When you’re assessing the potential of a real estate investment, there are numerous metrics you can perform to determine if the property is viable. Among the most useful metrics is the 2% rule, which states that the rental income you bring in from an investment property should amount to 2% or more of the purchase price. By knowing what this rule means and how to incorporate it into your analysis, you can make a sound investment decision.
What Does the 2% Rule Mean?
The 2% rule is used by real estate investors to calculate how much rental income the property needs to generate. If you adhere to this rule, you can expect your cash flow to be positive if your monthly rent is 2% or more of the initial purchase price.
While this rule isn’t infallible, it’s a good way to estimate how much you need to earn from a property before you buy it. Let’s say that you purchase a rental property that’s valued at $300,000. If you collect $5,000 in monthly rent, this won’t pass the 2% rule. Depending on the size of the property, you could make the home available to multiple tenants, which would likely allow you to increase rental rates.
How the 1% Rule Compares
The 2% rule is an off-shoot of the 1% rule. This rule states that you only need to earn 1% of the property’s purchase price in rental income for it to be a sound investment. You’d need to earn $1,000 on a $100,000 property for it to meet this rule. There’s no consensus about which rule is more effective. However, a property will likely be more profitable if you’re earning 2% of its purchase price in monthly income.
Understanding the 2% Rule
The 2% rule gives you a good idea of how to set rental rates for your investment property. However, it doesn’t tell you if you’ll be able to collect that money with the property you’re buying. If you purchase a property for $100,000, adhering to the 2% rule should be doable.
However, investing in a $600,000 property means that you’d need to earn around $12,000 or more in rental income for it to qualify for the rule, which may not be possible. To determine if the 2% rule works for the property you’re about to invest in, compare it to comparable rentals in the area. If nearby properties are in the $8,000-$9,000 range, collecting $12,000 per month may prove untenable. When comparing properties, consider location, square footage, condition, and age.
Why the 2% Rule Isn’t Everything
While the 2% rule can be very helpful when you want to quickly evaluate the viability of certain investments, you shouldn’t rely solely on what this metric tells you. Before you use this rule to determine if you should make an investment, consider the downsides that come with doing so.
Estimations Aren’t Precise
As a real estate investor, you should perform numerous calculations and estimations before making investments. However, estimations aren’t precise. They don’t give you actual numbers. If you’re purchasing a rental property, two of the most important estimations are repairs and vacancy rates. The 2% rule is a good comparison tool that can simplify your search for a new rental property to invest in. Some properties that don’t meet the 2% rule could still provide you with positive cash flow.
Some Factors Aren’t Accounted For
There are two factors that the 2% rule doesn’t account for, which include net cash flow and the property’s condition or location. For example, let’s say you discover a small $50,000 home in New Jersey that allows you to collect $1,000 per month in rent.
Technically, this property meets the 2% rule. However, a property with such a low price is likely in awful condition. You’ll also be tasked with paying exceedingly high property taxes in New Jersey, which means that you could pay more than you earn from the property each month.
Great Investments Don’t Always Follow the Rules
Properties that don’t meet the 2% rule aren’t automatically bad investments. Even if a rental doesn’t adhere to the 1% rule, it might still be worth investing in. When considering these rules, you must also take your budget and portfolio goals into account. Most investments have trade-offs regarding risk, returns, and cash flow.
A property that brings in high returns might be riskier to invest in. Some of the risk factors to consider include a declining market, poor location, low property quality, or bad tenant quality. When the risk is higher, there’s a greater chance that you won’t earn the returns you’ve calculated.
The Bottom Line
Finding the right investment property to add to your portfolio means using the right calculations and information to make the best choice. It’s highly recommended that you use the 2% rule as the first step in deciding if you want to make an offer on a property. If you believe that a property is worth investing in, your next step involves performing more comprehensive research.
For example, you could study the condition of the nearby real estate market. Are rental rates in the area currently increasing? When performing your research, you may find that rental rates have been decreasing in recent months.
Before investing in a property, find out what the standard rent is for comparable ones. You should also identify vacancy rates. If vacancy rates are low but rents are high, there’s likely strong demand for rental units in the area.
Qualified renters also prefer living in places with low crime and good school systems. Weigh all these factors against your ongoing costs to make sure you’re confident in your decision. The 2% rule should just be one of the many guidelines you use when making a rental real estate investment. Contact LoanPathLoans today to discuss your financing options for a rental property.
