​What Is The 2% Rule In Real Estate? Should Everyone Use It For Profitable Investments?

Investors in real estate use various rules, which help them organize their business and make the most benefit from it. A 2% rule is one of the main principles, which can be applied by businessmen. With the help of it, it’s much easier to define, whether a property is worth investing in. Today we will observe the issue of this rule of thumb and find out how you can use it in real life.

The essence of a 2% rule real in estate

It is otherwise called “The rule of thumb”. It’s used along with the other popular rules, applied in the property investment sphere. This guideline can be used by experienced investors and newcomers. Not all potential investors understand, however, what it means and whether they should follow it. The idea is as follows.

When you are not sure about investing your money in this or that real estate object, apply a 2% guideline. Look at the purchase price and the monthly rent: the monthly net rent should be at least 2% of the total purchase price to be potentially interesting. Such property will be worth investing in (surely, the more the percentage is the better).

Look at an example now. Let’s presume, the price of the selected property is $100,000. To fit into the rule, the monthly net rental income should be not less than $2,000. To calculate it, we took 100,000 and multiplied it by 0.02 (2%). The algorithm suits all sums, working in both directions. So, if an investor wants to buy a property with a monthly rent of $1,500, its max price should be capped to $75,000 ($1,500/0.02).

A 2% rule in real estate resembles a 1% rule, which is also applied in the industry, working in the same way. Actually, the 1% rule is more frequently met – since it represents a more realistic financial outcome. Thus, the main idea of the guideline is to choose real estate, which can provide a lucrative cash flow, which will more likely be positive than negative.

The practicality of the rule

The rule, surely, is not some theoretical thing. It is really helpful in real life and allows avoiding financial losses and other unforeseen problems. However, it can’t be used alone because an investor can’t get all the data required to make a successful investment only with it.

Generally, if the investment is made according to this rule, the purchased property is mathematically able to generate enough income to cover all the expenses and create a financial cushion for vacancies, unexpected maintenance, and other unforeseen circumstances.

However, when buying a property, many other factors should be taken into account, including location, the rate of development of the neighborhood, vacancy rate, type of property, and other factors that we have already written about in other blogs.

It’s important to understand that a 2% rule in real estate is not used for all types of properties. For example, when it concerns the houses and apartments in big and well-developed cities. In such a case, the location is crucial for the purchase price generation and rent. The guideline is more applicable in smaller cities. For instance, in Memphis, it’s quite real to achieve such a ratio nearly in all deals but not so in LA.

In most cases, however, investors can only purchase a property in very poor condition (dilapidating real estate) following the two-percent rule. It’s also possible to find such a ratio when the property market is weak, not strong. It’s required to mention that taking the situation with coronavirus into account, the rule becomes even less balanced all over the world. An opposite situation is with the growing prices for certain types of property, which are more relevant for people today, as well as in the ascending real estate markets, like the one in Ukraine – the local profitability is not rarely even higher than 2%.

Conclusion

The described guideline can’t be considered strict and always applicable by investors. It is rather “nice to have”. Such a method is able to provide investors only with the general information concerning the probable cash flow, without any particular insight. The formula does not take into account any other factors, risks, peculiarities, and features of a property. You are always advised to thoroughly estimate many other important factors, such as location, condition of a property, correlation of net to gross rental income, cash on cash (CoC), ROI, cap rate, appreciation, regional taxation…

However, a 2% guideline can help investors see a general picture of the possible cash flow fast – if the fast decision is important in their particular situation and time.