What Is the 2% Rule in Real Estate?

Jul 21, 2021

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When investing in real estate, the goal is always to make a profit. However, you will only make that profit and get the return on investment if you identify and understand the rules of real estate. One of those is the 2% rule. Experts in real estate came up with these rules to help investors make better decisions when buying rental properties.

So are the real estate rules helpful to investors? Are they viable when it comes to property investing? Let's look at the 2% rule and its impact on investors when buying rental properties.

What Is The 2% Rule In Real Estate?

The 2% rule is the guideline that real estate investors use to determine if a rental property they intend to buy is worth the investment. To make a good investment in rental property, you have to ensure that the monthly rent it produces makes at least 2% of the purchase price.

To determine this, you'll need to divide the monthly rent by the purchase price. If the rent-to-price ratio investment property gives you less than 0.02, the property doesn't fulfill the 2% rule. This mean that the cash flow you'll get from the property is not the amount that a good investment should generate.

Are There Properties that Meet the 2% Rule?

While every investor's dream is to find a property that meets the 2% rule of real estate, most of them do not succeed. Even finding the ones that meet the 1% rule has been an uphill task in most instances. Imagine how hard it can be to double that amount and get the average return on real estate.

When searching for a property, it is important to know that investors don't quickly sell such a cash cow. If someone is selling a 2% rule real estate property easily, it must be riddled with issues, or the real estate market is fragile.

Even though finding a real estate property that meets the 2% rule is difficult, such properties still exist. To be an investor, you must also be a good researcher. You'll have to sort through the bad properties to find the good one, but that's sure to take time.

Can You Convert a Property to Fit the 2%?

Most investors don't get a 2% property outright. Instead, they purchase a less worthy one and convert it. To convert a property into a 2% one, you have to analyze it beyond the monthly rent and the sales price. Don't assume that any property will automatically convert into good cash flow. You still need to analyze the property further to determine if it meets the 2% rule.

Why Investors Should Use the 2% Rule

The 2% rule tells about how much the property is likely to produce a good cash flow. It reveals how the property is expected to perform in the market and how much money you'll get from it. The rule helps to determine the rent, as well as the sales price of the property. Essentially, it helps investors determine whether the property is worth investing in or not.

More specifically, the rule tells you about the monthly cash flow the property will bring in to help you determine whether it's worth the purchase price. According to real estate experts, a property is supposed to bring in at least 2% of the initial purchase price monthly to be a good investment.

If the property you intend to buy has the potential of fulfilling this rule, then consider it a good investment. But don't forget to calculate in the other costs that come with managing a rental property. Also, consider management issues such as finding tenants, determining security deductions, and all expenses.

Problems with the 2% Rule

The 2% rule is not the only thing you should consider when purchasing a property because it doesn't tell you everything.

One of the essential things that isn't considered in the 2% rule is the location of the property. It's necessary to understand the specific neighborhood of the property to determine the area's vacancy rate. If the property stays vacant for a few months, this will be enough to eat up the cash flow. The location also matters in the appreciation and depreciation of the property.

Another thing that the rule doesn't consider is how much maintenance the property will need based on location. A property located where the climate is harsher or has a rougher neighborhood is likely to need more maintenance. In most cases, this means higher expenses. The rule also doesn't take into account the property's current state, the incurred costs of maintenance, and other additional costs. All these factors can affect the results of the 2% rule.

Finally, the 2% rule in real estate misses out on real estate taxes. Any real estate investor must understand how much tax they're likely to pay. The taxes can either build or destroy a deal for investors; hence, it is essential when purchasing an investment property.

Why Many Properties Don't Meet the 2% Rule

While the 2% rule is still a good way of determining an excellent property to invest in, this is not always the case. Many properties are in perfect condition but don't meet the 2% or the 1% real estate rule. Some only meet 0.5% or as low as 0.25%, and you'll still find experienced investors going for them. Those wholesaling real estate investors prefer properties with a lower percentage because they have experience with how such properties work.

What these investors are considering are returns, cash flow, and risks. Some properties perfectly meet the 2% rule but carry significant risks, including bad neighborhoods, low quality, declining market, and high vacancy rates. A better property with, let's say, 0.5% might appear to bring in less cash flow, but it's a good investment in the long run.

So, before jumping on a property that meets the 2% cash flow, consider its condition, the physical location, and the market.

What About the 1% Rule?

Like the 2% rule, the 1% rule is another barometer used in real estate to determine whether a rental property can be a good investment. The only difference is that instead of the property would have a rent-to-price ratio that is less than 0.01. For example, if you buy a rental property at $100,000, it should return at least $1,000 every month for you to consider it a good investment.  It follows the same guideline as 2% but mainly applies in markets with much tighter margins.

Summary

Investors can choose to abide by the 2% rule in real estate to determine their propert's returns. However, the only thing that differentiates failure from success in this context is how you can mitigate the risks of this investment. You can use the 2% rule real estate or any other rule of thumb but make sure you also consider other factors that make a property worth the investment.

SimpleShowing can help make this possible by helping you purchase the property of your dreams. Get in touch with us and let out team of experienced agents help you make sure your investment is a worthwhile venture.

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