into the condo’s actual operating expenses, like the association fee, the property taxes, and vacation rental insurance, the real metrics show the actual cash flow would be closer to zero. This makes buying the condo a poor return on investment.
Not only can high interest rates on property financing tank your returns, but running a rental business requires expenditures on property insurance, taxes, regular upkeep, and renovations. That’s why you should factor in all the associated costs to get a more accurate picture of how a rental property will perform financially over time. You’ll need to know the local market conditions, such as the vacancy rate.
The 2% is just a ratio based on the property’s purchase price. It doesn’t tell you the property’s actual condition. That $100,000 list price you found on Zillow might be a good deal on paper, but not so much when the property needs $50,000 in renovations. And that’s just what you can estimate from the photos.
Real estate investing requires due diligence; speaking with experienced investors or hiring an experienced real estate agent can help you make smarter decisions when considering investment properties.
What about the 1% rule?
The 1% rule is similar to the 2% rule but less conservative. This rule states monthly rental income must be equal to or greater than 1% of the purchase price for an investment property to generate cash flow. For example, if a rental property costs $200,000, the monthly rental income should be at least $2,000.
The 1% rule is generally used by real estate investors who are comfortable with taking on higher-risk investments and have the right resources (like rental management) to maximize returns.
Whether you’ve been investing in rental properties for years or just starting out, understanding the 1% and the 2% rule can help you screen potential rental properties when speed is of the essence.
A quick tip: let’s say you know the property will need repairs or renovations before it can be put on the market for tenants. You can estimate the rehab costs and add them to the purchase price. Then apply the 1% or 2% rule to see if the expenditure makes sense with the market’s asking rent.
If the property already has a tenant, you can use the 1% rule to evaluate if the asking rent covers the property’s list price. For instance, let’s say there’s a single-family home valued at $175,000 currently generating gross monthly rent of $1,600 per month. By rearranging the 1% formula, you can see that the yearly gross rent covers $160,000. That indicates the property make be overpriced or, if you explore the property further, perhaps it’s time to raise the rent.
What to remember about real estate investing
Whether using the 1% or 2% Rule, remember that real estate investing comes with its own risks and rewards. Before diving into the rental property market, ensure you have a solid understanding of the area where you plan to invest, your financing options, rental regulations, real estate depreciation, and associated taxes.
Do some research on rental properties that have recently sold in the area. This can provide insight into rental rates and sales prices and help you determine if a potential rental property is a good investment opportunity.
A long-term vacancy can seriously impact a property’s cash flow. Two months vacancy on a $1,500-a-month rental is 16.7% of your yearly revenue. And even if it’s not vacant, you still need to pay property taxes, insurance, and any mortgage payments.
Investing is a balancing act between returns, cash flow, and risk management. Sure, you may spot an opportunity that ticks all the boxes of the 2% Rule, but is it worth taking on given its high-risk factors such as location issues, poor property quality, or market depreciation? Will your projected cash flow actually materialize after assessing these risks? Does the after-repair value still generate a profit? These are essential considerations to make before proceeding.
Although many properties are deemed satisfactory, they don’t necessarily abide by the 1%, 2%, or even 0.5% rule. Instead, it all comes down to your budget and what you aim to achieve with your investment portfolio.
Next steps if a property meets the 2% rule
Let’s say you choose to use the 2% rule to evaluate potential properties. If the property meets the 2% rule at first glance, the next step is to ensure that the property has long-term value. Start by looking at property appreciation over time and researching any nearby developments planned in the area. This can affect property values positively or negatively, so it’s essential to be aware of these factors when making an investment decision.
It’s also worth noting that rental income may not always come from tenants alone but from other sources, such as Airbnb rentals or short-term leases. This can increase monthly cash flow; however, taxes and regulations vary from state to state. If short-term renting is part of the investment strategy, know the local regulations and market demand before investing in a property.
Do a detailed analysis of the actual cash flow. Include property management expenses, taxes, insurance, and capital repairs. These can add up quickly if you’re not prepared for them.
Finally, if you’re still unsure about investing in property, talking to a real estate professional or property manager can help you analyze the property and determine if it’s a good fit for your investment goals.
Investing with the 2% rule
The bottom line? Limit using the 1% and 2% rules to evaluating rental properties at first glance. They should never be used as the only factor in making an investment decision. Do your due diligence and consider all factors before buying property so you can ensure your capital investment is secure.
When you are ready to start real estate investing, Arrived simplifies the process by selecting some of the best rentals available. Invest in any of our properties, and you’ll benefit from long-term appreciation. Start browsing through all the available homes now – what are you waiting for?
