For investors looking to maximize cash flow, the 2% rule is a guideline to enable smart decision making
Real estate investing is full of “rules” around what makes a smart buy. The 2% rule is one that often gets applied to rental investment properties. The idea behind the 2% rule is that if you can rent the property for 2% of the price you pay for it, you’ll make money.
Sounds easy, right?
Of course nothing in real estate, or investing, is ever easy, nor are any so-called rules set in stone. The 2% rule offers a guideline for whether a property is worth a closer look and worth investing in.
Let’s see how the 2% rule works as a starting place, and also explore some caveats.
What is the 2% rule?
If you’re looking to buy a property to rent as an investment for positive cash flow, you want to make sure it’s actually going to make money. Using the 2% rule as a guide, if you spend $100,000 on a property, you need to collect at least $2,000 in rent each month for healthy cash flow.
Most seasoned investors consider the 2% rule as more of starting point than an ironclad law. It’s a good way to filter a long list of properties for closer consideration. But if you set your filtering too tight, you might miss a good opportunity that doesn’t fit the rule but is still a sound investment.
The 2% rule works best on less expensive properties
The 2% rule tends to work well as a tool for finding inexpensive investment properties in lower-cost markets. It has been often employed in areas such as the south or midwest.
For instance, in a city like Cleveland, Ohio, it’s possible to buy a $50,000 property and rent it for $1,000 a month in accordance with the 2% rule. In markets where a property doesn’t appreciate in the same way as New York or Los Angeles, following the rule can create steady cash flow.
The 2% rule doesn’t tell the whole story
However, it would be a mistake to buy a property based only on its ability to pass the 2%.
As an investor, you need all the facts about a property to make a good decision. You also need to factor in mortgage rates, taxes, HOAs or condo fees, insurance, estimated repairs, vacancy rates, and rental management fees.
After you account for these items, a property that passes the 2% rule might look like a poor investment. Use a property calculator (or make your own) to make sure you’re not missing any hidden costs.
Remember that the opposite may also be true. A property that at first appears to net under 2% rental income might turn out to have very low overhead in other areas.
The 2% rule doesn’t work in every market
Some markets won’t support the 2% rule. It’s unlikely, for instance, that you’d get a renter to pay $10,000 a month for a property you bought for $500,000. That doesn’t mean properties that cost $500,000 can’t be a good investment. It just means they won’t meet the 2% rule.
In fact, in expensive real estate markets like San Francisco, it may be tough to even reach a half percent. But investors in hot markets can make up for low rental income with capital appreciation on the real estate itself.
Of course, this speaks to the vast differences in local geography, with each requiring its own distinct investment strategy. Research to see how your city stacks up against the top 10 U.S. cities to buy real estate, and always keep a lookout for red flags that property value might be sinking.
The pandemic effect has created opportunity in real estate investment
The pandemic turned life upside down for many of us. But real estate rebounded swiftly. The recovery is creating real estate investment opportunities in abundance.
In fact, the post-pandemic residential housing market in the U.S. is hot. Meanwhile, as working remotely becomes more common, areas once thought of as vacation spots are becoming live/work havens. Demand is surging for more outdoor space and room for a home office.
Key takeaways about the 2% rule
- It offers value as a starting point for finding properties with good cash flow.
- It shouldn’t be the only thing you consider when evaluating a property.
- It’s most useful for evaluating low-cost properties, especially in undervalued real estate markets.