The 2% Rule
Here’s a great rule of thumb for buy-and-hold investors (rental property owners) who focus on single family houses. And again, this is a good rule of thumb to use to perform a quick, first-pass financial analysis on an investment to determine whether it’s worth looking at further.
The 2% rule states that, to make a good profit on a single family investment property, the gross monthly rents should be at least 2% of the total purchase price of the property. For example, if you could charge $1200/month in rent on an investment house that costs $60,000, you would make a good profit.
It’s important to understand that the 2% rule is a very conservative rule. I prefer to look at this rule as a “sufficient, but not necessary condition” to make an investment, meaning that if you find a property that meets the 2% rule, you likely will want to buy it, but just because a property doesn’t meet the 2% rule doesn’t mean that you don’t want to buy it. In fact, in many parts of the country, it can be very difficult — if not impossible — to find properties that will generate rents that are 2% of the purchase price of the property. But this certainly doesn’t mean that you can’t make money in these parts of the country…you just need to work harder to evaluate deals.
Let’s look at an example of the 2% rule in action, and see why it works:
Say you find a single family investment property for sale for $25,000. Additionally, let’s say that based on your research of the local market, you believe you can rent that property for $500. As you can see, this property meets the 2% rule — monthly rents are 2% of the total cost of the property.
With a gross rent of $500/month, using the 50% rule, your monthly NOI (amount remaining for mortgage and profit) would be $250:
NOI = Gross Rents * 50% = $500 * .5 = $250
Assuming a 100% fixed interest loan at 6% for 30 years, your monthly mortgage payment would be exactly $150, leaving exactly $100/month in profit:
Profit = NOI – Mortgage = $250 – $150 = $100
Most SFH investors consider $100/month to be minimum acceptable return per month, and any property that meets the 2% rule will generally return at least $100 per month. Also notice that in this example, the investment generated a good return on property that was 100% financed. If you were to put 20% down on this property, the cash flow would be even higher.
Remember, the 2% is great, conservative financial estimation tool, but it may not work in your local market or for the properties you’re considering. Just because the 2% doesn’t work in your area doesn’t mean you can’t make money; but if it does work (or you can make it work), you’re sure to find some great investments!
According to your 2% rule, that’s 24% interest per year. And you say 2% is conservative? Which part of the country are you from? Show me so that I can buy a house for $25,000 and rent it out for $500/month.
Hi Lana,
First, when I say 2% is conservative, I mean it the other way — that you can be getting less than 2% but still be doing okay (1.5% is a lot more common).
That said, I’m in the process of purchasing a small house in a nice suburb of Atlanta for $35,000. House is only 10 years old, needs less than $5K in rehab to get it nicely rent ready, and will rent for between $900-925 per month. Not all deals around here are that great, but getting between 1.5% and 2% in rent isn’t too difficult. There are many areas of the country where you can find these types of deals, though there are also many areas of the country where finding 1% deals is tough — those are areas where you probably don’t want to be holding rentals.
JS,
Sorry friend but I have to call BS on this one.
As the lady said – 2% per month x 12 = 24% Gross Yield.
High returns generally = High risk.
24% on SFR is VERY HIGH RISK – potentially going to land you in a gang-land, crack-head locale!
Invariably a big chunk of this 24% GR will be eaten thru “costs” leaving you with a large ulcer and “hopefully” a reasonable NETT return.
If you said 1% / month for long-term rental – i would agree this is a sensible metric.
peace
Sandman –
Like I wrote in the article, the 2% rule is “a sufficient, but not necessary condition.” That means that if you have a property that meets the 2% rule, it’s almost certainly a great deal. But, just because you have a property that doesn’t meet the 2% rule doesn’t mean it’s not a great deal.
In my area, 2% deals are not uncommon, and you can certainly find them non-war areas. My House #18 (my first rental property) was nearly at 2% and I have a property coming up in a few weeks that we’ll likely hold as a rental that will be more than 2%. Both of these properties are in very good areas, not far from where I live.
That said, I recognize that many areas don’t see deals like this, and that’s why I was careful to point out that a deal doesn’t need to meet this criterion just to be a good deal. Plenty of 1.5% deals are great deals, especially if financed correctly, and some 1% can be decent as well.
Here’s the math:
If you assume 50% of gross rent will go to expenses (including vacancy, concessions and capital costs), a 2% deal will generate a 12% cap rate. A 1.5% deal will generate a 9% cap rate. And a 1% deal will generate a 6% cap rate. Obviously, these returns can be improved by smart financing, but those are the all-cash returns at the various rent percentages.
Obviously, every market is unique, but having experience in a few different markets (both urban and rural-ish), I typically see 0.7% to 1.1% as the usual range. I would call it the 1% rule, and follow it up with “as long as it is close to 1%, then it’s worth a look.”
I am considering renting my house that i purchased for $55000. I am moving out of the neighborhood. Not a great neighborhood but not bad. I like it here. Rental comp says they can get 700-750/month. They take 10%. Any input would be much appreciated! I have no idea what I’m doing but it seems in this market of no one buying this would make sense.
Hi Melissa,
If you’re going to be generating about $725 per month in rent, your NOI (basically the cash left after all your expenses other than a mortgage) will be about half of that (see my article on The 50% Rule). So, you’ll be making about $360 per month. That’s about $4350 per year.
If you bought the house with cash ($55,000), your return on investment will be $4350/$55,000 = 8%. Not too bad for a house that you weren’t expecting to be purchasing as an investment. If you have a mortgage, you’ll need to factor those costs in to determine if it’s still a good deal.
But overall, if you don’t think you can sell, it looks like you’ll be getting a decent return as a rental.
J thank you for getting back to me. I do have a mortgage. How do I figure that one out? It $55k. I have $53k left on it. Mrg p/i is $375 a month. I am so on the fence about it. The market isn’t great. I may be able to clear 60 or 65k in a sale..maybe.
Thanks again.
My mortgage rate is 3.6%
And that 375 includes taxes of $75.
Hi Melissa,
Like I said, if you have $725/month in rent, your NOI will be about $360/month. Your mortgage P&I is $300/month. So, the amount you’re taking home each month (on average) is $60. That’s about $700 per year.
Not a lot, but still better than losing money.
If you can sell the house and clear $60-65, you’ll walk away with a $10K profit or so. That sounds like a better option than renting for $60/month. But, then again, that’s just me and everyone is different.
Thank you for your input.
Need advice. We’re looking for investment property. We found a 5 plex, totally renovated (looks brand new), 4 – 2 bdrm, 1 ba, and 1 efficiency. Utilities are included in the efficiency’s rent. Each apt. has a large storage space in the also beautifully finished basemt. No laundry hook ups, but there is a coin operated washer and dryer in the basemt. Price is 295,00, down from 310,000. Kept empty to show but since it didn’t sell, they are starting to rent the units. Spec sheet shows rental income at 2,500. We think we could get more rent than she’s asking. This is no where near your 2% rule, not even 1%. We’re considering offering 250,000-275,000 ish. What’s going on here? Renovate and the sky’s the limit? After looking at so many other cheaper duplexes (older homes) in terrible neighborhoods, this is the Taj Mahal. Across from a hospital, where we could tap into renters. Also, there’s a 23’x14’8 room that could be rented – storage/meeting room. What’s your take? We’re new at this.
Hey Lisa,
Without knowing your specific financing terms, it’s difficult to determine what your likely cash flow will look like. But, it’s safe to say that if your monthly rents (about $2500) will only be about 1% of the purchase price (about $250K), you’ll want to make sure that you have a decent financing in place (under 5%, amortized for at least 20 years, etc) in order to maintain enough cash flow that you won’t have to stress about coming out of pocket each month.
I would start by putting together a pro-forma analysis. This might help:
http://www.123flip.com/education/introduction-to-analysis
Thanks for the info to read. Just wondering if this property sounds overpriced considering the monthly income. If she’s asking 290k, don’t know how low she’ll go so that it looks profitable to us.
Hi Lisa,
Based on the types of returns I look for, this property is WAY overpriced…but then again, I like great deals… 🙂
Hi J Scott,
I find this 2% rule really hard to accomplish here in the NYC area. Can you please take a look at Manhattan and Queens Prices and rents on Trulia and let me know if you can find something that come close to .5%. All of these are under .5%. Are all the real estate investors in Manhattan money losers? I certainly don’t think so because more than 80% of NYC is rented out.
Hey Steve –
Some locations just aren’t suited for rental cash flow. NYC is certainly one of them, as are most high-priced markets. It’s nearly impossible to find property that will have positive cash flow in markets like that.
The reason why everything is rented out is that many investors are more interested in speculating on appreciation than they are about cash flow. They don’t need the small monthly income — they want the big payoff if/when the value of the property increases 2 fold or more.
If you’re looking to invest for cash flow, you’ll want to find more reasonably priced markets…
Hi J Scott,
Thanks for your reply. I am currently located in NYC and I think you are right about people investing for appreciation in property instead of cash on cash return. If I was in a more reasonably priced market, what kind of cash on cash return would you say is a modest return? an aggressive return?
Thanks,
steve
Hi Steve,
In this market, it shouldn’t be too difficult to get 12-15% returns if you’re willing to do a little bit of looking around. If you find a good market and a good property and employ some leverage, you can get 20-30% returns (I have a couple of those properties).
Hi Scott,
I wanted to get your take on my situation. I want to rent my current home andbuy another to live in. I owe 75k on a 79k 4.15% 30yr mortgage with a monthly payment of $607 which includes taxes escrowed. I can rent it for $1000/mo. I would include water and sewer with rent which is about another 60/mo. i may live in the new home for a year, rent that out and move back into the original property. My biggest concern is how much it hurts you at tax time….having to claim all the rental income as regular income?
scott is right about the 2% rule being common in certain parts of atlanta .in fact over the past couple of years i have personally been buying 3 bed,2 bath houses and townhouses (1400 to 1600 square feet) for 20 to 25 k and remodle them (me doing all the work) for 5 to 7 k-then i rent them for 800 to 900 per month which is actually 3 %
If you were me, would you rent, sell or get a reverse mortgage? I owe $890K on my home built 25 years ago for $1.1M — property taxes are $1K/mo; mortgage $3.9K/mo; insuranc e is $500/mo for total expenses of $5,400/month. (utilities, trash, garbage, yard maintenance another $1.8K/month. I’m told the 6,500 sq ft house could rent furnished for $15k/$18/mo . My house could sell for $4.5M less 50% taken for taxes & commissions– broken down for — 25% fed tax, 15% CA state tax; 3.8% Obamacare Tax; and 6% realtor commission. Subtract out $890k mortgage and $100k to move, there’s not much left to help me survive financially for another 30 years: I’m 62 years old, single female, scared. What would you do: sell, rent, get a reverse mortgage? Thx for sharing you expertise. I thought my equity would be my nest egg in old age. Now I’m depressed.
Deborah –
By my calculations, you’d net about 3.3M at sale (after commissions and payoff of mortgage). That’s a gain of about $3M — about $300K wouldn’t be subject to taxes because it wasn’t a gain and the first $250K of the gain is tax free. So, about $500K would not be subject to taxes. The remaining $2.8M would be subject to about 40% tax (I don’t believe you’d pay the Obamacare Tax, as this isn’t an investment, but you should check with a tax professional). Worst case, you pay 45% taxes, and have about $1.5M left in addition to the $500K. For a total net of about $2M (assuming I’m not missing anything). If you can invest that at 3-5% into something very secure or real estate related, that’s $60-100K per year to live off of. If you can get higher returns, that additional annual income.
Now, if you rent, you’d be making about $180K per year in gross rents. About 50% of that would go to expenses, leaving about $90K per year. And then you’d have your mortgage payment, which I assume is about $5-7K per month, leaving you with only $20-30K in annual income.
If you need the income to live off of in the near future, it looks like selling is the best bet of those two scenarios. I’m not well versed in reverse mortgages, so I can’t comment on that option.
Regardless, I would find a professional financial planner and tax person to walk you through each of the options in much more detail than I can — they should be able to help you figure out how to leverage that equity as best as possible to provide you with annual income for the rest of your life. Good luck!
I have 5 rental properties, 2 of which are paid for by using this rule. I’m in Northwest NC. We have lots of properties out there in the $30k range. I always think of a potential investment property strictly based on the numbers. If I can’t get 1.5% per month of the purchase price (regardless of whether it’s financed or not) then I walk from the deal. 2% is preferred, but most of the time it’s not realistic. If I can obtain a property and pay for the rehab for $35k and get $575/month then I can’t lose. The way to make money renting properties is to do the management and rehab with your own hands (sweat equity). If you do this several times over several years, you can really build a big portfolio. I’ve recently struck a deal with. my local bank to set me up with a $100k credit line putting those 2 paid for properties up as collateral. I should be able to buy 3 more properties with this money to make my monthly profit about $2k ish per month. (Rents $4625 – taxes, insurance, interest, maintenance, $2500 = net $2100ish per month) this scenario will yield $25000/year profit. Since my plan is to keep acquiring properties, this amount is reinvested in paying down the credit line so I can borrow against it again every year to purchase another property. As the profit increases, it’s reinvested to make the time between buying properties shorter. Bottom line – regardless of financing, if the rent isn’t at least 1.5% per month of the cost (price + rehab) of the property, stay away from it. jsoakes31@yahoo.com
[…] 2% rule—whereas hardly ever explicitly outlined—states one thing like “to make a good profit on a […]
[…] heard of the “2% Rule” or the “1% Rule” in real estate investing? These rules of thumb compare the property’s […]
[…] heard of the “2% Rule” or the “1% Rule” in real estate investing? These rules of thumb compare the […]