I have a love-hate relationship with the 2% rule: on the one hand, it is a pretty good estimator of the rent you should get based on a purchase price; on the other hand, the 2% part sucks.
Sorry about my choice of words. I took care of a seriously drunk late-night bar guy last night and he kept on vomiting and I was afraid he was going to suck that down into his lungs, so I got out the suction, sucked his throat out, then intubated him (put him on a ventilator). After that, everything seems to suck today. Seriously, stay away from the booze, late-night bar guys.
The 2% Rule
Having a quick way to estimate what price you should pay based on the rent is very enticing. I think that place is where the 2% rule comes. It says that if you can get 2% monthly in rent of the price you paid for the place, it is a good deal. In reality 2% is an amazingly good deal. This rule is very dependent on the market and location.
0.02 * (Purchase price + Rehab) = Monthly Rent
Some people don’t put in Rehab but I do. This is the total cost you will need to purchase the place, then get it rehabbed to rent-ready status. The 2% rule is probably good if you are in a very poor neighborhood, are in a market that sucks, or are investing in 2008. For the rest of us, stick to the 0.8% to 1% Rule. At least that is what I can reasonably get in my area. Sioux Falls, South Dakota, by the way.
Sioux Falls is the country’s best-kept secret, which is why I didn’t tell you earlier. The problem is, the secret is getting out and I’m hearing more and more about people from California wanting to out-of-state invest here. We generally have solid growth when the rest of the country is failing, and great growth when the rest of the country is doing well. Just keep in mind that this won’t last forever.
With growth, comes increased prices. That is great when the rent increases, not so great when housing prices increase. It is a seller’s market right now and that has a big effect on our ability to purchase SFRs for rental. Sellers aren’t as willing to deal and so the housing prices go up. While rents have been going up, they haven’t matched our 10% year over year rise of housing prices.
When you apply this rule, I think it is much better to calculate it for a range. You just don’t know what you will get for rent until you put it on the market. The rule doesn’t sound as good as the 0.8% to 1% Rule and historically Investors call it the 2% rule so I don’t have a good name for you.
Let’s look at Dumpy again. You know you love Dumpy. I do. Kind of like I love late-night drunk bar guy’s grandmother who came in to the ER with him (she was sober). He lived with her at age 27 and she doted on that fool all night and was such a sweet granny. But she enabled that behavior. He could do no wrong in her eyes. I love the grannys of the world but it would be nice if they, just once, had a Come to Jesus talk with their grandsons.
What were we talking about? Dumpy. Sorry about that. Dumpy’s purchase price was $106,900 and I put $26,420.40 in repairs and $9,600 in holding costs (rehab took six months) into the place. Total cost to me was $142,920.40. Applying the Rule, we get:
0.008 * $142,920.40 = $1,143.36
0.01 * $142,920.40 = $1,429.20
Therefore, we should be able to get rent between eleven hundred and fourteen hundred. I’m getting $1,125 monthly right now. This would be a terrible deal if we used the 2% rule, but it is OK for my area. Not great, but we will keep the rent for now (with the obligatory yearly increases).
Just keep in mind that this rule is one of many measuring sticks you will need to use to evaluate the property. Speak with your real estate agent and get a feel for what percentage is best to use in your area, then apply it to your deal analysis. Good luck and see you next time.